RV Blog Risks of the 2022 Ethereum Merge

Risks of the 2022 Ethereum Merge

Risks of the Merge

After years of research, Ethereum’s long-awaited transition from its Proof-of-Work to Proof-of-Stake is finally happening. Undoubtedly, the Merge represents a feat of engineering that will make the Ethereum network grow in complexity. While this major update will bring various advantages like the potential for better scalability, more security, and greater sustainability, it is not without risks.

The most challenging thing about the Merge is the fact that its implementation is taking place while Ethereum keeps on running. Therefore, upgrading Ethereum is usually likened to the analogy of replacing an airplane engine duhring an ongoing flight. It goes without saying that such a Herculean task comes with risks — be they imminent as well as more long-term risks. In this piece, we want to highlight some of the most tangible risks.

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Implementing the Merge

Since December 2020, Ethereum’s PoS chain called Beacon Chain has been running parallel to Ethereum’s existing PoW chain. With the Merge, these two chains will be fused, explaining where the Merge has gotten its name from.

From then on, the Ethereum blockchain will exclusively rely on the Beacon Chain for establishing consensus, which is why this chain is also referred to as Ethereum’s consensus layer. The current Ethereum chain will turn into Ethereum’s execution layer. Going forward, this is the layer that Ethereum users will broadcast their transactions to whereas the consensus layer will be responsible for processing and ultimately settling them.

In order for this new setup to become reality, the Merge will occur in three phases:

Step 1: The Bellatrix Upgrade — already successfully implemented on September 6 — has made it possible for Beacon Chain nodes to technically accept transactions initiated on the Ethereum execution layer. These nodes will start accepting the transactions once a specific target defined by what is called the Terminal Total Difficulty (TTD) is met.

Step 2: TTD is calculated by adding up the mining difficulty of all the previous blocks in Ethereum’s history. In other words, TTD represents all accumulated difficulty in the network. Once this number is met, the final step before the Merge’s activation is triggered.

Step 3: In what is called the Paris Update, nodes of the existing Ethereum chain will be made PoS-compatible by losing dependence on the PoW mining algorithm Ethash. At the same time, Beacon Chain nodes will start accepting transactions from Ethereum’s execution layer, marking the completion of the Merge update.

Execution risks associated with Merge activation

Although each and every Merge activation step has been thoroughly thought through and carefully planned, a few main imminent risks remain:

Miscommunication or a lack of communication:

To guarantee a smooth transition, node operators on either side of the spectrum (Beacon Chain and existing Ethereum chain) will need to follow multiple action steps, thereby adhering to a strict timeline. Should they fail to get the information in time or even be presented with misinformation, the network could stall or be disrupted as either consensus could not be reached or transaction activity could come to a halt.

Implementation errors on part of node operators:

Even without any miscommunication and no lack of communication from the Ethereum Foundation, there is still the possibility of errors. Because the Merge updates require manual updating, mistakes could happen on part of node operators. As a matter of fact, there is even the chance that some node operators might be overwhelmed, unintentionally dropping off during the Merge update. Again, if the number of non-upgrading nodes reaches a critical mass to cause disruption, network consensus or transaction finalization could be at risk.

Client software failures:

The new PoS-based Ethereum will have both consensus-layer nodes as well as execution-layer nodes. As the former will have to know about incoming transactions, while the latter will need to be aware of the correct chain, constant communication between the two is essential. This communication will be made possible through something called the Engine API, software that is integrated into different Ethereum clients. Should unexpected bugs occur, affected nodes could drop off, once again impeding a smooth Merge activation procedure.

Services and application breakdowns:

Because Ethereum serves as a settlement layer and backbone for numerous services and applications — think DeFi, NFTs, and more — all of them are ultimately relying on a particular set of technical specifications the current Ethereum blockchain offers. These include a specific block structure, block timing, Opcode, and the transaction finality property. As these parameters will change with the Merge, Ethereum-based applications will have to adapt by fitting their code to the new block times and transaction confirmation speed. Should they fail to do this, they could be running the risk of breaking down or being exploited — also to the disadvantage of users.

Long-term risks associated with the Merge

Because the Merge changed Ethereum fundamentally, the upgrade also comes with long-term risks. The most tangible among them are:

Centralization risk on the consensus level:

With the move to PoS, Ethereum could see its native asset, ether, become more centralized as staking entities like exchanges end up owning the coins of users that don’t want to venture into staking themselves. This could have the unintended consequence where an increasingly smaller number of entities own an ever-greater amount of ETH, leaving them in a position to manipulate the network by double-spending or censoring transactions. 

PoW as a competitive advantage:

By switching to PoS, Ethereum will join the various other smart contract platforms like Solana, Avalanche, or Polkadot that already are PoS-based. One concern arising from this: By moving away from PoW, Ethereum could be abandoning a consensus mechanism that has made the blockchain the second largest crypto project in terms of market capitalization in the first place. There remains a non-zero chance that PoW could have been a competitive advantage that fundamentally distinguished Ethereum’s smart contract platform from the many others out there.

Deflationary base currency:

The Merge cuts Ethereum’s annual issuance by a factor of ten, from 4.3% to 0.43%. Together with Ethereum’s built-in burn mechanism (EIP-1559), chances are that ether could actually turn deflationary. While this is generally considered to be bullish for ether holders, there’s also an argument to be made that Ethereum’s wider token ecosystem could be negatively affected by this. Ether acting as the deflationary base currency of the Ethereum economy could dampen the prospects of investing in other assets besides ETH. This is because the opportunity costs of not having exposure to ether might outstrip the potential of holding Ethereum-based assets. While the current bear market has reduced on-chain activity and thus ether’s burn effect, the danger of a deflationary ether that could hurt the wider Ethereum ecosystem is increased by the Merge.

The Bottom Line

For years now, Ethereum developers have been carefully working towards the Merge, postponing it many times to make sure all eventualities have been considered and possible errors can be avoided. As with any human-made endeavor though, unexpected failures can always occur.

Should some of the risks outlined above materialize, then the value of Ethereum and Ethereum-based tokens would most likely be affected to the downside. Also, the reputation of the crypto industry at large could be damaged.

That being said, the cryptocurrency space is known for accepting the risk that represents the price one has to pay to continuously innovate. As history has proven so far: From any intermediate failure, crypto has only come back stronger. This shouldn’t be different this time were any of the risks described above to occur. And pointing to these risks and making them known beforehand can surely help avoiding them in the first place.