Ethereum’s biggest moment comes with “merging”. What does that mean for cryptocurrency?

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Bitcoin

As the cryptocurrency’s answer to gold, Ethereum is the closest thing it has to its own internet. Anyone wanting to mint a new token, launch a crypto app, or spend $150,000 on a non-fungible token, or NFT, will likely use the Ethereum network. Over $3 billion in transaction volume flows through Ethereum daily, and is traded in the network’s native token,


ether.

About $60 billion in crypto assets are on the blockchain through third-party applications. Aside from Bitcoin, there is no other network that is more important to the infrastructure of cryptocurrency or its future.

Messing with Ethereum is no small feat. However, the network’s developers aren’t about to mess around – they’re about to fix the basic plumbing and mechanics of Ethereum in an upgrade enthusiasts call The Merge.

The change, scheduled for September 15, represents a major technological risk and could be a transformative moment for cryptocurrencies. Companies like

Coinbase Global

(bar: COIN) The effect will be felt almost immediately. And there are likely to be ripple effects across the industry, touching everyone from crypto miners to chip makers like

nvidia

(NVDA) and investors who have some Ether in their portfolios.

“The merger is the most significant upgrade in crypto history,” says Sami Kassab, an analyst at crypto research firm Messari. “It is similar to changing the engines on an airplane in mid-flight. A single flaw in the code can wreak havoc in the coding ecosystem.”

Years in the making, The Merge may be the cryptic answer to critics who say the industry is a colossal waste of energy. Ethereum, which has a market capitalization of nearly $200 billion, uses the same method of verifying transactions as Bitcoin.

In this process, known as proof-of-work, computers compete to solve cryptographic puzzles. The network reached a consensus on the winner, which proves that the set of transactions is valid and should be added to the chain. The winner then receives some bitcoin, a practice known as mining.

It is energy intensive and requires a huge amount of computing and electrical work. Built on the same system, Ethereum is also an energy hog, using roughly the same amount of electricity in a year as countries like the Netherlands.

Now, developers are scrapping this model and moving to a more green system for processing transactions, called Proof of Stake. Instead of mining, Ether owners use their tokens as collateral to validate transactions, and “put” them onto the network in return for the return paid in the Ether token. To participate, the partner must deposit 32 Ether, worth about $50,000, and run some software. The system selects validators at random, like a lottery. Cryptocurrency exchanges and other companies operate staking pools, allowing anyone to participate in smaller amounts of Ether.

This shift should eliminate ether mining. By doing so, you will reduce Ethereum’s energy use by more than 99%, according to the Ethereum Foundation, sharply reducing the network’s carbon footprint.

This is just the beginning of a process of greater change. The merger should also reduce the new ether that is produced each year. The developers are planning more upgrades over the next few years that are aimed at increasing Ethereum’s productivity and lowering its usage fees. Ideally, they aim to turn Ethereum into a crypto-internet – a base layer for applications, financial services, and many digital assets such as NFTs.

Today, we are talking about decentralized finance. “Within 10 years, if we succeed, people will call it funding, a complete stop,” says Justin Drake, the Ethereum researcher who is helping with the project. “For almost any financial transaction, they will use Ethereum.”

However, the merger may also have a loss of life. This can cause malfunctions, outages or loss of tokens due to the integration of the existing Ethereum blockchain with a new one called Beacon. “The laundry list will need to continue to run smoothly after the merger to keep exploits and liquidations at bay,” says Shaun Farrell, head of digital assets at Fundstrat Global Advisors.

The stakes are high because a lot of the cryptocurrency industry has a stake in its performance – from exchanges like Coinbase to mining operations, NFT platforms, and stablecoin issuers. “Usually, when you push to make a change to a website and it crashes — well, it’s not the end of the world. In that case, you could lose a lot of money,” says Katie Talati, director of research at Arca, a director of crypto assets.

The immediate effect can be on the price of Ether. Since mid-June, the token has risen more than 50%, while Bitcoin has remained flat. Both coins are down about 60% this year, pressured by rising interest rates and weak demand for highly speculative technology.

Some analysts say a successful merger could make Ether ready for another round. This is partly because the move to proof of stake should reduce token issuance to about 0.5% per year, down from the current 4.5%. Reducing the version may raise the price. “In the current market, supply and demand are relatively balanced,” says Steve Golden, chief analyst at Cumberland, the crypto arm of trading firm DRW Holdings. “After the merger, there will be a material supply shortfall.”

