The Breakdown - Welcome to the Post-Merge Era in Crypto

Episode Date: September 16, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US.   At 2:44 a.m. ET Thursday, Ethereum successfully transitioned from proof-of-work to proof-of-stake. On today’s show, NLW breaks down what that means for the network’s security and economics and looks at the political dimensions that could impact Bitcoin and the rest of the crypto industry.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company ensures the safety of your funds by employing five key fundamentals including real-time auditing and recently increased $775 million insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “Razor Red” by Sam Barsh and “The Life We Had” by Moments. Image credit: Andrei Akushevich/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.    

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and ftX, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, September 15th, and as of very early this morning, Ethereum has moved to proof of stake. Before we get into it, though, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.LY slash

breakdown pod. Also, a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. Now, as I said, early this morning, depending on where you are, early for me, East Coast time, Ethereum has transitioned from proof of work to proof of stake. A big picture power shift, get it, if ever I've seen one. There were all. a lot of tweets in the lead-up yesterday about just how significant the event was. Patrick Collison from Stripe wrote, Excited about the Merge, one of the coolest examples of sustained, ambitious, technically difficult open-source development.

Congrats and good luck to Vitalik Buterin and the entire Ethereum community. Eric Forhees of Shapeshift wrote, After Bitcoin's white paper release, Ethereum's merge is the most consequential event in crypto's history. It happens in less than 24 hours. I feel awe and gratitude towards the beautiful minds. that enabled both of these events. Chow Wang wrote, the merges, in my opinion,

the most important technical upgrade in the history of crypto. Risk is non-trivial. I'm rooting for them. Jake Chavinsky wrote, You don't have to be an Ethereum to be excited for the merge. It's an amazing achievement in the history of open source software and one that will lay bare the hollowness of Web3 skeptics who used environmental concern trolling to disguise their hatred for crypto

and now must pivot. So on this big occasion, let's do a bit of a 101. and for many of you, this will be completely repetitive or overly simplified, and if that's you, apologies. What's more for the sake of a lot of this, such as the next section on security, I want to be clear that I'm not saying these are things that will definitely happen. I'm just presenting hypotheticals to help people think through scenarios and understand the changes.

The event, a technical switch this big, is totally unique in the history of the industry. So let's talk first about security. The merge is a fundamental change in the security model for Ethereum. Whereas original Ethereum relied on miners guessing block hashes just like Bitcoin's consensus mechanism, post-merge Ethereum relies on validators to propose and verify valid blocks. The new consensus model requires validators to stake 32-Eath to participate in consensus. One validator is then chosen at random to propose each new block. That block is then sent to a council of other randomly selected validators to sign that

block and signal that it should be added to the blockchain. Now, in terms of the considerations or concerns with a new security model, One Dimension is a 51% attack. This has long been the main hypothetical attack vector for blockchains. It's where a bad actor would gain access to enough mining equipment to represent a majority of the network for a prolonged period of time. This would enable them to double spend coins and break the consensus model. Now, we've never really seen a serious attempt at a 51% attack for any major blockchain network, so it's a little difficult to estimate the cost of feasibility of attacking a mature network in this way. Some previous back of the napkin calculations that I've seen have put the cost of an attack at

at least $2 billion worth of mining equipment and then a few million dollars per hour in electricity to run the attack. Suffice it to say, this attack vector is generally impractical while a large mining network exists. Ethereum's proof-of-state network also won't really likely be vulnerable to this type of attack. There are currently around $24 billion worth of Ethereum staked in the validator network. While estimates vary on whether 30% or 51% would be required to attack the work, we're still talking about $8, $12 billion at a bare minimum which would be needed. So realistically, 51% attacks are not the vector that most people are thinking about. In the wake of tornado cash sanctions, the much more relevant concern is the prospect of censorship and other

regulatory attacks. Currently, staked Ethereum is largely pooled with large entities. Coinbase operates 15% of validators, Krakken operates another 8%, and both of those are actors who are likely to respond to U.S. regulatory action. There are also 30% of validators operating within Lido's Federated Staking Network, which is governed by a Dow and doesn't seem to have a clear regulatory jurisdiction. 7% are also staked with Binance who are also unclear about their regulatory jurisdiction. In the fallout of the Tornado Cash Sanctions, these large entities set out their views on how sanctions interact with POS validation.

