Ethereum is undergoing a massive infrastructural
change that will have far-reaching effects for traditional financial
institutions.
The Merge, as it’s called, is shorthand for
transitioning Ethereum’s consensus mechanism, from Proof of Work to Proof of Stake.
This will make the world’s second-largest blockchain, and most important venue for DeFi protocols, far more accessible to traditional financial institutions.
Ethereum goes green
The first change is on Ethereum’s environmental footprint. Today it relies on Proof of Work to mine new blocks and validate transactions, just like Bitcoin. Miners race to solve mathematical puzzles with bespoke computers, and are rewarded in ETH (the blockchain’s token) to compensate for the electricity they burn.
The result is a huge waste of energy.
This has either meant banks and large
corporations have either had to avoid the entire crypto space, because it
clashes with their ESG commitments – or they have decided to ignore those
commitments to access the network.
The Merge will move Ethereum to a different
model, Proof of Stake, in which voting power correlates to the amount of wealth
invested in the network, rather than consuming energy. Assuming the transition
is successful, Ethereum’s energy consumption could fall by 90 percent to 99.95
percent (estimates vary).
“This is cleaner and more energy efficient,” says Swen Werner, managing director at State Street Digital in London. “The message is loud and clear. The Merge will allow firms to feel better about reaching their sustainability objectives.”
Scaling the network
Secondly, the Merge is a specific part of a long-term project to make Ethereum scalable and more secure. It’s called the Merge because Ethereum’s consensus layer is being commingled with its execution layer – a massive engineering project. This will be followed by other steps to improve scalability, so that eventually Ethereum can process transactions at a pace equivalent to a Visa or a Mastercard’s payment technology.
This will make blockchain far more attractive
to financial institutions. For example, tokenization has yet to take off for
several reasons, one of which is the lack of a scalable platform. (Regulations
and the lack of a secondary market are other issues.)
This leaves would-be tokenization programs stuck with executing trades off chain, but a scalable, reliable network with Ethereum’s reach would enable atomic settlement, as well as allow institutions to plug into DeFi protocols seamlessly, says Paris-based Thierry Janaudy, CTO at digital-asset custodian Zodia (which is backed by Northern Trust and Standard Chartered Bank).
“Clients are starting to look at atomic settlement,” he said. Traditional securities markets are tightening settlement times – measured in days. Now they might be able to settle in hours.
Today, even in crypto, trades may execute off the chain, because of scalability issues (think of high-frequency strategies). Or if someone wants to swap bitcoin (BTC) and ETH in a DeFi protocol, they might need to create a synthetic representation of the bitcoin leg to enable it to settle instantly on an Ethereum app.
The same principles could extend to traditional financial securities, Janaudy says. “Custodians would facilitate virtual swaps on-chain,” he said, noting that crypto protocols already do this – the missing ingredient is a platform to handle these at scale. The revamped Ethereum network could become such a venue.
Changing TradFi
Just as an upgraded Ethereum can start to drive changes in traditional, real-world market operations (aka “TradFi”), the experience of the Merge is also seeping into the mindsets of traditional bankers.
In TradFi, an infrastructure change of this magnitude takes years of planning and documentation – think of the U.S. securities market shifting from T+3 to T+2. Not only is everything mapped out and tested, but there are ways to halt or reverse changes if something goes wrong.
With the Merge, the process is much faster,
community-driven, and – although there have been lots of tests and debates – requires
a degree of faith. The major reset in the Merge is scheduled for 15 September
and, while people are confident it will work, no one knows for sure.
“Because the community is decentralized, if
something doesn’t go well, there’s no clear pathway,” said Werner at State Street
Digital. “In crypto, the market might suspend trading for a few days, but we
can’t do that. For financial institutions, everything must work at scale.”
But traditional players don’t have much choice with the Merge: the community is driving this and financial institutions have to simply hang on and be ready to respond to a surprise.
Ethereum’s PoW origins
The Ethereum blockchain launched in 2015, created by Vitalik Buterin and Gavin Wood. Unlike Bitcoin, which went live in early 2009 as a financial instrument (either a payment token or a speculative asset), Ethereum was designed to be a foundation for building applications. It introduced the idea of smart contracts, which has been key to many decentralized applications, including many in DeFi.
However, as a public, permissionless
blockchain, like Bitcoin, the need to have the entire network validate every
transaction has rendered Ethereum slow and expensive, unsuited to financial
institutions.
