Fintech Fridays 16/09: Ethereum Merge
By Paavo DCastro and Owen Jackson
As of yesterday, the Ethereum network has officially merged from Proof of Work to Proof of Stake. This has been a long waiting and highly anticipated move in the cryptocurrency market, and it will likely have ongoing implications not just for Ethereum but for other coins as well. In this article, we look to explain what exactly this merge means and give a little bit of insight into its implications.
What is Proof of Stake and Proof of Work?
Proof-of-stake (POS) and Proof-of-work (POW) are consensus mechanisms that process transactions and create new blocks on the blockchain. Under Proof-of-work, miners expend energy to solve cryptographic puzzles to add and verify blocks on the blockchain. Under Proof-of-stake, miners are replaced with validators who are responsible for checking, verifying and sometimes, if randomly chosen, creating blocks themselves. POS uses a staking system whereby users can become a validator by staking capital (Ethereum or another token) into a smart contract. This acts as collateral and will be taken if the validator is dishonest or lazy.
POS has many benefits over POW, mainly because it is much more environmentally friendly. Since much less energy is required to create and validate blocks on the blockchain.
Environmental Implications of Ethereum Merge
On Proof of Work, the Ethereum Network was running on 8.5GW of power (about 20% of what China installs in solar panels per year). After the merge, Ethereum will be running on just 85MW, or 1% of its original amount and this has been a major selling point of the merge.
This is a significant step in reducing the carbon footprint of Ethereum and cryptocurrency, particularly if other coins begin to follow suit. It will also be interesting to see if the correlation between Bitcoin and Ethereum begins to break down, as Bitcoin continues to operate on the POW mechanism. This may be a point of separation for Ethereum which could attract green investors. However, this is still a relatively large amount of power relative to other technology, so it is still far from Carbon Neutral.
Investment Implications of Ethereum Merge
With the merge already occurring, market census is unclear, with Ethereum trading flat after the merge. This comes after a very negative market sentiment in the days leading up to the merger. Short sellers took hold in perpetual futures markets, driving prices down and funding rates (compensation to long position holders for shorting) to 16-month highs. $1.2 billion in Eth flowed into exchanges pre-merge, which usually highlights selling intentions. This may be on the back of concerns about centralisation, with some reports that two addresses control 45.38% of POS nodes. These reflect negative market sentiment. In the long term, many are taking bullish sentiment based on security upgrades, better scalability, reduced ether supply and a more user-friendly chain. This could benefit investors long-term, with many of these being catalysts for upside.
While market sentiment is unclear, what is clear is that these are uncertain times for millions of eth investors and the Dapps built on Ethereum like Aave, who hold billions in deposits. With a historic event in the history of cryptocurrency occurring, price volatility will be likely so investors need to be prepared to take action no matter the direction of the move. If the merge is successful, this could mark a major point in the history of cryptocurrency.
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References and Further Reading