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The Merge is not risk free: Four scenarios Ethereum investors should consider


After years of anticipation, Ethereum’s merge, which switches the consensus mechanism of the flagship smart contract platform from Proof-of-Work (PoW) to Proof-of-Stake (PoS), is finally happening. On August 10, the most anticipated event in Ethereum’s history had its final dry-run in the Görli testnet, finishing the testing phases of the new PoS consensus layer and giving developers one final opportunity to identify and fix any bugs before the final mainnet merge, currently scheduled to occur on September 15.


Figure 1: Tim Beiko’s tweet on the scheduled date for Ethereum’s mainnet merge.


In early May, we wrote an in-depth analysis of Ethereum’s merge, discussing the many technical and economic upgrades Ethereum will go through in its switch to PoS. This migration will cause a huge reduction in Ethereum’s power consumption (~99.95%), establish the infrastructure for the future implementation of sharding, and will modify the monetary policy for its native token, with a potential ~90% decrease of the current issuance velocity of new ether (ETH). 


Although we believe this long awaited change is the very first step of a promising roadmap that can consolidate Ethereum’s position as the leading smart contracts blockchain, it doesn’t come without risks. This update is arguably the most significant event in the crypto space to date, with  relevant impacts both technically and economically, and discussions regarding its risks have started to gain more traction. Being only a few weeks away from the actual upgrade, we believe it’s a good time to revisit some of the potentially troublesome scenarios associated with The Merge, and what can investors expect from this unprecedented event in the history of crypto.


Scenario 1: The blockchain is halted due to unexpected issues.


We start by considering a post-merge scenario where the blockchain needs to halt block production due to unforeseen problems. These may include block reorganizations, bugs in the algorithm that randomly selects validators, network instabilities in block production and propagation, etc. If the halt takes too long and no estimated timeline for a resolution is identified, Ethereum developers may be forced to trigger a rollback of the blockchain to a pre-merge state. This could entail disregarding any blocks included in the blockchain after The Merge happened, postponing the difficulty bomb[1] to allow block production through PoW to be profitable again, and doing a huge move of social coordination to convince miners to come back and resume working on block production for Ethereum.


Our take: 

Of course, we can never say a piece of software is free from any bug or vulnerability which hasn’t been identified in testing environments, meaning investors should be aware of the non-negligible risk of this scenario panning out after The Merge. This would be a major issue for the reputation of the Ethereum network, not only severely affecting the value of ETH, but also of all other assets and applications built on top of the network. Ethereum-only decentralized applications (dApps) and utility tokens would be particularly impacted. This is because with the blockchain halted, investors wouldn’t be able to move their assets around and market prices of Ethereum-related tokens would be entirely driven by pure speculation on the outcome of the network halt, as opposed to blockchain activity. 

However, after several years of development, and with The Merge being successfully deployed in several testing environments—including the network’s three major testnets (Ropsten, Sepolia and Görli)—we believe that the Ethereum’s core development team had the opportunity to identify and fix all crucial vulnerabilities present in the code operating the new consensus layer. This means that a blockchain halt due to unexpected problems should be considered a remote risk for Ethereum investors, with the drastic consequences—such as a potential rollback to PoW—also being highly unlikely to happen.

Scenario 2: Validators act maliciously.


Post-merge, Ethereum block production will be conducted by validators in the Beacon Chain—the new consensus layer for Ethereum. As with any other PoS blockchain (Solana, Avalanche, Polkadot, etc.), there is a second scenario we should consider, namely, a relevant share of Ethereum validators to collude and attack the network by:

1. Intentionally creating two different chains starting from a common block height and broadcasting them to two different sets of honest validators;

2. Proposing and voting on empty blocks;

3. Censoring transactions coming from specific addresses or applications.

For the first point, similar to how PoW is resilient to attacks if more than 50% of the global hashrate is controlled by honest miners, PoS also has a degree of tolerance to dishonest validators. However, PoS consensus on the correct state and transaction finality of the blockchain can only be achieved if more than two-thirds of its operators are honest. To understand why, consider a situation where a group of malicious validators with exactly one-third of the total stake in Ethereum propose and sign two different blocks at the same blockchain height. They then broadcast one candidate block one-third of honest validators, and the other candidate block to the other one-third of honest validators. Since the two-thirds of honest validators will have access to conflicting information with a 50/50 ratio, they won’t be able to achieve consensus and decide which new block is the correct one.


Figure 2: Distribution of stake in the Beacon Chain[2].


