Ethereum’s big upgrade raises big questions, complications for NFTs

What happened

Leading smart contract platform Ethereum underwent its biggest upgrade yet, as The Merge was successfully executed on the morning of September 15th. Often analogized as “changing the engine of a plane mid-flight”, the platform swapped its energy-intensive proof-of-work consensus mechanism for an environmentally friendly proof-of-stake alternative.

Although this transition will not immediately affect Ethereum’s performance, it is a necessary first step towards subsequent upgrades that will improve throughput and efficiency. Once these stages are completed, Ethereum will be able to handle thousands of complex platforms and applications that use NFTs.

However, that does not mean that NFT holders, especially those based on Ethereum, do not have important decisions to make today. For example, a long-awaited Ethereum fork, i.e. a derivative that sticks with proof-of-work, could result in NFT holders having duplicates that have wildly different values. In addition, NFT prices have fallen in the days since The Merge as part of an overall market sell-off.

Broader context

Ethereum is the dominant home for NFT activity and trading, accounting for 76% of all NFT volume. Then follows Axie Infinity’s sidechain Ronin with 11% share of trading volume, Solana with 7%, Flow with 3% and Polygon with 1%. The successful merger, along with subsequent updates planned in the coming months and years called Surge, Verge, Purge and Splurge, should help the network protect its edge against competitors offering cheaper and faster transactions.

However, that doesn’t mean The Merge didn’t leave loose ends. Upset by the upgrade that cut them out of the network, a group of Ethereum miners have banded together and launched a forked version of the Ethereum chain that retains proof-of-work, the new chain is called EthereumPoW (ETHW). For NFT holders, this means that they can now own duplicates of their assets, but their value will depend on the level of exchange support and the general use of this forked network.

The largest NFT marketplace, OpenSea, announced that it would only support NFTs on the upgraded Ethereum PoS chain. Similarly, the creators of the Bored Ape Yacht Club collection, Yuga Labs, announced that they intend to only recognize licensing and copyright to the collection for owners of the NFTs on the upgraded PoS chain.

On the contrary, competing NFT marketplace Rarible took the opposite stance. Rarible stated that they will recognize all copies of NFTs resulting from a fork created in the same wallet address when they were held on Ethereum. Duplicate NFTs can also cause confusion, opening the door to new scams and carpet pulling, in a space already full of bad actors and malicious activity. More companies and projects are expected to make similar decisions as the fate of the ETHPoW fork becomes clearer in the coming days.

Although there is no data yet on the value of ETHPoW NFTs, ETHPoW’s rollercoaster ride in recent days indicates that the NFTs will be worth significantly less than their regular counterparts.

Since its launch on September 15th, ETHPoW hit an all-time high of $60, or about 4% of ETH’s total network value, before quickly falling in value 82% to $11, where it trades today. This trend indicates that Ethereum holders who were rewarded with the ETHPoW airdrop have dumped their airdropped tokens as exchanges started listing the token and increased liquidity.

Assuming this trend continues and EthereumPoS emerges as the winning canonical Ethereum chain, we may see similar dynamics among duplicate NFTs now living on the EthereumPoW chain. This will lead to significant discounts in the value of NFTs on ETHPoW compared to their EthereumPoS counterparts.

Key quote

“The merger may disrupt many NFT projects that are not ready for the change and are not anti-fragile. Some projects will have problems due to technical issues and we may face a large influx of fraudsters. There will likely be more Ethereum forks , which can create confusion and lead to fraud when duplicate NFTs enter the system. As a result of the confusion, NFT holders can lose the original version of their NFTs if they are not careful,” said Alex Obchakevich, co-founder of Misfits DAO.

Prospects and implications

Another important implication of The Merge, and the elimination of the carbon footprint, is that it could open the door for ESG-conscious developers and investors to enter Ethereum’s NFT industry.

That said, Proof of Stake is still unproven in such a large network. It remains to be seen whether the network can maintain decentralization and avoid institutional value capture over time where large entities participate in strikes and gain a greater share of ownership and control over the network. There are already concerns that two entities, the crypto exchange Coinbase and the betting platform Lido, control almost 40% of the total betting power of the network. Furthermore, SEC Chairman Gary Gensler suggested this week that Ethereum’s switch to proof-of-stake could move it closer to being a security in the eyes of the regulator.

It is also important to reiterate that the merger has not affected scalability or transaction throughput, meaning that transaction fees for sending and trading NFTs are unchanged and may still remain high depending on gas usage and demand. During periods of high activity, gas fees for NFT transactions can reach hundreds of dollars, pricing out many users and encouraging them to adopt second tier chains such as Polygon and Arbitrum or competing tier one chains such as Solana, Flow, Tezos, and Avalanche.

Low transaction fees are important as high fees take out many NFT use cases, especially in the gaming and metaverse space. Many NFT game weapons, avatars and skins are likely to trade at relatively low values, requiring faster transaction speeds and lower costs to be financially viable.

To reduce transaction fees and meaningfully increase scalability, users will have to wait for the Surge, Verge, Purge and Splurge upgrades.

Much is also uncertain about how or if intellectual property rights will transfer to NFT duplicates on forked versions of Ethereum. Most NFT creators will likely only grant rights to holders of NFTs on the most widely used post-fork chain, likely EthereumPoS.

Ultimately, the answer can be determined by the collection creators, evidenced by Yuga Labs declaring that they will only recognize IP rights of NFT holders in the canonical EthereumPoS chain. In this case, new buyers must be careful which version of the NFT they buy, as they may think they are the owner of the asset, but instead discover that they are not entitled to any of the associated rights.

If major players in the NFT ecosystem recognize the legitimacy of both the PoS and PoW chains, the forked EthereumPoW chain could dilute the value of existing NFT collections due to the increase in supply. This will also create a messy situation around IP and commercial rights, which could potentially lead to major disputes between NFT owners. Ultimately, the market will legitimize which NFT assets are valuable based on liquidity and acceptance by the wider community.

Decision points

Investors betting on the ESG narrative acting as a strong catalyst for capital allocation among institutional investors can see the Ethereum ecosystem as a major asset to the ESG movement. This will support the price of Ether, but will also indirectly support the value of top NFT collections built on top of the network. The winning smart contract platform will attract the most talent and capital, strengthening the entire NFT ecosystem native to that chain.

It may be prudent for investors and traders to wait until the dust settles before making any decisions for their Ether and NFT holdings. This can take several days or weeks or play out completely. Additionally, investors should follow the guidance provided by the marketplaces, wallets and other service providers they regularly interact with to see which chains and assets they want to support.