Ethereum Aims to Become the Internet of Cryptos with ‘The Merge’

Playing around with Ethereum is no small feat. Still, the network’s developers aren’t just fooling around — they’re overhauling the plumbing and mechanics of Ethereum in an upgrade enthusiasts are calling The Merge.

The change, set to happen around September 15, is a major technological risk and could be a transformative moment for crypto. Companies like

Coinbase Global

(ticker: COIN) will feel the impact almost immediately. And there will likely be ripple effects throughout the industry, affecting everyone from crypto miners to chip makers who

Nvidia

(NVDA), and investors with some Ether in their portfolios.

“The merger is the most important upgrade in crypto history,” said Sami Kassab, analyst for crypto research firm Messari. “It’s similar to changing the engines on a plane mid-flight. A mistake in the code can wreak havoc on the crypto ecosystem.”

Several years down the road, The Merge could be crypto’s answer to critics who say the industry is a colossal waste of energy. Ethereum, with a market cap of nearly $200 billion, now uses the same method of validating transactions as Bitcoin.

In that process, known as proof of work, computers compete to solve cryptographic puzzles. The network reaches a consensus on the winner, proving that a block of transactions is valid and should be added to the chain. The winner then receives some Bitcoin, a practice known as mining.

It is very energy intensive, requiring a huge amount of computer work and electricity. Ethereum was built on the same system, and it’s also an energy hog, consuming about the same amount of electricity in a year as countries like the Netherlands.

Now developers are scrapping that model and moving to a much greener system for processing transactions, called proof of stake. Instead of mining, Ether owners use their tokens as collateral to validate transactions, and “pitch” them to the network in exchange for a return, paid with the Ether token. To participate, a staker must deposit 32 Ether tokens, worth about $50,000, and run some software. The system randomly selects validators, like a lottery. Crypto exchanges and other companies run staking pools, so that everyone can participate with smaller amounts of Ether.

The shift should eliminate Ether mining. Doing so will cut Ethereum’s energy use by more than 99%, according to the Ethereum Foundation, and greatly reduce the network’s carbon footprint.

It’s just the start of a bigger makeover. The merger should also reduce the newly minted ether produced each year. And developers are planning several upgrades over the next few years aimed at increasing Ethereum’s throughput and lowering usage fees. Ideally, they aim to make Ethereum the crypto-internet – a base layer for apps, financial services and many more digital assets such as NFTs.

“Today we are talking about decentralized finance. In 10 years, if we succeed, people will just call it finance, period,” said Justin Drake, a researcher for the Ethereum Foundation who is helping with the project. “For almost any financial transaction, they will use Ethereum.”

Nevertheless, The Merge can also have injuries. It can cause errors, outages or loss of tokens as the current Ethereum blockchain merges with a new one, called Beacon. “A laundry list of items must continue to function seamlessly post-merger to keep leverage and liquidations at bay,” said Sean Farrell, head of digital assets at Fundstrat Global Advisors.

The stakes are high because so much of the crypto industry has a stake in its performance – from exchanges like Coinbase to mining, NFT platforms and stablecoin issuers. “Typically, when you push out a change for a website and it breaks — well, it’s not the end of the world. In this case, you can lose a lot of money,” said Katie Talati, director of research at Arca, a crypto-asset manager.

The most immediate effect could be on Ether’s price. Since mid-June, the token has risen more than 50%, while Bitcoin has remained flat. Both tokens are down around 60% this year, under pressure from rising interest rates and weaker demand for highly speculative technology.

A successful merger could make Ether ripe for another run, some analysts say. That’s partly because the move to proof-of-stake should reduce the issuance of tokens to about 0.5% a year, down from 4.5% currently. Reducing the issue can push up the price. “In the current market, supply and demand are relatively in balance,” said Steve Goulden, senior analyst for Cumberland, the crypto arm of trading firm DRW Holdings. “After the merger, there will be a material supply shortfall.”

Meanwhile, demand may get a boost as owners stake their tokens in return for a return. Investors can earn 4% to 8% by betting, depending on how much revenue the network generates and other factors, according to Talati. Institutional funds with a mandate to invest in environmentally friendly assets can also buy Ether as the blockchain’s carbon emissions become less of an issue.

