The Ethereum Merge is one of the most impactful events in crypto history

For the last four years "The Merge" has been one of the most fundamental shifts in the crypto landscape since it caught wind in mainstream media back in 2017. To those who are uninitiated and are new to the crypto space, the merge is the transition for the Ethereum Blockchain from Proof-of-Work (PoW) towards Proof-of-Stake (PoS) as its security and consensus model.

We will discuss the benefits and drawbacks of each consensus model whilst providing you an understanding of why the merge is happening plus some of the economic benefits that spring up for the Ethereum blockchain from this transition.

What is the Merge?

The merge is simply a transition away from validating blocks via a Proof-of-Work consensus mechanism towards a Proof-of-Stake consensus model, we will explain what these consensus models are later in the article. The reason it's called "The Merge" is best explained by the Ethereum Foundation themselves, "The Merge represents the official switch to using the Beacon Chain as the engine of block production. Mining will no longer be the means of producing valid blocks. Instead, the proof-of-stake validators assume this role and will be responsible for processing the validity of all transactions and proposing blocks." 

In essence since December 1st 2020 the Beacon Chain was created, which has since existed as a separate blockchain to Mainnet (the Ethereum blockchain we are using today), running in parallel.

The Beacon Chain has not been processing Mainnet transactions. Instead, it has been reaching consensus on its own state by agreeing on active validators and their account balances. This Beacon Chain can be visualised as a highway running in parallel to another highway and "The Merge" is when they transition into the one road.

*A handy infographic has been designed by the Ethereum Foundation highlighting how this transition works*

What is a consensus mechanism and why is it important?

In the core of every layer 1 blockchain cryptocurrency lies a network of computers that secures the software from attackers and control the issuance of new units of its supply. This technology is called a consensus mechanism.

Transactions are processed by a blockchain by adding a set of transactions into a block, with each block reference the valid block before it.  The Proof mechanism can be considered like a monetary bond attesting to the validity of the block and its transactions.  Attempting to cheat the system will see this bond lost.

The two most widely used consensus mechanisms are Proof of Work (PoW) and Proof of Stake (PoS), and they both regulate the process in which transactions between users are verified and added to a blockchain’s public ledger, all without a central party’s help. The lack of centralisation is the most critical design requirement that separates a blockchain from an ordinary database.   The consensus mechanism not only helps validate true transactions but also issues the block rewards, going to either the miners in PoW or to validators in PoS.

Understanding the differences can help you better understand how the cryptocurrency ecosystem works and why there is such strong contention between the different mechanisms.

What is Proof of Work (PoW)?

A truck with portable bitcoin miners in Texas to capture wasted energy at gas flaring sites

Proof of Work (PoW) as a concept was developed by Moni Naor and Cynthia Dwork in 1993 as a way to deter denial-of-service attacks and other service abuses such as spam on a network by requiring some work from a service requester, usually meaning processing time by a computer

The idea was computers might be required to perform a small amount of work before sending a request. This work would be trivial for someone sending a legitimate email, but it would require a lot of computing power and resources for users to spam requests.

This helpful spam filter was first applied this technology to be used as a consensus and security model for digital money by the brilliant Satoshi Nakamoto and the math was outlined in the Bitcoin Whitepaper.

Proof-of-Work Benefits

The economic models of many Proof-of-Work blockchains are also quite well designed, this is especially true in the case of Bitcoin.

A block reward refers to new cryptocurrency awarded by the blockchain to the miner for each block that is deemed valid and accepted by the network.

In the case of certain cryptocurrencies, like Bitcoin, the block reward is reduced after 100 blocks have been found. 

This is done to keep the total money supply finite and deflationary.

The benefits of Proof-of-Work is not limited to diminishing block rewards but the ease of which a user can spin up a Bitcoin validator node that helps broadcast their transactions to the network is much easier and cost effective when compared to Proof-of-Stake.

