Not your regular Merger

Authored by: Jazz Osvald

The Merge is probably the most anticipated and complex upgrade to Ethereum in the blockchain’s history. Its impact may extend far beyond Ethereum, making the Merge, quite frankly, one of the most important moments in the history of the crypto market. But what is the Merge, and why does it matter?

What is the Merge?

The Merge is the process by which the method of processing transactions on Ethereum is to convert from energy intensive proof of work consensus mechanism, to a more energy efficient proof of stake model.

The method by which transactions are processed, verified and written to the network is known as “securing” the network as this ensures that a record of transaction is available on the network in a way that is programmatically immutable (impossible, or very difficult, to reverse).

Currently, the Ethereum network uses proof of work to “secure” the network. This involves participants called “miners” who collate transactions posted by users of the network competing to build and propose blocks of transactions to be added to the blockchain in exchange for rewards denominated in Ether.[1] Participants called “full nodes” hold a complete record of the ledger and verify that the transactions within the proposed block follow the network’s rules. Once validated by 51% of the full nodes on the network, the new blocks are appended to a blockchain’s ledger. Each block includes a reference to the most recent block, forming a chain. A single change in any block will alter every subsequent block, meaning that should an attacker want to alter any information in a past block, they would need to calculate each subsequent block at a rate faster than the rest of the network. This would naturally require over 50% of the network’s processing power (hence why this is referred to as a 51% attack) which requires significant hardware and energy costs. Transactions in a proof of work blockchain are seen to be technologically immutable as it is economically unviable to alter the record of blocks and transactions in a blockchain. In Ethereum’s case, these records are known as the blockchain’s state.

Proof of stake does not rely on computational power to validate transactions. Instead, Ethereum “validators” lock up (known as “staking”) Ether in a smart contract for a period of time to secure the network. Validators are randomly selected to propose a block based on the amount of Ether staked, proportional to the total amount staked on the network. The validators that were not chosen to propose the current block verify the proposed block in a process referred to as attestation, which is functionally similar to the process performed by a proof of work network’s full nodes. Upon successful attestation, the block is added to the blockchain and the successful validator is rewarded with Ether. Penalties can be levied against a validator’s stake where they attack the network. This is referred to as slashing. Bad actors can also be blacklisted from being a validator.

How will the Merge work?

Ethereum’s eventual transition to proof of stake was considered by its creator, Vitalik Buterin from its inception.[2] Despite earlier plans to launch, including under the name Ethereum 2.0, the delay reflects that complex systems require slow and deliberate upgrades to allow the greatest chance of success. This seeks to lessen the risk of systemic failure.

The Merge will involve the merge of the Beacon Chain, referred to as the “Consensus layer”, with the current proof of work layer, referred to as the “Execution layer”. The Beacon Chain is the ledger of accounts that conducts and coordinates the network of stakers for the proof of stake upgrade.[3] The Merge will be activated by several hard forks,[4] and its effect will be that transactions on Ethereum will be processed through the new proof of stake mechanism.

The first practical stage of the Merge occurred in December 2020, where Ethereum developers successfully launched the Beacon Chain. From this date, anyone could stake Ether to the Beacon Chain provided they had 32 Ether.[5] The purpose of this was to incentivise users to stake Ether in preparation for the Merge. At the time of writing, the Beacon Chain has over 13.5 million Ether staked.[6]

Does the industry support the Merge?

While the Merge has seen widespread support across the crypto industry, there are still proponents of the proof of work model who have committed to continue to process transactions on the proof of work chain.

If a miner was to continue to support the old proof of work chain (“ETHPoW”) this will operate simultaneously and independently of the proof of stake Ethereum blockchain (“Ethereum”). All records of transactions before the Merge will be duplicated on each fork after the Merge.

Why Merge?

Many are unsure as to what benefits the Merge may actually bring. Despite early suggestions, it seems the Merge won’t

make transactions cheaper, this will be left to scaling measures such as rollups and sharding; or
materially increase transaction speeds.

In addition, the move to proof of stake does not come without risks. Proof of stake presents different security and trust assumptions to proof of work, and brings about additional technological, legal and governance risks. Which begs the question - what are the benefits presented by the Merge, and what actions should you consider in anticipation?

Benefits - The Merge should make Ethereum more energy efficient …

The key benefit is that proof of stake should make Ethereum far more energy efficient. The biggest complaint about proof of work is that it is power hungry. At the time of writing, the Ethereum proof of work network uses around 90-100TWh of energy per year, roughly the same amount of energy as Kazakhstan. Moving to proof of stake is estimated by the Ethereum Foundation to be a reduction in consumption by 99.95%,[7] as it no longer requires intense computations be performed when processing transactions.