The upgrade could be a boon for companies like Coinbase. The exchange is developing a service that makes it easy for investors to stake Ether, with Coinbase taking a 25% cut of the revenue generated. The efforts business has already “grown into a major source of subscription and service revenue and is growing well,” CEO Brian Armstrong said on an earnings call in August.

However, as in any technical upgrade cycle, there will be a legacy of obsolescence. Some of the biggest losers in this cycle could be mining companies that spent hundreds of millions of dollars on hardware that could be rendered worthless. Executives at Hut 8 Mining (HUT), which mines both Bitcoin and Ether, said in August that they were studying how to adapt their Ether miners to other tokens or projects.

Hive Blockchain Technologies

(HIVE), another miner, said a shift to proof of stake “could make our mining operations less competitive.”

Chip manufacturer Nvidia looks like another casualty. The company’s graphics chips and cards have been adopted by industry to mine Ether. But demand now seems to be disappearing. Nvidia, whose stock is already suffering a slowdown in gaming and other core areas, said on its latest earnings call that it could not predict how reduced crypto mining might hit demand. Analysts for investment bank Baird say The Merge is likely to “generate a wave of mining GPUs [graphics processing units] on the second-hand market, which exacerbates the stock problems.”

In the longer term, Ethereum may pose more of a threat to rival blockchain networks. Blockchains and tokens such as Solana, Avalanche and Tezos were launched with the promise of being faster and more efficient than Ethereum. All run on proof of stake and have established various uses, but if Ethereum pulls the plug on the upgrades, they may run out of time to prove their relevance. “Now that Ethereum has obtained proof of stake, there is less of an argument for many other blockchains,” says Kassab.

Some crypto companies are not taking The Merge lying down. The threat has led a few miners to launch a competing Ethereum blockchain, called a fork, using the proof-of-work method. The idea is to create an Ether spinoff and a parallel universe of smart contracts, NFTs and decentralized finance, or DeFi, applications.

The potential for dueling Ether blockchains is forcing companies to choose sides or declare neutrality. Exchanges such as Coinbase, Binance and FTX say they will apply their normal listing standards to the forked tokens and may allow them to trade. Creators of crypto apps such as Uniswap, Compound and stablecoin USDC have pledged to only recognize the new Ethereum blockchain.

An Ethereum split has some crypto leaders worried that fraudsters may find new ways to perpetuate theft and fraud. “Someone is going to spend 80 real Ether on a fake Bored Ape,” says Robert Leshner, founder and CEO of Compound Labs, a DeFi company. “There will be all kinds of disasters,” he says, advising investors to wait for the kinks to be worked out and “do nothing.”

Another unknown is how Washington will respond. Officials at the Securities and Exchange Commission have indicated that Bitcoin and Ether should be treated as commodities – potentially removing these tokens from SEC oversight. But because many investors will buy Ether with the expectation of a return, some advocates believe it could make the token look more like a security. If the SEC agrees, crypto exchanges like Coinbase could be vulnerable to lawsuits or enforcement actions if they allow it to trade on their platforms anyway.

Changes of this magnitude are an “opportunity to try to separate the previous analysis from the current analysis,” says Teresa Goody Guillén, a partner at BakerHostetler and former SEC attorney, who believes that Ether still will not qualify as a security. The SEC did not respond to a request for comment.

As with all things crypto, the hype surrounding The Merge is already outpacing the reality. Advocates say it could be the start of a renaissance of useful apps and services — finally silencing critics baffled by a multibillion-dollar industry that has yet to find a raison d’être other than speculation. Conversely, if it flops, it will be another setback for a technology that is long on complexity and short on the real world.

“The most important part of The Merge is the narrative,” says Kassab. “It’s something everyone’s talking about that could bring people back to Web3 and crypto, assuming it’s successful.”

The crypto market is now suffering from a crisis of confidence, having lost $2 trillion in value in the past year and angering governments around the world. A successful merger cannot revive the market or its reputation. But it could at least make crypto a little greener down the road.

Write to Joe Light at [email protected]