The 'merge' didn't fix Ethereum

The author is a law professor at the American University Washington College of Law

The Ethereum blockchain, which facilitated much of the crypto world last month, has finally accomplished the long-promised and oft-delayed “merge,” a technical shift in the way it works.

The Ethereum blockchain is one of the world's most widely used digital ledgers and the main platform for Web3, non-fungible tokens and decentralized finance. While the merger is clearly good news for the environment, it highlights the Ethereum blockchain's other problems even more clearly.

Instead of relying on centralized intermediaries like a bank to approve transactions, blockchains rely on what is known as a “consensus mechanism.”

Before the merger, Ethereum used the “Proof-of-Work” consensus mechanism. This involves so-called “miners” using enormous amounts of electricity to power computers to repeatedly guess the number that allows them to add a block of transactions to the blockchain. The winning miners are then compensated for their work with cryptocurrency.

The Bitcoin blockchain still does it that way. Verifying Bitcoin transactions uses more energy than entire countries like Norway; In areas where there is a lot of Bitcoin mining, the local population suffers from rising energy costs and noise pollution.

Ethereum’s move to a proof-of-stake system avoids these environmental costs. Ethereum now uses an algorithm that randomly selects someone to create a new block to add to the blockchain. The party is chosen from those who have staked their Ether (the native Ethereum blockchain). coin) for the opportunity to do the work and get paid for it. The more Ether someone stakes, the more likely they are to be chosen to create the new block.

This creates incentives to acquire even more Ether, and it seems reasonable to predict that any blockchain that relies on proof-of-stake will begin to concentrate the ability to process transactions in just a few hands. According to data provider Nansen, staking is already a highly centralized business, involving some of the industry's largest companies such as Coinbase. Greater centralization seems inevitable.

Remember, the whole point of a blockchain with a consensus mechanism is to avoid having to rely on centralized intermediaries to verify transactions. Without meaningful decentralization, one has to wonder whether all the other problems associated with Ethereum are worth it.

For example, the Ethereum blockchain is notorious for congestion at peak times, which manifests itself in slower transaction processing times and fluctuating transaction fees (known as “gas fees”). At peak times, gas fees can be prohibitive for users trying to complete smaller transactions (in May 2022, average daily gas fees reached nearly $200), but the merger did not change the way gas fees are calculated or collected.

Such overload contributes to another problem. Users can pay validators higher fees to have their order executed first within a block of transactions. This is a cost to users that benefits the larger validators, who are chosen to create more blocks of transactions and therefore have more opportunities to reap higher fees. A validator can even insert its own transaction in front of others to profit from market movements, a practice known as MEV or “maximum extractable value.”

The merge will not make the blockchain more secure either. Ethereum’s claims to do so assume that the merger will increase decentralization. But if the opposite is true, there are risks. A report commissioned by the US Defense Advanced Research Projects Agency found that proof-of-stake blockchains can be successfully manipulated if the number of validators is too small.

The move to proof-of-stake also increases legal uncertainty surrounding the status of Ether. Before the merger, US Senator Debbie Stabenow proposed a bill listing Ether as an example of a "digital commodity" that falls outside the jurisdiction of the Securities and Exchange Commission (in the US, securities are regulated by the SEC, while commodity futures trading). Commission has oversight of the raw materials markets).

Now that stakers are pooling their Ether in hopes of being compensated by the Ethereum blockchain's gas fees, a stronger argument can be made that Ether are securities and not commodities. The SEC may have something to say about Ethereum’s claims about its decentralization and benefits.