Other blockchains have emerged that are far
more efficient (usually based on some version of PoS), threatening Ethereum’s
future as global infrastructure.
Ethereum still has by far the most utilization: there are over 400,000 validators on the network, which hosts 200 million unique addresses and facilitates around 1 million transactions a day. Most of the DeFi and stablecoin world is built on Ethereum. But without a drastic change to the blockchain protocol, Ethereum could get left behind.
From rewards to staking
Just making a change to Ethereum alone is a big deal in crypto markets. “ETH has a market cap of $182 billion,” noted Kevin Loo, Hong Kong-based managing director at IDEG, an investment firm dedicated to digital assets. As a function of the Merge and its new dynamics of supply, the issuance of new tokens will plummet. “This is a fundamental change from a trading perspective, and it’s touched off a lot of opinions about whether people should be long ETH or short.”
By moving to PoS, Ethereum’s miners will no longer get rewarded with ETH to mint new blocks. On the other hand, miners and anyone else holding Ethereum can now stake their ETH – that means locking the coins in order to help run the blockchain and maintain its security, in return for a yield.
Today already 11 percent of outstanding ETH is staked, earning returns that can vary from 5 percent to 13 percent, says Charles D’Haussy, Asia managing director at ConsenSys, a blockchain enterprise company dedicated to Ethereum projects.
“This is an attractive yield,” D’Haussy said. “Go long, park your position within the protocol, and put the assets to work.” The yield is derived from fees from helping facilitate transactions and safekeep the protocol.
The new hard money?
Unlike Bitcoin, which is programmed to max out at 21 million bitcoins, Ethereum was initially written to be mildly inflationary, with an annual increase in ETH of 4 percent.
The move to PoS is changing this equation, with part of the governance of the blockchain including burning eth in proportion to its usage. D’Haussy expects ETH supply to even out or even turn negative. This will give ETH a “hard money” profile, which may attract more investors.
No one knows yet how attractive holding ETH or staking will prove. IDEG’s Loo says yields are likely to remain low. “Within the digital-asset space, this is the closest thing to a government bond,” he said.
Short-term risks
There are also short-term risks about whether some vested interests such as ETH miners will baulk at the Merge and create a hard fork in the chain, leaving one version based on Proof of Work and a new one using PoS. This could create trading arbitrage opportunities – and a new line in scams, as people flog NFTs using the PoW version.
But heavy hitters in the industry, such as
Circle (issuer of popular stablecoin USDC) have been outspoken in their support
of the Merge. The likely scenario is that the value moves to the PoS version, and
the rump PoW version will wither.
While the Merge does not address the
compliance and risk-management issues that institutions face in crypto, it will
probably force some kind of regulatory accommodation.
The most divisive aspect of the Merge within the crypto community is that PoS will make it easy for authorities to identify and force the largest ETH stakers to obey state sanctions.
“This raises the question of what is neutrality?” Loo said, citing a theoretical problem if U.S. regulators banned a U.S. digital-asset exchange from providing staking services to validate transactions. This could create a “censorship reaction” by other Ethereum community members, who would try to force a “slashing” (reduction) in network rewards to that exchange’s staked assets.
This is not just an academic question. U.S. crypto exchange Coinbase is now contesting a decision by the U.S. Treasury to force it to halt actions related to Tornado Cash, a coin-mixing service. The government says Tornado Cash’s sole purpose is to facilitate money laundering and tax evasion, but Coinbase is going to argue in court that privacy should supersede such concerns.
The argument is not related to the Merge but Ethereum’s move to PoS would make it easier for states to identify and force sanctions on stakers. Financial institutions are comfortable with a state role in AML and KYC compliance, but they could find themselves in the middle of a fight not of their making.
Open for business
These questions all reflect the novelty of the
Merge. The only way to answer these questions will be to see what happens. But
the Merge represents a fundamental change for financial institutions. This
gives them an opportunity to access public blockchain in a way they couldn’t
before – letting them participate in Ethereum’s global reach, and avoid the pitfalls
of bank-led blockchain consortiums using permissioned rules.
The Merge means Ethereum will tick the green box. It offers a staking yield that is low-risk, by crypto standards. The new burning mechanism in the PoS system should stabilize ETH’s supply and demand.
D’Haussy adds one more feature for institutional investors: “The Merge is a rare event in that it is not macro-driven. It’s just an update of its software, but it’s creating trading opportunities. This is part of making ETH a truly uncorrelated asset.”