With the increase in ETH deposited in the Beacon Chain, there is one group of validators, namely, Lido, a liquid staking provider and a permissioned platform giving higher accessibility to Ethereum staking, which is currently close to achieving 33% of the total stake in the network (see Figure 2). This raises the concern of a coordinated attack that could harm the block production post-merge. Furthermore, even if Lido stays honest, a hack which compromises the private keys of their validators could give a malicious actor access to a large share of the validation network of Ethereum with no capital cost. This concern has been addressed in several discussions regarding the role of Lido in the Beacon Chain, including governance proposals for Lido to self-limit their participation in the validation process for Ethereum post-merge, which hasn’t been approved by the holders of LDO, the platform’s governance token. The fact that Beacon Chain withdrawals won’t be available right after The Merge—this functionality might take anywhere from six to twelve months—worsens this situation, since users of liquid staking services in the likes of Lido cannot simply withdraw their ETH to decrease the stake in control of malicious validators, but actually need to deposit more ETH into other validation nodes to raise their share of the total stake.


Our take:

Scenario 2 is possible in every PoS blockchain, so this risk is no different from the one with networks like Solana or Avalanche. Surely, even though one of the crucial aspects of moving to PoS was to improve the degree of decentralization of Ethereum—whose consensus today revolves around a little over 20 mining pools—the current concentration of validation power in players like Lido, or even Coinbase and Binance, should be a cause for concern and investors should keep following quite closely how this situation will evolve over time. 

However, as soon as ETH withdrawals become available in the Shanghai hard fork, a later network upgrade post-merge, users that currently delegate tokens to liquid staking providers will be able to easily rotate their ETH from one provider to another, similar to how miners today can switch between mining pools if any of them becomes too concentrated in hashrate. We believe this points to a medium term state where the validation share in PoS Ethereum will become more and more decentralized, even if the big players today continue to have relevant shares of the total stake. Also, given the business model of these staking providers, it is clearly not in their best interest to have their validators intentionally starting an attack, since similar to 51% attacks in PoW blockchains, this would harm the network they are highly invested in and depreciate the value of their staked assets. In addition, an unsuccessful attack can lead to a substantial amount of their employed capital to be slashed

Of course, a private key compromise is always a concern, but similar to how custody is a key aspect of institutional-grade products in crypto, we believe that Ethereum staking providers will only be able to thrive in this business if they also employ stringent custody measures in their operations. Therefore, we consider the risk associated with malicious validator activity to also be remote, which should continue to fade away with a successful mainnet merge and the future implementation of ETH withdrawals.


Scenario 3: A Proof-of-Work fork.


Current Ethereum miners have invested billions of dollars in GPUs and general computer hardware, with industrial miners also expending money in warehouses and electricity infrastructure for large scale mining operations. Since The Merge will eliminate PoW completely from Ethereum, this employed capital will have to be either sold or repurposed to other PoW networks, which unfortunately have far less network activity and market value, and therefore are less profitable than PoW Ethereum today.


This is currently leading to a third scenario where integrants of the Ethereum mining community can coordinate a PoW Ethereum fork during The Merge, creating a parallel PoW blockchain that will start from the same pre-merge state as the PoS Ethereum chain. To make this happen, miners have to collaborate with developers to change the Ethereum client softwares and remove the difficulty bomb.


Figure 3: Tether and Circle have released public statements supporting the switch to PoS.


Similar to the Bitcoin Cash fork resulting from the Blocksize War in Bitcoin—taking place between 2015 and 2017—this PoW fork would create a parallel blockchain with a pre-merge history and state in common to the PoS Ethereum chain. However, a fork in Ethereum has way more dramatic consequences than one in Bitcoin, since not only ETH tokens in users wallets in the PoS chain will have a counterpart in the PoW chain, but all smart contracts (e.g., Uniswap, Maker, Compound) and tokens (e.g., governance tokens, utility tokens, stablecoins) and their pre-merge states will have duplicates in a parallel blockchain. To account for the likelihood of a PoW fork happening, some exchanges (though smaller ones) have already started listing PoW and PoS ether pairs in their platforms.


Our take:

From the recent market movements in the crypto space, we believe a PoW fork is highly likely to happen during The Merge. Similar to the outcomes of the Bitcoin forks we have seen a few years ago, it all comes down to social (and economic) coordination, and which network will be the chosen one by the vast majority of the Ethereum community. 

For example, key service providers in crypto, like the issuers of the two biggest stablecoins in the space—USDT’s Tether and USDC’s Circle—have already publicly claimed they will support only the Ethereum PoS chain, meaning their cash reserves backing the stablecoins they issue will only be redeemable if users own USDT and USDC tokens in the PoS chain. Since these two stablecoins alone account today for more than $120 billion in market capitalization[3], and are key elements in the whole of DeFi and NFTs in the Ethereum blockchain, forbidding any redemptions of either Tether or Circle cash reserves through the PoW tokens will significantly impair the future of a PoW fork, which could see most of its assets having their value considerably affected—stablecoins losing their peg to the dollar, decentralized loans getting liquidated, liquidity pools being drained, etc.

