Understanding The ‘Ethereum Merge’

After many delays, the long-hyped “Ethereum Merge” is about to happen. The first stage of the process – Bellatrix – happened on September 6.

The second stage – Paris – completes at some point next week. At that point, the way Ethereum – the world’s second largest cryptocurrency behind Bitcoin – fundamentally works will change, which is sure to have an impact on its value and send ripples across the wider cryptocurrency market.

But what is the Ethereum merge and why does it matter? Here’s a look at what it all means and why it’s important.

Remember: the cryptocurrency is purely speculative and all your capital remains at risk at all times. You may lose some or all of your money. Cryptocurrency is unregulated in India and you are unlikely to have any recourse to compensation if something goes wrong.

Two become one

As far as the world of crypto is concerned, the upcoming change is a big one. 

Essentially, it’s all about how transactions are recorded onto Ethereum’s blockchain – an immutable record of all Ethereum transactions.

Since 2016, there have been two versions of Ethereum running in parallel. One has used the traditional method of recording transactions, while the other relied on a new method. This month, the two versions will be merged into one, adopting the new record-keeping paradigm. See below for the timeline of upcoming events.

To understand the difference between the two versions you need to understand two big cryptocurrency concepts: blockchains and consensus mechanisms.

How a Blockchain Works

A traditional bank keeps a huge ledger of all its customers’ transactions. This ledger contains vital information.

For example, it tells the bank which customer has what amount of money in each account, who has sent money, who has received money, and so on. This register of records is known as a centralized ledger. Nobody can claim they have more money than they really have, or to have made a transaction that they haven’t.

A blockchain, in contrast, is a “decentralized ledger”. This means the information is not held by a financial institution like a bank, but by normal people who volunteer to maintain it. It records every transaction made and cannot be edited, providing a definitive account of who holds what assets.

So, why would anyone volunteer to help maintain a blockchain? The answer is that there are lucrative rewards available for a few lucky volunteers. Who gets the rewards depends on the blockchain’s “consensus mechanism” – more on that in a moment.

Every volunteer has their own, independently held copy of the blockchain. Each individual keeps this updated according to transactions “broadcast” to them as a member of the blockchain’s network. As they receive updates, they update their copies of the ledger. 

As long as nobody lies about what’s in an account, everyone’s copy of the ledger should match.

But why would you trust anonymous, random people on the internet to be honest about how much digital money was in theirs or others’ accounts? 

Again, this comes down to the blockchain’s consensus mechanism – so let’s take a look at what a consensus mechanism is, and why it matters.

Consensus mechanism

A consensus mechanism is how a blockchain ensures that everybody involved in keeping records of transactions is being honest and not trying to claim that there is more in their – or other – accounts than there should be.

It works like this: a member of a network is chosen to have their record of the ledger become the official record of transactions. A majority of members (51%+) have to agree that theirs is an accurate record.

So, in order to cheat the system, you’d have to control at least 51% of devices connected to the network. This would take either a tremendous amount of computing power or a large amount of money to pull off, depending on the consensus mechanism in use.

Ethereum started with a Proof of Work consensus mechanism. In 2016, the network split into two “forks”, one still using Proof of Work, the other using a process known as Proof of Stake. When the merge happens, Ethereum will use the Proof of Stake consensus mechanism only.

Proof of Work

On a blockchain using Proof of Work as a consensus mechanism, members of the network compete for the chance to be the one chosen to add their copy of transactions to the ledger.

They do this by guessing a long string of letters and numbers out of trillions of possible combinations. The more powerful your computer network, the more guesses you can make each second and the faster you’ll reach the winning solution.

When someone submits the right answer, they’re invited to submit their copy of the ledger to be checked by the community before it’s added to the blockchain and they’re rewarded with an amount of cryptocurrency as a reward.

If the person who correctly guessed the code tried to cheat the system by adding a dishonest record of transactions, the community would reject it as incorrect and they’d lose their reward. In effect, there’s a carrot to play fairly and a stick for cheaters.

In order to successfully cheat the system, someone would need the computing power to control at least 51% of the network – a feat which, while possible, is very expensive.

Proof of Work, which is also used by Bitcoin, is criticized for its impact on the environment. For example, the Bitcoin network is thought to use more energy than the entire country of Argentina.

Proof of Stake

Proof of Stake asks people to put up their own crypto assets as collateral for the chance to have their record of transactions made official, and earn the rewards for doing so.

It’s considered better for the environment, since there’s no energy-intensive computing to be done, and fairer, because it’s not just people who can afford vast computing arrays that can hope to earn rewards.

The more you stake, the better your chances of being chosen as the next person to add their copy of the ledger to the blockchain.

Anyone trying to cheat the system should, as with Proof of Work, be called out by the community for doing so, and they would also lose the assets they’d staked for the opportunity they’d bought themselves.

While it is better for the environment, it does favor people and organizations who can afford to stake the most crypto – funneling more assets to the already asset-rich.

Ethereum 2.0

The first stage of Ethereum’s two-stage merge, codenamed Bellatrix, happens today, 6 September 2022. The second stage, Paris, will happen between 10 September and 20 September 2022. Only once both stages are complete will the merge be complete.

Post-merge, the Ethereum 2.0 network will use Proof of Stake as its only consensus mechanism and is predicted to consume 99.5% less energy than it did while it used Proof of Work.

The price of Ethereum’s native currency ETH has increased by 6% over the past three days in the leadup to the Bellatrix update. ETH is currently trading at around INR 1,40,900, with experts predicting further increases once the merge is complete.

Crypto exchanges such as Binance had temporarily suspended Ethereum transactions this morning in anticipation of the merge.