What is the merger? Ethereum upgrade is a big crypto moment

Several months into a likely crypto winter, token prices have fallen like leaves from a tree, falling to the ground where they may remain for months, if not years. But even as industry star Bitcoin has struggled to recover from losses that halved its value, Ethereum has risen like a phoenix from the snow-covered ashes – rising nearly 70% in value in recent weeks.

The revival most likely stems from a promising narrative in the crypto world: “the Merge,” an upcoming technology upgrade to the Ethereum blockchain. More than two years in the making, the merger is already being heralded by crypto experts as a defining moment for Web3, one that could move toward blockchain technology that could one day power the world.

On August 10, Ethereum developers conducted their third and final test of the upgrade before it goes live on September 15. The run-through, which took place on a training network called Goerli, has successfully prepared the engineering team for the grand finale, as well as investors for a big rally.

“It would not be an understatement to say that the Ethereum merger is the most anticipated event in crypto history,” Tom Dunleavy, senior analyst at crypto research firm Messari, wrote this week. And according to James Butterfill, head of research at crypto management firm CoinShares, over $159 million has flown into Ethereum in the past two months.

For some, it has sparked hype that a long-awaited “flipping” — the hypothetical moment when Ethereum overtakes Bitcoin as the top crypto token, first predicted in 2017 — may finally be on the horizon.

The promise of the merger

The merger matters, partly because Ethereum is the blockchain variant that makes up the vast majority of Web3 technology today. The world’s second largest cryptocurrency is built on it (ETH), as well as most NFTs and blockchain games such as the massive Axie Infinity and Alien Worlds. It also pioneered the architecture of smart contracts, or coded programs that run automatically when certain conditions are met, to do everything from auctioning off a rare collectible to canceling a rent.

But if we were ever to live in some kind of techno-future, where virtual cash changes hands in an instant and algorithms divvy up free-flowing digital assets among billions of people, there must exist a blockchain with the capacity to log trillions of transactions every day. Currently, the Ethereum blockchain can only crunch around 6 kilobytes of data per second (in the 7 years since its founding, it has accumulated over 9 terabytes of archive data). Now imagine transaction volumes swelling exponentially, as crypto moves from fringes to standard, and applications grow beyond finance into art, music and gaming spheres. Can blockchains create such an increase without servers freezing, consumer taxes increasing or energy costs skyrocketing?

That’s the looming question, and the merger is the first step toward finding an answer. Crucially, it will not immediately affect Ethereum’s scalability – the blockchain’s transaction capacity, including transaction speed and so-called gas prices that go with them, will remain the same – but the hope is that the new infrastructure will support a future system that can spread.

It will be the first of five major upgrades on Ethereum’s roadmap in the coming years: The others, meanwhile, have been called “surge,” “verge,” “purge,” and “splurge.” At its final destination – and after a switch known as “sharding” takes place – the blockchain will be able to log 100,000 transactions per second, the chain’s founder Vitalik Buterin said at a conference in July. Today, the capacity is only 15 per second, according to Coinbase.

All in all, it is literally a beacon of light in the dark of crypto winter. The first prototype of Ethereum 2.0, created in December 2020, is called “Beacon Chain” – and it has been running in parallel with our version of Ethereum for almost two years, recording all transactions as developers tinkered with the mechanics. Once it’s ready, the two chains will “merge”, converging like trains on a railway track (Goerli is actually named after a train station in Berlin). The old system will go down and a new one will dawn, bringing with it the possibility of a better Web3.

To a greener world

One of the loudest criticisms of the growing Web3 economy has been its carbon footprint, largely due to a consensus mechanism known as proof-of-work (PoW). Consensus mechanisms allow blockchains to determine how much money is in any person’s digital wallet, and therefore must be engineered to defend against entities that hijack the blockchain for malicious purposes. PoW ensures this by demanding huge energy payloads from those who encode the blockchain transactions – more than any single company can reasonably control. The whole process, known as “mining”, can eat the carbon equivalent of the country of the Netherlands in a year.

