Ethereum, the world’s second-most valuable digital currency by market capitalization, completed a long-awaited upgrade to its system on September 15.
The move, known in the cryptocurrency community as “The Merge”, is expected to slash energy costs and lay the groundwork for more use of crypto technology in mainstream applications, including finance.
The upgrade was one of the most eagerly anticipated events in crypto’s history. But the process is complicated. Here’s what to know about it.
What is Ethereum?
Ethereum is a blockchain – a publicly-viewable, distributed ledger that verifies and records all transactions on the network. The platform was conceived by Russian-born Canadian programmer, Vitalik Buterin, in 2013. What sets apart Ethereum’s blockchain from Bitcoin’s is that it allows users to run “smart contracts.” These are computer programs stored on the blockchain that automatically perform a chain of actions when certain conditions are met. This functionality has allowed many people to build a large network of financial institutions, such as decentralized exchanges and lenders, and even other digital tokens on the Ethereum blockchain.
What is ‘The Merge’?
The years-long effort has changed how transactions are verified on the Ethereum blockchain. In December 2020, Ethereum began running on two parallel blockchains, one using the legacy system to validate transactions and another blockchain using proof-of-stake for developers to test and improve. This merge combines the two blockchains into a single one using a proof-of-stake system for validations.
Ethereum, like Bitcoin and other lesser-known cryptocurrencies, previously relied on network participants (so-called miners) solving complex mathematical problems to validate transactions, a process known as proof of work. For their effort, miners receive newly minted digital tokens. Ethereum’s new process will rely instead on what’s called proof of stake and it will eliminate the need for miners. Proof-of-work systems have recently come under fire for using tremendous amounts of electricity. By contrast, proof-of-stake systems consume very little electricity.
What is Proof of Stake?
In a proof-of-stake system, individuals or companies act as validators (instead of miners), staking their own Ethereum tokens (known as ether or ETH) as collateral to validate transactions and secure the network. Validators are incentivized to do so by the chance to earn rewards, namely additional ETH tokens.
How will Proof of Stake Make Ethereum More Secure?
The proof-of-stake system makes decisions about updating the Ethereum blockchain by a vote among the holders of the cryptocurrency. Voting power depends on how much ETH has been staked. Large holders, known as validators, must invest 32 ETH, and are required to perform certain duties to maintain the blockchain’s integrity, such as confirming the transactions of other validators. Their “staked” tokens can be destroyed if the validators misbehave, such as putting through invalid transactions.
The promise of financial punishment for validators misbehaving also makes it harder for the Ethereum blockchain to fall under a “51% attack” in which bad actors take control of more than half of the network, allowing them to write parts of the blockchain as they wish.
What Does the Transition Mean for Ethereum’s Energy Consumption?
The switch to proof-of-stake by Ethereum will likely decrease its electricity usage by an astonishing 99.95%.
It is no secret that proof-of-work crypto mining uses a jaw-dropping amount of electricity. Bitcoin and Ethereum were using more electricity than Sweden or Argentina before the merge. In Bitcoin-friendly Texas, for example, crypto mining gobbles up about 3% of local demand for electricity during times of peak usage, and may account for a third of new electricity demand in Texas over the next decade. Since much of that electricity is not generated by renewable sources like wind and solar, crypto is responsible for large amounts of carbon dioxide and other emissions that contribute to climate change.
All that new demand for electricity is difficult to meet. In some states, crypto mining has led to restarting of retired plants that burn fossil fuels for electricity, increasing mining’s climate change impact.
Crypto mining also uses and burns quickly through large amounts of computer hardware, resulting in almost 38 kilotons of electronic waste (or “e-waste”) per year. E-waste is typically contaminated with harmful substances like mercury, lead, or arsenic, which can cause neurological problems or cancer. Ethereum’s proof-of-stake system should reduce its e-waste output dramatically, according to Alex DeVries of Digiconomist.
What Are the Investment Implications of the Transition?
The merge could help push crypto further into the mainstream not only because of proof-of-stake’s more energy-efficient process but also because of the financial incentives that users will now have to stake their ETH and earn a yield on it.
The transition to a proof-of-stake model should lower inflation and increase staking yields, which should make it more appealing for institutional investors. Needham & Co. estimates that the annual new issuance of ETH will decline from around 4.9 million annually before the merge to roughly 970,000 annually post-merge.
Right now, the yield for staking ETH sits at 4.1% for validators, but it could rise to as much as 7% after the merge. This means more revenue for companies that are allowing investors to pool their ETH holdings (there is a 32 ETH minimum at the moment) for staking, such as crypto exchanges Coinbase and Kraken, as well as institutional and individual validators.
Rodrigo Sermeño covers the financial services, housing, small business, and cryptocurrency industries for The Kiplinger Letter. Before joining Kiplinger in 2014, he worked for several think tanks and non-profit organizations in Washington, D.C., including the New America Foundation, the Streit Council, and the Arca Foundation. Rodrigo graduated from George Mason University with a bachelor's degree in international affairs. He also holds a master's in public policy from George Mason University's Schar School of Policy and Government.
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