Financial opportunities, risks and thoughts behind Ethereum’s “The Merge” upgrade

Ethereum - The Merge

Unless you’ve never heard of Ethereum, you’ve most likely heard of Bitcoin. Ethereum is another cryptocurrency and is the second largest by market capitalisation behind Bitcoin, i.e. the number of Ether in circulation multiplied by the price of each Ether. 

Ethereum is the name of the blockchain, and Ether is the name of the currency used on the blockchain. Every process or transaction on the Ethereum network requires a fee paid in Ether.

The Ethereum network, like anything relating to technology, goes through upgrades to make it faster, cheaper and scalable. The same happens with other different blockchains. 

A case in point is “The Merge”, which is the name of the upgrade of the Ethereum network from Proof-of-Work (POW) to Proof-of-Stake (POS), expected to take place on the 15th of September 2022. 

Proof-of-Work requires an energy-intensive process to secure the Ethereum blockchain through the use of hardware called miners. On the other hand, Proof-of-Stake is more of a software-based approach to secure the Ethereum blockchain. The upgrade from POW to POS will reduce energy consumption by at least 99%. 

POW is associated with Bitcoin, while POS is associated with cryptocurrencies like Cardano. POS is more environmentally friendly as it has a lower carbon footprint than POS. At one point, the European Union considered banning Bitcoin in the bloc due to claims that POS harms the environment. 

Unlike other blockchains, Cardano and Solana already used POS from their beginning. Ethereum is switching from POW to POS. Yet, Ethereum seems to have more appeal in the eyes of investors. There may be various reasons, such as the first-mover advantage.

Bitcoin was the first cryptocurrency on a blockchain. Bitcoin, however, is only limited to purely financial transactions. Ethereum is an entirely different system – it aims to create an entirely new internet – decentralised and censorship-resistant.

Several new concepts were invented and developed on the journey to build this “new” internet – such as smart contracts, Initial Coin Offerings (ICOs), Decentralised Finance (De-Fi), Non-Fungible Tokens (NFTs), metaverse and Web 3.0. These ideas aren’t unique to blockchain, yet their origins are associated with this technology. 

Proof-of-Stake

Safe deposit box
Source: Pixabay

Opportunity

Proof-of-Work incentivises miners to secure transactions on the blockchain through energy-intensive processes using hardware. Once a group of transactions called a block is mined, miners get rewarded with financial incentives. 

Once Ethereum merges from POW to Proof-of-Stake, Ethereum will no longer offer miners rewards. However, Ethereum must provide a financial incentive to validate and secure transactions through staking, hence proof-of-stake. Miners in POS are called validators.

Validators don’t need any hardware. They need to stake Ether (the currency on the Ethereum network) to validate transactions. Validators would need to stake or deposit 32 Ether into a smart contract. 

Staking is equivalent to a bank guarantee, where the validator commits itself to validate transactions in good faith. If the validator tries to manipulate transactions or act fraudulently, the validator will lose their stake, i.e. their 32 Ether. On the other hand, if the validator acts in good faith, the validator will earn interest on their staked Ether, similar to an interest-bearing bank account.

Without going into the complexities of computer science, one can earn interest on staked Ether. You don’t need 32 Ether to stake Ether; you can stake with any amount. Most cryptocurrency exchanges allow clients to pool their Ether and earn interest. 

If you’re going to stake your either through an exchange, you have to keep in mind that the exchange will get its cut on your staking rewards. For example, if an exchange promises a return of 5%, the likelihood is that the exchange will be earning more and keeping the difference.

If you own or afford to buy 32 Ether, you can become an Ethereum validator. It would be best if you had the technical know-how and necessary setup to become a validator. If you don’t know what you’re doing, it would be better to earn less and go through an exchange.

Risks

If you deposit $100 in a fixed bank account with a deposit rate of 5% per annum, you’d expect to earn $5 after one year. The same is true for other cryptocurrencies like Cardano, Cosmos, Solana, etc. 

The argument doesn’t hold for Ethereum. Staking Ethereum is like storing valuables in a vault that cannot open once it is closed. The locksmith still has to invent a key to open the safe. In this case, if Ether gets staked, it cannot be retrieved, as it will need another upgrade.

The timeframe for the upgrade is between six to twelve months after “the Merge.” The most probable scenario is that it would take more than one year. 

“The Merge” got delayed for several years, and future upgrades will probably follow suit. The past isn’t a guarantee of future performance.

If you deposit $100, as mentioned, you’d expect $5. In the case of Ethereum, if you deposit the equivalent of $100, the bank will give you five pebbles as a reward. The pebbles are worthless as the original $100 is locked inside a vault without a key, yet the bank still gives you five pebbles. 

The pebbles are worthless, yet, exchanges have created a secondary market that allows buyers and sellers to trade such pebbles. On Coinbase, the tradeable return is referred to as “cbETH”; on Kraken, it’s referred to as “ETH2.S”. Different exchanges refer to the return on the staked Ether with different names.

The staking returns (“cbETH” and “ETH2.S”) arent’ transferrable from one cryptocurrency exchange to another. They’re unique to that exchange. 

There are risks associated with staking returns. The first risk is that there might not be enough liquidity to trade the staked returns. One would expect that $1 will trade strictly for $1. However, if the $100 deposit generates a 5% return on investment after one year, five pebbles should be equivalent to $5; or $1 for each pebble. 