Similar to how social coordination of developers and users made the market choose Ethereum over Ethereum Classic after the DAO hack—even though Ethereum Classic was the chain obeying the “code is law” ethos—we believe that the combined support to the PoS chain from crypto service providers, huge stablecoin issuers and major development teams will dim a PoW fork unsuccessful, making this parallel chain most certainly irrelevant and/or a target of pure speculation rather than utility. Therefore, even though this is very likely to pan out, we believe investors shouldn’t fear this scenario as a major risk for Ethereum after its switch to PoS.

Scenario 4: PoW was a competitive advantage.


Ethereum became the flagship smart contract platform employing PoW as its consensus mechanism since inception. Together with Bitcoin, Ethereum has been a key case of success for PoW, demonstrating that it is a robust consensus mechanism, enabling the two largest blockchains by market value and user adoption to have huge levels of security.


Now, all relevant alternatives to Ethereum (Solana, Avalanche, Polkadot, etc.) already use some variant of PoS, meaning that Ethereum will abandon one of its key differentials by transitioning to PoS. Furthermore, as we mentioned in our May article, the switch to PoS only won’t imply higher scalability—that is, higher transaction speed and cheaper fees. Rollups, for instance, which increase Ethereum’s throughput by bundling and executing transactions off-chain, already function under PoW. Hence, from a technical perspective, the switch to PoS will only be an intermediate step for the future scaling of Ethereum’s base layer through sharding, a solution that is still years away from implementation, although it will be a game changer when it comes to reducing energy consumption and allowing for more decentralization in the medium term.


Somewhat connected to this is the possibility of Ethereum users, developers, and miners migrating to other PoW Layer-1s which don’t plan any switch to PoS—such as Ethereum Classic, Ergo, and Zilliqa—in search for an environment where PoW continues to be used to achieve decentralized consensus and power a base layer where assets and dApps can be built.


Our take:

This scenario assumes that PoW, and the fact that it is more battle-tested than PoS, is perceived by investors as a competitive advantage of Ethereum over its competitors. In our opinion, this is an assumption which isn’t supported by strong evidence, considering that alternative Layer-1s have indeed gained a lot of traction during 2021, when most users couldn’t interact with Ethereum dApps due to high transaction costs. This is an indication that blockchain investors are comfortable enough with using any smart contract platform, as long as it is secure, and they have a good user experience and pay small fees to have access to DeFi, blockchain gaming, NFTs, etc. In other words, the way a blockchain achieves consensus is somewhat irrelevant to most people, everything else constant. 

Further, the scenario where alternative PoW Layer-1s take over a decent share of Ethereum’s dominance after the switch to PoS has a very little probability of happening, since, up until now, these alternative networks have largely lagged in adoption and development of applications. For instance, coming back to Ethereum Classic—with its native token ETC—it is yet to experience the development of a vibrant ecosystem of dApps, and from a quick inspection of its blockchain activity in any blockchain explorer, Ethereum’s offshoot has blocks which are mostly empty, meaning that the user demand for it is still very small, with its miners basically using the network to profit on the market speculation for the price of ETC.

This leads us to conclude that the switch to PoS shouldn’t really impact Ethereum’s dominance among all relevant smart contract platforms today, with the main contenders in the market actually still having breathing room to expand their market share before Ethereum is able to support a lot more scalability in the medium to long term, but not necessarily changing the market appreciation of the fact that Ethereum will always possess the first mover advantage in the Layer-1 space.

Our final take


Our goal here was to elucidate the different foreseeable scenarios that may play out during and immediately following Ethereum’s merge, bringing to light the main risks and what we can expect from them. As we pointed out, none of these scenarios should be considered as having a zero probability of happening. However, we believe each of these four scenarios don’t pose serious risks to the Ethereum blockchain once it fully switches to PoS.


We remain confident that The Merge will be a major breakthrough for Ethereum, being the first step to unleash its potential to support tens of thousands of transactions per second in the future, once sharding and rollups become commonplace. Furthermore, having a consensus mechanism with minimal environmental impact will unlock Ethereum as a viable investment to a large number of big institutions, whose portfolios today have been steadily incorporating ESG principles. Finally, the new monetary policy for ETH and the fact that validators will start earning transaction fees post-merge—meaning current annual staking yields could effectively increase from today’s 4% to around 8-12%—have the potential to diminish quite substantially the liquid supply of ETH available in the market, since around 90% less ETH will be issued on an annual basis, and more people will have the incentive to lock their assets as stake for validation purposes in exchange for rewards. 


All in all, there is reason to believe that The Merge is not fully priced into market expectations. Its success will not only remove a huge uncertainty surrounding Ethereum’s future for the past several years, but unlock even more potential for the network to continue being crypto’s flagship smart contract platform.


[1] The difficulty bomb is an intentional and sudden growth in mining difficulty when Ethereum switches to PoS, which exponentially increases the time to mine new blocks, disencouraging the process of mining and the creation of blockchain forks. 

[2]  Source: Dune Analytics, ETH Beacon Chain Deposits, accessed July 5th, 2022.

[3] CoinMarketCap, accessed August 29, 2022.



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