What is the Merge?
In September, a highly anticipated upgrade was completed on the Ethereum blockchain, the network which supports the world’s second largest cryptocurrency (Ether), as part of a plan to reduce energy consumption by 99.9%.
This upgrade, known as the ‘Merge’, changes the security system which underpins the Ethereum blockchain. Historically the blockchain relied upon a system known as ‘proof of work’ to determine the validity of transactions. A proof of work system relies on a global network of ‘crypto-miners’ to verify transactions by solving a cryptographic algorithm associated with a block (a block being a bundle of transactions). Thousands of crypto-miners compete to be the first to solve the algorithm and the winner receives cryptocoins in return for their efforts. The process is extremely energy intensive – only one miner can ultimately verify the block so the energy expended by all of the unsuccessful miners is wasted.
The Merge sees the Ethereum blockchain merge with an identical blockchain copy called the Beacon Chain, which is underpinned by an alternative verification process known as ‘proof of stake’. Proof of stake replaces crypto-miners with a smaller number of ‘validators’ who stake their own coins (Ether in this case) against their work in order to be added to a register of individuals who are allowed to validate blocks. One validator is randomly selected (however, greater odds of selection are given to those with larger stakes) to verify the transactions in a block. If a validator is successful they are rewarded with additional cryptocurrency as a transaction fee, but if a mistake is made their stake could be lost. By removing the ability to compete to mine a block, proof of stake reduces the total number of computers needed to support the blockchain, massively reducing the energy output required.
The Merge is the first in a number of planned upgrades to the Ethereum blockchain, and those upgrades are expected to be important in ensuring the longevity of the network. The Ethereum blockchain supports both its native cryptocurrency, Ether, and hundreds of millions of dollars worth of cryptoassets such as NFTs.
What legal issues might arise?
A hard fork in the network provides an opportunity for fraudsters to exploit confusion
One of the key legal risks associated with the Merge arises from the risk that an Ethereum ‘proof of work fork’ arises.
The blockchain is an open-source code so it can simply be copied onto a new blockchain and continue to run if it has enough support. A group of miners who are concerned about maintaining their livelihood have indicated that they plan to continue to run an Ethereum proof of work (‘ETHPoW’) network post-Merge. Hard forks have occurred in the crypto market in the past, and if successful it would mean that anyone who had ownership of a digital asset recorded on the Ethereum blockchain pre-Merge would now also have a record of ownership of an identical asset recorded on the forked ETHPoW network.
Whether those assets have any value will depend on what the asset is – for example, is it Ether, a stablecoin or an NFT? ETHPoW coins have the potential to have value if there is market demand to continue trading on the ETHPoW network and crypto exchanges are prepared to support the trading of those coins, which would then become their own spin-off cryptocurrency. Stablecoins which were recorded on the network would not likely be supported (as the stabilised issuers will not double the number of coins in circulation) and the duplicate coins would likely be denied, delisted or burned.
NFTs pose a different set of challenges as there can only be one genuine NFT, meaning that the NFT on the ETHPoW forked network would be a copy and not the original. Fraudsters might seek to exploit confusion arising in these scenarios and a very high degree of caution should be exercised by anyone transferring assets, to ensure they are clear about which assets they are dealing with.
The environmental angle
The move to a proof of stake model drastically improves the environmental credentials of the Ethereum blockchain. The environmental concerns associated with the proof of work verification model have been a major barrier to entry for many investors. More institutional and corporate investors may now look to invest.
The perceived pros and cons of that have been well rehearsed recently in BlackRock’s partnership with Coinbase and the launch of a private Bitcoin trust for its clients. On the one hand, more institutional investment could increase the perception of legitimacy of digital assets but on the other hand, crypto-traditionalists are concerned that a move in this direction will detract from the qualities that originally made crypto attractive as an alternative and revolutionary asset.
A significant proportion of staked Ether on the new network comes from large players/exchanges in the crypto space, which has led some market participants to express concern that the decentralisation of the ecosystem is being eroded, and that the move will provide targets for law enforcement agencies. This, combined with a potential increase in institutional and traditional investors could be a catalyst for increased regulation in the space.