Coinbase in particular has been very vocal in their statements that they would not censor transactions at the protocol level, and have claimed that they would rather shut down their staking business than censor transactions. They've gone so far as to actually support a lawsuit against the U.S. Treasury, seeking a declaration that the sanctioning of a crypto protocol was beyond the scope of the Treasury's currently legislated role. Now, as it stands, there are currently penalties for dishonest validators known as slashing. However, these only punish validators that are inactive when called upon to validate a block, or who attempt to double sign blocks. There isn't currently a mechanism to punish validators

who censor transactions by refusing to include them in blocks. To introduce this sort of mechanism would require a protocol change, which is a concept that's come to be referred to as social slashing, indicating that it would need to be some kind of ongoing social consensus on which validators were acting against the wishes of the community. Now, all of these concerns are very real, not just theoretical, especially in the wake of the tornado cast sanctions. Many in the Ethereum community have stood up and said no to censorship, but ultimately this will be about action, and how the reality of pooled stakers that are regulated within jurisdictions that want to do censoring, like the United States, will come up uncomfortably against the idea of a permissionless

network. Next up, let's talk changes about the economics. One of the big drivers of excitement around the merge has been changes to the economic structure. Some in the Ethereum community have nicknamed this the triple halving, referencing the similarity to the Bitcoin having but having an estimated effect equivalent to three halvings worth of issuance reduction. There are three changes that will reduce Ethereum issuance. First is the reduction of issuance of new tokens via consensus rewards. Before the merge, the Ethereum network issued around 13,500 new tokens to miners as rewards, around 4.9% of supply annually. After the merge, this will drop to between 0.3% and 0.4% annually rewarded to validators. This is because, although validators will earn significant yield,

currently estimated to be around 5% of their stake annually, this results in much less issuance because only around 12% of Ethereum supply is currently staked in earning yield. A second element of the triple-havening is token burning. This design feature was added with EIP 1559 upgrade in August 2021 that modified the way that Ethereum fees were handled. Instead of simply distributing fees to miners, this upgrade instead burns part of the protocol fee, which reduces overall supply. Since the upgrade was introduced, more than 2.5 million tokens have been burned, although total issuance has still exceeded the burn rate. The third element is the reduction in cell pressure due to stakes being locked up, because validators do not have the high

ongoing operating cost of miners, there should be less need to sell off reward tokens to meet costs. This will cause stakers to retain their rewards and add to their stake. At present, there is no ability to remove a stake from the protocol. This will be activated by a protocol upgrade currently on the roadmap for implementation after six to 12 months. This means that until then, there will be no selling pressure whatsoever from token issuance to stakers. Now, there are a lot of interesting debates around this economic model and how it will work,

what it means for other parts of the ecosystem like defy and more. The critique or concern levied from outside is that the marketer. that this design might lead to increasing concentrated wealth within the protocol. The counterpoint is that this design simply replaces the opportunity cost of energy usage in capital investment to participate in mining. One impact could be an Ethereum defy. If a user can earn 5% yield by simply staking Ethereum, then might that impact how valuable yields across the rest of the space will be? Could it drive up the cost of borrowing in defy, or even dry up lending markets if higher yields are not sustainable? The strongest current narrative around the tokenomics of Ethereum

is that it will end up being deflationary, reducing in supply over time, and thus becoming what folks like the bankless boys have called ultrasound money. For what it's worth, they first premiered that meme while my wife was pregnant with our second kid, so ultrasound has always had a slightly different meaning for me. Nexo is a security first platform built for the long run with everything you need for your crypto. Five key fundamentals, including real-time auditing and insurance on custodial assets, safeguard your funds. making nexo the right place for you to buy, exchange, and borrow against your assets safely.

Learn more about nexo's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more informed decisions around crypto, chainelysis is here to help. Chainalysis demystifies cryptocurrency by providing industry-leading compliance, market intelligence, and investigations support for all crypto assets. For organizations like Gemini, Crypto.com, and BlockFi. Gain unparalleled visibility and maximize your potential with the leading blockchain data platform by visiting us now at Chainalysis.com slash CoinDesk.

The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Another big change regarding the merge, and obviously the one that has received the most mainstream media attention is, of course, around energy usage.