The environmental impact of crypto assets have recently been a major focus of regulators both in Australia and internationally.

For example, ASIC has increased its focus on environmental impact disclosures with respect to crypto assets. ASIC specified that where a managed investment scheme holds crypto assets, “the environmental impact of a crypto asset should be disclosed where the environmental impact is large enough to raise the risk of, for example, increased regulation or negative market sentiment which could affect the value of crypto-assets held by a scheme.”[8]

Internationally, an early draft of the Markets in Crypto-assets (“MiCA”), a regulatory framework developed to help streamline distributed ledger technology and virtual asset regulation in the European Union (“EU”), included articles requiring virtual assets issued, offered or admitted to trading in the EU meet a specified environmental sustainability criteria,[9] as well as banning virtual asset service providers from providing services with respect to crypto assets that do not meet these criteria.[10] Although not included in the most recent version of MiCA, more recent provisions seek to limit the use of proof of work to only small scale applications, and encourage the deployment of environmentally friendly alternatives. Crypto asset issuers are also required to disclose in their whitepaper an independent environmental assessment where their crypto asset uses proof of work.[11]

… and more secure

Proof of stake should also bolster elements of the network’s security, as the costs to attack the network will be higher, the overheads associated with being a validator are lower than that of a miner, and penalties can now be imposed against bad actors.[12] However, whether proof of stake is more secure overall than a proof of work network is a constant source of debate.

The Merge should create new opportunities and new risks for businesses

When a person stakes Ether, they may receive a yield. This will present new opportunities for businesses to earn revenue. However, this also introduces fresh considerations, such as:

whether activities involving Ether, including services which provide a return for investors, or provide validator services, are regulated under existing financial services laws, requiring an exemption, a new licence, or additional authorisations under existing licences;
whether cybersecurity systems and infrastructure are sufficiently robust to provide validation services;
managing validator risks such as slashing and other network-imposed penalties and the apportionment of these penalties between participants, as well as risks associated with using validator software (referred to as clients) that is used by the majority of the network;[13] and
whether transactions in connection with wallets that have had sanctions imposed on them should be validated (and what that connection might be). Legal risks of processing these transactions and commercial risks of penalties imposed by the network for not processing certain transactions may be considered, although legal compliance remains essential.

There is no guarantee that an exchange or wallet provider will support EthPoW, so any customer relying on these services should review any agreements or terms and conditions to establish what their rights are with respect to any duplicated crypto assets that are being held with third parties.

In addition, the Merge raises some unique legal issues particularly where assets and rights are duplicated on 2 blockchains.

Legal issues arising from the Merge

Following the Merge, the same assets and rights will be duplicated on both the ETHPoW and the ETHPoS chain. This raises a number of unique questions depending on the nature of the asset or right, or person providing those rights.

In the past, a hard fork has resulted in duplication of a protocol’s native crypto asset, such as during Ethereum’s split into Ethereum and Ethereum Classic, and Bitcoin into Bitcoin and Bitcoin Cash. Although there was concern, it was fairly simple to ascertain which asset was the new asset and which was the continuation of the same original asset. These forks occurred at an earlier stage in the ecosystem’s evolution and did not involve the duplication of an entire ecosystem at this scale.

Now, not only might the native token split in two, but every crypto asset issued using the Ethereum protocol may be technologically duplicated. This extends beyond other crypto assets to include non-fungible tokens (NFTs) and other rights, records of which are stored on the Ethereum protocol.

Further, all smart contracts and decentralised applications will also be duplicated. This includes bridges between blockchains and layers, oracles receiving information from external data sources, DAOs and layer 2 protocols. This will introduce unprecedented issues into the crypto ecosystem. For example, whether these links, particularly to external systems, will be maintained and will facilitate the continuation of the processes as intended is yet to be seen.

