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15 Sep 2022
Insight
London
This week one of the dominant blockchains Ethereum undertakes 'The Merge': a high-stakes move to a new platform, slashing its vast energy use and paving the way for major upgrades. HSF digital law expert Alex Cravero explains the impact and separates crypto from cryptic
The Merge has huge expectations riding on it. What's involved in the process?
Alex Cravero (AC): The Merge has been in the works for years. It involves a two-step process to usher in a new proof-of-stake system called the Beacon Chain – which validates transactions by selecting computers holding more of the network's cryptocurrency. This replaces the existing proof-of-work system known as Mainnet, where transactions are validated by computers competing to solve complex mathematical puzzles. The first step was a network upgrade known as Bellatrix, which was completed on 6 September. The second step is the bit everyone is excited about, called Paris, which updates the execution layer and moves everyone onto the Beacon Chain. This marks the end of mining on Ethereum.
Why are supporters hailing it as a breakthrough for blockchain?
AC: Principally because of how little energy proof-of-stake systems use compared to proof-of-work. This upgrade will see Ethereum reduce its energy consumption by around 99% overnight. The Ethereum network runs the second most popular cryptocurrency in the world and currently consumes the same energy as Singapore. This is the first and possibly last time we'll see something like this, certainly at this scale.
First and last?
AC: Yes, at this scale. Ethereum is second in popularity only to Bitcoin, the original proof-of-work system. Whether Bitcoin ever moves to a proof-of-stake system is contentious but I think it's unlikely. The ethos underpinning the Bitcoin community is well understood and respected, and I doubt any proposal to transition will come from them. That would mean someone outside the community with vast resources would need to take over to table and pass any proposal. That may have been possible when global mining power was consolidated in China but that power is increasingly distributed and so this is ever less likely.
How significant is the push towards proof-of-stake across the blockchain?
AC: Very. Current estimates say around 60% of the total market cap of cryptocurrencies run on proof-of-work. The energy these systems need can be astronomical and increases all the time - Bitcoin today consumes more energy than Argentina. This is a good test case for an industry that needs to build a greener future. Though, with that said, it's not just about energy efficiency.
Alexander Amato-Cravero, Director, Emerging Technology (Advisory)
Then what else?
Proof-of-stake systems are seen as fundamental to a mainstream digital economy. Take throughput of transactions. Proof-of-work makes validating transactions slow, and the increasing complexity of the mathematical puzzles to validate transactions means times will only get slower. The throughput of Ethereum Mainnet – around 20 transactions per second – doesn't come close to non-crypto payment systems like Visa, which run about 1,700 per second, which in turn are dwarfed by proof-of-stake systems like Avalanche running at north of 4,500 per second. Slow processing means sometimes having to wait for tens of minutes for a transaction to be added to the chain, and causes wildly fluctuating – and often very expensive – 'gas' (transaction) fees. Proof-of-stake should facilitate faster processing of transactions and more stable pricing, which leads to a more scalable, accessible and resilient financial ecosystem.
Bitcoin today consumes more energy than Argentina. This is a test case for an industry that needs to build a greener future.
Alexander Amato-Cravero, Director, Emerging Technology (Advisory)
Not everyone is convinced by The Merge – some say it undercuts the democratic, decentralised ethos inherent in blockchain. Is this shift an inevitable part of crypto assets going mainstream?
AC: Most arguments made against proof-of-stake systems are less about law and regulation, and more about technology risk. The main one is that proof-of-stake is more susceptible to 51% attacks where a malicious actor uses majority control over the network's cryptocurrency to alter the blockchain in their favour. Decentralisation sits at the heart of this argument. As proof-of-stake systems rely on algorithms that prefer computers that hold more of the network's cryptocurrency, it is theoretically easier for malicious actors to amass the cryptocurrency needed to control the blockchain. I'm not sure how much weight I give this argument. Looking at proof-of-work systems, over recent years the growing cost of the powerful computers and energy needed for crypto mining has led to activity consolidating into a small number of professional mining businesses. This may not pose a significant risk to larger networks like Bitcoin or Ethereum Mainnet, but it could for smaller ones. The risk of centralisation and 51% attacks could be argued for either system.
This year's cryptocurrency sell-off has grabbed headlines for months – is the smart money expecting a prolonged rebound?
AC: That's a big question. The crypto market is facing a number of challenges. Increasing regulation, falling consumer trust after high-profile failures like Terra and broader issues that are reducing the disposable income people are willing to invest in riskier assets. These are all contributing to a sustained dip. Financial markets move in cycles and we are living through the first cycle for crypto. How long that takes to run its course, and what it will look like on the other side, are anyone's guess. But cryptocurrencies will continue to have a role in modern financial ecosystems – people see value in this.
Alex Cravero leads Herbert Smith Freehills' Digital Law Group in the UK, EMEA and US
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