Ethereum, the world’s second most valuable digital currency by market capitalization, completed a long-awaited system upgrade on September 15.
The move, known in the cryptocurrency community as “The Merge,” is expected to significantly reduce energy costs and lay the groundwork for increased use of crypto technology in consumer applications, including finance.
The upgrade was one of the most anticipated events in crypto history. But the process is complicated. Here’s what to know about it.
What is Ethereum?
Ethereum is a blockchain – a distributed, publicly visible ledger that verifies and records all transactions on the network. The platform was designed by Russian-born Canadian programmer Vitalik Buterin in 2013. What sets Ethereum’s blockchain apart from Bitcoin’s is that it allows users to execute “contracts intelligent”. These are computer programs stored on the blockchain that automatically execute a chain of actions when certain conditions are met. This feature has allowed many people to create a large network of financial institutions, such as exchanges and decentralized lenders, and even other digital tokens on the Ethereum blockchain.
What is “The Fusion”?
This years-long effort changed the way transactions are verified on the Ethereum blockchain. In December 2020, Ethereum began operating 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 merger combines the two blockchains into one using a proof-of-stake system for validations.
Ethereum, like Bitcoin and other lesser-known cryptocurrencies, previously relied on network participants (called miners) solving complex mathematical problems to validate transactions, a process known as proof-of-work. For their effort, miners receive newly created digital tokens. Ethereum’s new process will instead rely on something called proof-of-stake and eliminate the need for miners. Proof-of-work systems have recently been criticized for using huge amounts of electricity. In 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 (called ether or ETH) as collateral to validate transactions and secure the network. Validators are incentivized to do so by the possibility of earning 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 through a vote among the cryptocurrency holders. Voting power depends on the amount of ETH staked. Large holders, called validators, must invest 32 ETH and are required to perform certain tasks to maintain the integrity of the blockchain, such as confirming transactions from others. validators. Their “staked” tokens can be destroyed if validators misbehave, such as performing invalid transactions.
The promise of financial penalties for misbehaving validators also makes it harder for the Ethereum blockchain to fall under a “51% attack” in which bad actors take over 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?
Ethereum’s switch to proof-of-stake will likely reduce its electricity consumption by 99.95%.
It’s no secret that mining proof-of-work cryptocurrencies uses a breathtaking amount of electricity. Bitcoin and Ethereum used more electricity than Sweden or Argentina before the merger. In bitcoin-friendly Texas, for example, crypto mining is gobbling up about 3% of local electricity demand during peak periods and could account for a third of new electricity demand in Texas over the next decade. Since much of this electricity is not generated by renewable sources such as wind and solar, cryptography is responsible for large amounts of carbon dioxide and other emissions that contribute to climate change.
All this new demand for electricity is difficult to meet. In some states, crypto mining has prompted the restart of retired factories that burn fossil fuels to generate electricity, increasing the impact of mining on climate change.
Crypto mining also rapidly uses and burns large amounts of computer hardware, resulting in nearly 38 kilotons of electronic waste (or “e-waste”) per year. Electronic waste is usually contaminated with harmful substances like mercury, lead or arsenic, which can cause neurological problems or cancer. Ethereum’s proof-of-stake system is expected to significantly reduce its generation of e-waste, according to Digiconomist’s Alex DeVries.
What are the investment implications of the transition?
The merger could help push crypto further into the mainstream not only because of the more energy-efficient proof-of-stake process, but also because of the financial incentives users will now have to stake their ETH and stake it. get a return.
The transition to a proof-of-stake model should reduce inflation and increase staking returns, which should make it more attractive to institutional investors. Needham & Co. estimates that annual new issuance of ETH will increase from around 4.9 million per year before the merger to around 970,000 per year after the merger.
Right now, ETH staking yield sits at 4.1% for validators, but it could rise to 7% post-merger. This means more revenue for companies that allow investors to pool their ETH holdings (there is currently a minimum of 32 ETH) for staking, such as crypto exchanges Coinbase and Kraken, as well as institutional and individual validators. .