Impact on rights to redeem

Certain crypto assets, particularly some “stablecoins”[14] provide a right to redeem another underlying asset. For example, many fiat-backed stablecoins maintain their value through rights to redeem fiat currency. Where stablecoin issuers do not recognise duplicated stablecoins on any EthPoW chain as providing these rights to redeem, there may be interesting consequences for the DeFi ecosystem. Despite the technological duplication of the stablecoin, the legal consequences could be managed through an appropriate legal framework. For example, Tether and Circle, issuers of the largest US dollar denominated stablecoins USDT and USDC respectively, have each signalled that they will not be supporting any EthPoW chain, meaning only the stablecoin on EthPoS will have the right to redeem.[15] Each of their terms of service have provisions which provide that only one fork will be supported.[16]

An economic consequence is that any “stablecoin” which is on an unsupported fork could lose value. This may impact other systems if they have not upgraded to recognise the new token.

Similar issues arise in relation to NFTs.

Impact on contractual rights conferred by NFTs

Many NFT projects grant their holders rights, such as commercial rights to copyright, royalties and other revenue streams, or access to future products, ecosystems or airdrops. Terms and conditions of NFTs may not address which chain will be supported. Supporting all chains may be the simplest means to foster community and inclusion across a project. However, this may also affect the value of an NFT which is intended to be unique or limited. Additionally, legal issues arise where the NFT confers legal rights, particularly those which necessitate exclusivity, such as a licence to commercialise artwork. Unless expressly dealt with under contract this may well give rise to uncertainty and disputes.

Addressing this is likely to require revisiting existing agreements including terms and conditions of issuance to consider whether these address the Merge, and any rights associated with crypto assets.

Holding crypto assets on behalf of another

There are also considerable challenges around arrangements where third parties hold crypto assets for their customers, including as custodians or service providers such as a wallet provider or exchange. There has been much discussion around whether consumers that hold their crypto assets with these third parties will be given access to both crypto assets that result from a hard fork. Historically, this has only had to be considered with respect to native crypto assets, and not to other crypto assets like NFTs, tokens and stablecoins. Part of the reason that uncertainty and disputes were prevalent during earlier hard forks was that many of the agreements that governed these third party arrangements did not contemplate hard fork events.

However, this may no longer be the case. Some exchanges have already signalled that they will be supporting EthPow by providing users access to its native asset, and providing trading markets. Of course, such a decision may be both commercial and legal in nature as operational changes would be required to distribute the duplicated crypto assets to customers, provide liquidity for new markets, and connect systems with the EthPoW blockchain. Legal analysis may need to be undertaken as to what duplicated crypto assets, if any, are provided to customers, and whether this fits within that company’s contractual and other legal obligations, particularly when held on trust, as well as legal and risk frameworks including statutory and licensing obligations.

Many other unique legal questions may arise

Some other legal issues which may need to be considered include:

Consumer protection. Consumers may be exposed to ‘replay attacks’ which occur where users attempt to interact with a crypto asset that is duplicated on the resultant EthPoW chain. In certain circumstances, transactions on the EthPoW chain can be replicated or “replayed” on Ethereum. For example, a user may send 10 Ether from wallet A to wallet B on EthPoW. In certain circumstances, an attacker could send this transaction information to Ethereum and replicate the same transaction causing 10 Ether to be sent from wallet A to wallet B on Ethereum. Industry has cautioned users to take certain precautions when interacting with any EthPoW chains.[17]
Derivative transactions. Uncertainties also arise in the context of derivative transactions where the underlying is either Ether or a crypto asset on the Ethereum blockchain. Counterparties entering into trades may encounter difficulties with respect to the valuation of the underlying if there is uncertainty as to which is the “true” version of that crypto asset. Parties to these trades should be aware of how these mechanisms work, and whether they trigger any additional termination or disruption events.
Tax. There may also be tax implications. For example, this may arise where a new crypto asset resulting from a hard fork is received and subsequently disposed of. The ATO’s current website guidance on crypto asset chain splits states that where an investor receives a crypto asset as a result of a hard fork, the value of that crypto asset is not treated as either ordinary income, or a capital gain at the time of receipt. Rather, a tax event occurs at the time of disposal of that crypto asset, with a cost base of $0. Where a taxpayer acquires the new crypto asset in carrying on a business, it may be treated differently for tax purposes.[18]

Conclusion

These are just a few of the issues that the Merge presents. Truth be told, it is unclear how the market will be affected by the Merge. While the Merge has undergone considerable testing, there is still some concern as to whether, even after the Merge is successful, Ethereum continues to function as it should.

The legal issues to consider range from financial services and sanctions regulation (including licensing), to consumer protections, tax, derivatives, cybersecurity and data, and fundamental legal concepts in contract law. If you need assistance with any of the above, or more broadly, please do not hesitate to reach out to our team.

Keep an eye out for the second edition of Move Fast and Make Things launching soon.