But it is a far less carbon-guzzling consensus mechanism. Called proof-of-stake (PoS), it instead works by claiming a sum of cryptocurrency as collateral, in a process known as “staking”. A number of newer blockchains now use PoS for their sustainability – but until now the top two cryptocurrency tokens, Bitcoin and Ethereum, which together hold nearly 60% of the global crypto market cap, both used PoW.

That will change when the merger transfers Ethereum’s blockchain from PoW to PoS, making it the biggest test so far of this consensus mechanism in the wild. According to developers, the move could cut energy consumption by 99.95% and bring the network’s greenhouse gas emissions back to earth.

New tokenomics

As Dunleavy tells Fast company, the merger will also disrupt the tokenomics of a $200 billion cryptocurrency, which has perhaps been its biggest appeal to investors. Part of that, he says, comes from a shift in supply and demand. In the current system, so-called validators, who encode blockchain transactions, are awarded 2 newly minted Ethereum tokens – meaning that every time a new block is added to the chain (every 15 seconds), 2 ETH are released into circulation. However, when the merger happens, the price will be cut to 0.2 ETH, drastically reducing the inflationary pressure on Ethereum. Some believe that this dynamic could even lead to a reversal in the next 12 months.

Another factor, he explains, is the elimination of forced sellers in the market: “Every day, when miners receive tokens, they have to sell some of them to pay for their electricity and mining equipment . . . but stakers do not need to sell their tokens. It takes a lot of selling pressure off Ethereum.”

Ethereum’s kingdom is coming

As with most undertakings of such gargantuan proportions, the merger had been perpetually delayed, frustrating so-called crypto degenerates awaiting the next phase of the Web3 revolution, as the timeline for the merger stretched from mid-2021 to late 2022. Then in July, it revealed finally its target date, Ethereum’s price rose 20% in a single day.

But it is not without controversy. There are concerns that proof-of-stake is less secure than proof-of-work: In theory, an entity with a cryptocurrency war chest could set up enough of a stake in Ethereum that it could single-handedly manipulate the blockchain by encoding erroneous transactions .

Then there are the miners. Ethereum mining – which tasks supercomputers with solving complex mathematical puzzles for the sole purpose of generating a huge energy payload – has become a lucrative venture, as the fastest miners are rewarded with chunks of ETH. Traset has given rise to an industry worth an estimated $19 billion, according to a recent report by Messari. Miners made over $620 million in July alone, and according to Dunleavy, they can harvest up to $20 to $30 million per day. Many of them have fronted fortunes in cash, invested in supercomputer equipment, as well as venture capital. But the move to PoS could be a death knell, rendering mining mostly obsolete as a relic of PoW.

The looming concern has led some to call for a “hard fork” of the Ethereum blockchain, where the new Ethereum will launch as planned, but the old Ethereum will still live on, with one chain instead of two. Both would have tokens traded on crypto exchanges – one proposal, from prominent Chinese crypto miner Chandler Guo, lists them under ETHS and ETHW, respectively. Although a fairly niche campaign, it has won at least one major advocate in Chinese crypto-tycoon and Tron founder Justin Sun.

It won’t be the first time Ethereum forks. In 2016 – during one of the most frenetic sagas in blockchain history – the network split after hackers exploited a flaw in the smart contract code for one of the first ever Decentralized Autonomous Organizations, or DAOs, to be built on the Ethereum blockchain. After attackers drained $60 million and threatened to hold the blockchain hostage, developers made the controversial decision to split the chain, create a new Ethereum with fund allocations back to pre-hack status, and return the loot to its rightful owners. The hacked chain now exists as Ethereum Classic, but many have remained loyal to the original – the token, ETC, is still in the top 20.

But now, with all phases of the Merge greenlight, Ethereum is rushing towards its September destiny. Time will tell if there is enough green to bring the market out of crypto winter.