A sufficiently distributed network of computers producing blocks and validating transactions also greatly helps with decentralisation and as it has existed for over 13 years, the network has had the opportunity to sufficiently disperse throughout the globe.

Proof-of-Work also soaks up waste and excess energy by providing a constant base level of demand, making energy grids more reliable and efficient. 

Proof-of-Work Disadvantages

Mining requires extremely powerful hardware and is not affordable for every market participant. It can also be argued that its energy consumption which is naturally quite high as competition on the network grows, is detrimental to the environment. This hurts its ability to curry favour with the ESG crowd and can be labelled as a pollutant or a waste of energy resources.

It's also important to acknowledge the majority of mining pools are controlled by single entities.

What is Proof of Stake (PoS)?

Whenever someone is willing to pay you interest/yield you must (as a sensible investor) find out how that yield is generated. If you don't understand where it comes from and you invest you are opening yourself up to unacceptable risk. Moreover, you ARE the yield if the money you deposit is actually going to someone else.

Bernie (The Ponzi King) Madoff

Proof of stake (PoS) is a type of consensus mechanism which is used to validate transactions on the blockchain. It works by allowing cryptocurrency owners to stake their coins. This gives them the right to verify new blocks of transactions on the blockchain and add them to the network.

The model of Proof of Stake exists as an alternative consensus mechanism. 

Most of the layer 1 blockchains competing against ETH such as Polkadot, Cosmos, Algorand and Tron use PoS due to the ease of bootstrapping liquidity and incentivising users and developers to farm rewards by staking their tokens . 

Unlike in PoW where the block reward goes to whoever solves the problem first, the staking algorithm chooses any one of the stakers to publish the next block, this causes competition between stakers to be selected. 

Two developers named Scott Nadal and Sunny King created PoS noticing the flaws in PoW in the year 2012. Limited scalability and needing a lot of electricity are not a problem in the PoS model.

Proof-of-Stake Benefits

The PoS mechanism is safe from 51% of attacks as it is not reliant on hashing power to prevent a double spend. It also does not need expensive hardware for processing transactions and validating blocks make the barrier for entry much lower than PoW.

Transactions are faster and relatively inexpensive especially as layer 2 solutions get built on top of the core blockchain. More importantly, for the ESG narrative, processing transactions in the case of PoS does not use much energy and can be seen as a clean, green alternative to PoW.

Another important advantage is that PoS systems do not require as a high of an issuance rate of new rewards to keep the network secure as compared to PoW.

Bad actors are disincentivized to push in false transactions via slashing mechanisms which can send their stake to zero for misuse. 

Proof-of-Stake Disadvantages

PoS models have not yet been successfully implemented on an elaborate blockchain such as Ethereum, where it has a robust ecosystem of dApps, NFTs, protocols and stablecoins moving through the network.

It's also arguable that capturing control of the network is easier as it depends on capital and with the sheer size of financial incentives to be had by exploiting a robust DeFi network, it's not difficult to imagine capital to be pooled for control purposes. This leads to governance issues where users with more tokens can collude and change the rules of the network.  (See Steemit and Eos for an example of where this went wrong)

PoS requires more complicated mechanisms to remain stable and honest.  This complexity involves more risk than the much simpler PoW mechanism.

Wrapping Up

After reading this article, it's easy to see why there is so much contention and divisiveness between PoW proponents and the PoS advocates, as they both have clear benefits and drawbacks. This has quickly devolved into a Bitcoin vs Ethereum debate, as the two largest cryptocurrencies will diverge consensus models post merge.

Bitcoin and Ethereum are tackling different problems in different ways, giving investors the ability to have a balance in their portfolio. Bitcoin takes a more conservative, maximum decentralisation route, whereas Ethereum is more along the mantra of "move fast and break things".  

This sentiment isn't meant to dissuade you from being religiously in favour of Bitcoin or Ethereum but to highlight a world where both exist and provide an alternative financial system for the world to choose from.

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The information in this newsletter is general only. It should not be taken as constituting professional advice from the author - Stormrake PTY LTD.

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