Lack of liquidity in the market for staking returns, the price of the pebble will trade below $1. The problem gets solved once the necessary upgrades are made on the Ethereum blockchain, allowing investors to un-stake their Ether from the smart contract.

Arbitrage

Arbitrage is riskless profit. If, theoretically, one pebble in the example above is supposed to be equivalent to $1, it will probably sell below $1 due to the lack of liquidity and usefulness.

Once subsequent upgrades to the Ethereum network get done, a deposit of $100 will yield $5 and not five pebbles. A good strategy would be to purchase as many pebbles as possible below the $1 mark and sell them once the return on your staked Ether returns dollars and not pebbles.

For example, if one Ether is equivalent to $1,000. If one stakes Ether, one will get 0.05 “cbETH” or 0.05 “ETH2.S” depending on the exchange, which is equivalent to 5%. In monetary terms, 5% will be equivalent to $50 (5% of $1,000).

Due to liquidity issues and lack of utility of “cbETH” or “ETH2.S”, the 0.05 will trade at a discount below $50. For example, 0.05 will trade at $40 – equivalent to a 20% discount.

Once the upgrade to the Ethereum network allows Ether to be un-staked, an investor will get 0.05 Ether instead of 0.05 “cbETH” or 0.05 “ETH2.S”. Theoretically, 0.05 Ether is supposed to be equivalent to 0.05 “cbETH” or 0.05 “ETH2.S”.

The 0.05 “cbETH” or 0.05 “ETH2.S” got sold at a discount, e.g. $40, and the price of 0.05 Ether is $50 (5% of $1,000 – price per Ether). An investor can make a profit of 20% after the upgrade.

The above illustrates what theoretically should happen once the Ethereum network supports un-staking Ether.

Hard forks

Forks
Source: Pixabay

A hard fork is a term that relates to software terminology. A hard fork occurs when there’s a difference in opinion on the way forward. For example, a group of friends go for a hike and come upon a crossroad. 

The group can’t agree on whether they should take a right or left path. The group decides to split into two. Some go left, and some go right. 

The same analogy applies to a hard fork. Stakeholders collectively cannot decide which path to follow, so everyone goes their way. No group is right or wrong. It’s a matter of opinion.

“The Merge” may give rise to a hard fork between two groups: those who support Proof-of-Work (POS) and those who support Proof-of-Stake (POS). Proponents of POW mainly consist of miners. They argue that they’ve invested heavily in hardware, and Ethereum shouldn’t switch to POS.

On the flip side, supporters of POS include the Ethereum Foundation, which believes that POS is the way forward and does less harm to the environment. 

Hard forks aren’t something new in the crypto world. For example, in June 2015, Ethereum had its first fork after a Decentralised Autonomous Organisation (DAO) got hacked. The Ethereum Foundation decided to reverse the hack by “going back in time” as if the hack had never happened. 

Not everyone was in favour of erasing the hack, as it goes against one of the core principles of a blockchain – immutability. Immutable means that something is permanently written and cannot be changed. Some consider that Ethereum Foundation went against this principle, implying centralisation, which leads to censorship.

The disagreement caused a hard fork in the Ethereum blockchain. There are now two separate blockchains – Ethereum (ETH) and Ethereum Classic (ETC), and, therefore, two separate cryptocurrencies. 

Opportunity

Most notable exchanges gave their users an Ether Classic for every Ether they held. One must remember that one Ether Classic is not equivalent to one Ether in terms of monetary value. For example, 1 Ether may be equivalent to $1,000, while 1 Ether Classic is equivalent to $10.

If you had $100 in your bank, it would be like the bank giving you £100, or €100. It would be as if the bank would have given you free money.

Hard forks provide such opportunities that the exchange is willing to support new coins.

Bitcoin had at least three hard forks – Bitcoin Cash (BCH), Bitcoin Satoshi’s Vision (BSV) and Bitcoin Gold (BTG).

Exchanges like Coinbase and Binance are considering supporting the Ethereum network (POS), and the movement behind keeping POW is called EthereumPoW. The support evolves around several factors, which include regulatory scrutiny, regulatory compliance and liquidity.

Risks

The current market conditions dictate that all markets are in a bear market and a recession. The probability of a cryptocurrency exchange going bankrupt is higher than during a bull market. 

Does the consideration of exchanges supporting both Ethereum tokens (ETH and ETHPow) mean that it’s a lure for investors to transfer their Ether from cold wallets to exchanges? It’s difficult to say as the risk is high, but worth considering if the exchange enjoys consumer trust and confidence. Ideally, coins should be “stored” on cold storage devices like Ledger Nano and Trezor.

Final thoughts

There are two ways to acquire wealth through the upcoming Ethereum upgrade – staking Ether and a potential hard fork of the Ethereum blockchain.

Would I stake my Ether? Probably not now. I prefer liquidity, and since at least four significant upgrades (“the surge”, “the verge”, “the purge”, and “the splurge”) in the pipeline could take years to implement, I’d rather stake other coins and stake Ether once I’ll be able to withdraw them with ease.

Would I recommend transferring Ether from cold storage to a cryptocurrency exchange to benefit from the hard fork? Not sure. Tough question. Most likely not. Due to the current economic situation, I would rather miss out than lose my coins due to the high risks of centralised exchanges, especially if they go bust.

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