Meanwhile, demand can get a boost as owners stake their tokens for a return. Investors may earn 4% to 8% by betting, depending on the amount of revenue the network generates and other factors, according to Talati. Institutional funds with a mandate to invest in green assets can also buy Ether because the carbon emissions of the blockchain are becoming less significant.

Upgrading could be a boon for companies like Coinbase. The exchange is developing a service that will make it easier for investors to profit from Ether, with Coinbase deducting 25% of any income generated. CEO Brian Armstrong said in an earnings call in August that the staking business “has already grown into a significant source of subscription and service revenue and is growing well.”

However, as in any technology upgrade cycle, there will be a legacy of obsolescence. Some of the biggest losers in this cycle could be mining companies that have spent hundreds of millions of dollars on hardware that may otherwise become worthless. Leaders of Hut 8 Mining (HUT), which mines both Bitcoin and Ether, said in August that they are studying how to adapt their Ether mining machines to other coins or projects.

Hive Blockchain Technologies

(HIVE), another miner, said switching to proof of stake “may make our mining business less competitive.”

Chipmaker Nvidia looks like another victim. The company’s graphics cards and chips have been approved by the industry for ether mining. But it now appears that demand is fading. Nvidia, whose stock is already suffering from a slowdown in gaming and other core areas, said in its latest earnings call that it cannot predict how crypto mining will affect demand. Analysts at investment bank Baird say the merger is likely to “generate a wave of mining GPUs.” [graphics processing units] in the flea market, exacerbating inventory problems.”

In the long run, Ethereum could pose an even greater threat to competing blockchain networks. Blockchains and tokens like Solana, Avalanche, and Tezos were launched with the promise of being faster and more efficient than Ethereum. They all operate on proof of stake and have established different uses, but if Ethereum discontinues their upgrades, time may run out to prove their importance. “Now that Ethereum has realized proof of stake, there is less argument for many other blockchains,” Kassab says.

Some crypto companies do not deal with The Merge. The threat led to a few miners launching a rival Ethereum blockchain, called a fork, using the Proof of Work method. The idea is to create a sub-element of Ether and a parallel world of smart contracts, NFTs, decentralized finance, or DeFi applications.

The possibility of an Ether blockchain duel forces companies to choose one side or declare neutrality. Exchanges such as Coinbase, Binance, and FTX say they will apply their usual listing criteria to forked tokens and may allow them to trade. The creators of crypto applications such as Uniswap, Compound, and stablecoin USDC have pledged to recognize only the new Ethereum blockchain.

The Ethereum split has some cryptocurrency leaders concerned that scammers may find new ways to perpetuate theft and fraud. “Someone would spend 80 real ether on a bored fake monkey,” says Robert Lesnar, founder and CEO of Compound Labs, a DeFi company. “There will be all kinds of disasters,” he says, advising investors to wait until the kinks are resolved and “do nothing.”

Another unknown is how Washington will react. SEC officials have indicated that Bitcoin and Ether should be treated as commodities — potentially removing these tokens from SEC oversight. But since many investors will buy Ether with the expectation of a return, some lawyers believe it can make the token look like a security. If the SEC approves, cryptocurrency exchanges like Coinbase could be subject to lawsuits or enforcement action if they allow them to trade on their platforms anyway.

Changes of this magnitude are “an opportunity to try to differentiate the previous analysis from the current analysis,” says Theresa Jody Gillin, a partner at BakerHostetler and a former attorney at the SEC, who believes Ether still does not qualify as a security. The Securities and Exchange Commission declined to comment.

As with all things in crypto, the hype around The Merge really goes way beyond reality. Proponents say this could be the start of a renaissance of useful apps and services — finally silencing befuddled critics in a multibillion-dollar industry that has yet to find a reason to exist apart from speculation. Conversely, if it fails, it will be another setback for a technology that is long in complexity and short on real-world facilities.

“The most important part of integrating is the narrative,” Kassab says. “It’s something everyone is talking about that could bring people back to Web3 and cryptocurrency, assuming it works.”

The cryptocurrency market is now experiencing a crisis of confidence, losing $2 trillion in value over the past year and infuriating governments around the world. A successful merger may not revive the market or its reputation. But it could make cryptocurrency greener, at least, on its way forward.

write to Joe Light at joe.light@barrons.com

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