Nicholas Crossland Marcus Bagnall November 4 2022 Why does the evolution of Ethereum's ecosystem matter to blockchain businesses? Wiggin LLP | Tech, Data, Telecoms & Media - International Nicholas Crossland, Marcus Bagnall Tech, Data, Telecoms & Media IntroductionPoW and PoS protocolsHow to change protocolWho is affected by the merge?What is different after the merge?Potential regulatory impactIntroductionOn 15 September 2022, Ethereum pulled off an ambitious technical feat by merging a new blockchain with its Mainnet in order to change the way the network operates at a fundamental level, all while the over $200 billion ecosystem built on top remained live.This article explains what actually happened at "the merge" and some practical and legal implications for Ethereum-based businesses and their suppliers.PoW and PoS protocolsThe Ethereum ecosystem comprises several blockchain networks. Its primary public network, the Ethereum Mainnet, records over a million transactions a day and hosts the majority of smart contracts and decentralised applications that currently exist (nearly 3,000 applications). Other "test networks" exist, allowing users to deploy and test contracts without committing to the Ethereum Mainnet and its associated transaction fees.A blockchain is a decentralised network without a central control authority, instead relying on a consensus protocol to verify new transactions on its chain. The two most common protocols are proof of work (PoW) and proof of stake (PoS).ProtocolDescriptionNode incentivesPoWEthereum, like Bitcoin, was established as a PoW network. On-chain transactions are validated by network participants known as "miners", who expend computing power and energy solving hash functions. The more resources they expend, the more likely they are to be the miner that solves the function and gets to "validate" a block of transactions.Miners are rewarded for successful validation with new native currency (in this case ether). The network is protected because a single node would have to expend more than half the total energy of the network to maliciously alter it (a "51% attack").PoSEthereum's co-founder, Vitalik Buterin, has long favoured an alternative (and much less energy intensive) PoS consensus mechanism. Participating nodes can "stake" their ether (essentially locking it up temporarily), and the more ether they stake the more likely they are to be selected by the protocol's algorithm to validate a given block of transactions.Validators are rewarded with ether collected in the form of transaction fees from the given block. This similarly protects the network because a single node would have to stake more than half the total staked ether in the network to carry out a 51% attack.How to change a protocolBlockchains can be "forked" into new chains – this happens relatively often. Forking is usually caused by a number of nodes in a network deciding to adopt a modified version of the original blockchain's (open-source) protocol. A new consensus protocol means a new parallel chain is created, where transactions are validated according to that new protocol, while transactions can still simultaneously take place among the other nodes still using the old protocol. Therefore, there are two chains and one origin.A key consideration when Ethereum moved from a PoW to a PoS consensus mechanism was to ensure continued network security. To do this, it needed a fully functioning PoS network with enough network participants to verify transactions. In 2020 it created Beacon Chain, a new blockchain alongside the Ethereum Mainnet, which attracted over 400,000 validators (network participants). Unlike the Ethereum Mainnet, the Beacon Chain cannot run smart contracts and does not hold account details – it just exists to establish consensus by PoS. The Beacon Chain was then merged with the Ethereum Mainnet. This means that the Ethereum Mainnet as it exists now is the same blockchain that pre-dated the merge, and no pre-merge transactions are lost.All of this took over two years, with various forks created and test runs carried out in the process. The Beacon Chain now operates as a "consensus layer" on top of the Ethereum Mainnet, allowing Ethereum transactions to be validated using PoS, permanently replacing PoW.Who is affected by the merge?The merge impacts blockchain businesses either running on, engaging in or providing services in relation to the Ethereum network. Decentralised application and smart contract developers will now be able to create solutions utilising Ethereum 2.0, taking advantage of improved transaction speed and cost.Node operators and infrastructure providers (such as third-party network clients, mining syndicates or staking pools) will now be driven by staking rather than mining-related incentives.Anyone previously unable to buy a graphics processing unit during the heyday of crypto-mining in recent years will welcome the merge.What is different after the merge?The underlying economics have shifted with Ethereum 2.0. The abolition of mining means that the cryptocurrency is no longer inflationary (in fact, the merge might make it deflationary). The changes most relevant to businesses are largely those with the potential to drive wider network adoption:sustainability – solving the problem of PoW's extraordinary energy demands and reducing the network's consumption by approximately 99.95% may invite new market entrants previously concerned about the environmental impact of the ecosystem;higher volume – the upper limit on transaction capacity is reported to be increased by a measurable percentage by virtue of the merge alone; andinnovation potential – the move to PoS also opens up numerous technical possibilities that could further increase the capacity and speed of the network, such as shard chains (which allow participants to run Ethereum nodes from smaller, even portable, devices). The disruptive potential here is significant, especially for the payments industry, since Ethereum's technical estimates put the potential transactions per second (TPS) at around 100,000. This is almost double the maximum TPS for the Visa network, even by Visa's own estimates, and more than four times Visa's capacity by other estimates.Potential regulatory impactRegulators in major markets globally are yet to come to a clear view on PoS networks generally. The ability to lock up cryptocurrency in return for a reward (paid from transaction fees) is a contract that looks arguably like a bond. The merge means that the world's second-largest cryptocurrency could now be described as a yield-bearing asset and a step closer to being treated as a security under financial services regimes in some markets.The relative complexity of staking protocols and pooling arrangements is also likely to attract greater consumer protection scrutiny as it gets adopted more broadly.Also, should yields remain stable (especially in the context of uncertainty around government bonds), this could lead to greater institutional investment.For further information on this topic please contact Nicholas Crossland or Marcus Bagnall at Wiggin by telephone (+44 20 7612 9612) or email ([email protected] or [email protected]). The Wiggin website can be accessed at www.wiggin.co.uk.