To read any MSM publication, this is basically the only thing that matters about this. While accurate energy estimates for crypto mining are notoriously hard to come by, what we do know is that Ethereum hash rate has increased by a factor of six since 2020. In that same period, Bitcoin has roughly doubled. Now, it's disputed as to whether these increases would have been likely to continue into the future as price increases, but what seems to be clear is that Ethereum's energy footprint increased significantly during the last cycle. Obviously, environmental and energy use concerns are extremely controversial,

surrounding the crypto community. Now, one thing that's worth noting is that energy use wasn't necessarily a primary driver in the switch to POS early on in Ethereum's roadmap. However, high energy usage has always been seen as the primary drawback of blockchain technology, right back to Satoshi's discussions on the Bitcoin Talk forums. In 2021, Ethereum founder Vitalik Buterin said, Switching to Proof-Stake has become more urgent for us because of how crypto and Ethereum have grown over the last year. I'm definitely very happy that one of the biggest problems of blockchain will go away when proof of stake is complete. Researchers have estimated that Ethereum's total energy footprint post-merge will be somewhere between one-one-thousand-110th of the energy usage of the previous

proof-of-work Ethereum network. This, of course, gets us to political questions arising from the merge. One dimension of those is definitely the censorship questions that we discussed before. Bloomberg's Matt Levine covered this yesterday. He wrote, It is natural for big centralized crypto exchanges to be Ethereum stakers. They are keeping track of customer money anyway. They care about the economy. ecosystem. They have rails to pay staking rewards to customers, etc. But the exchanges have other incentives. They tend to be big regulated companies located in financial centers. Their executives tend to be rich and want to stay that way and avoid prison. They are thus convenient subjects

of regulation. Some people in crypto worry that letting them be in charge of confirming Ethereum transactions will mean that the Ethereum ledger itself becomes too subject to regulation. He then goes on to quote Scott Chippelina from the Financial Times. This problem has become clearer since the OFAC last month imposed sanctions against tornado cash. The staunches of Crypto's Libertarian Army had said the heavy hand of government would prove ineffective against the kind of smart contracts that run on decentralized platforms, yet sanctions have proven effective after all. In the week since tornado cash was targeted, transactions on the platform nosedived. That worry is bound to cross the minds of Ethereum's future guardians, including exchanges

Binance and Coinbase and staking platform Lido Finance. According to Nansen data, these companies are already some of the biggest Ethereum staking players around and thus will be trusted to secure the network post-merge. Last month, Coinbase chief executive Brian Armstrong said his exchange would likely quit the staking business before censoring the network. As guardians of the Ethereum network, these entities will have to decide whether or not to validate and process blocks of transactions that may contain transactions coming from entities under sanctions such as Tornado cash. That hardly sounds like the censorship-resistant utopia envisioned by the idealists. So where Matt Levine lands and what I sort of agree with is that this is kind of just an inevitable

consequence of this move to proof of stake, and it's something that the Ethereum community is going to have to grapple with and deal with. As I said before, I think it's going to be one of the chief points of conversation in the months to come. The other political dimension is, of course, around the ESG discourse. Now, there are some Ethereums who want to promote this as a way to get back at Bitcoin. Evan Van Ness tweeted, this is the last full day in America where proof of work will be seen as a viable technology. Tomorrow, Ethereum switches to proof of stake and obsolete's proof of waste forever. Still, this really isn't this standard view of Ethereum, at least not the ones who are allowed on Twitter. Instead, it's much less Ethereum community members and much more outsiders

who are politicizing the environmental narrative. Jake Trevensky wrote, Concern trolling over Bitcoin's energy use may continue, but there's a particular class of anti-crypto antagonists solely focused on hating smart contract platforms who don't much care about Bitcoin, so it'll be entertaining to see which empty critique they fall back on next. Alex Gladstein responded, sadly, A, it will be used as a prop to attack proof of work, and B, the cryptosceptics will find something else to complain about regarding the ETH ecosystem. Their concern for the environment is not why they don't like new digital currencies. Validating Gladstein's point, earlier in the day, Greenpeace had released a statement that said,

With ETH's move to an energy-efficient protocol, it's time for Bitcoin to end its growing reliance on fossil fuels. Companies promoting and profiting from Bitcoin have a responsibility to be a part of building a better climate-friendly BTC. Don't forget that Greenpeace is part of a $5 million campaign bankrolled by one of Ripple's co-founders to convert Bitcoin off of proof of work. I think even more pernicious is that it's not just antagonistic sources like Greenpeace. It's also journalists that just aren't familiar with the technologies to latch on to that easy narrative. Bloomberg's piece about the merge is called Ethereum finishes long-awaited energy-saving merge upgrade. Energy-saving is right there in the headline.

Now, I think there are two very different paths possible here. The frustrating one and the one that I hope not for is where people who don't really have much info say, well, why can't Bitcoin just do that too? The one I hope for, and that I'm optimistic for, is one where the merge serves to help make clear the difference between the two ecosystems and the tradeoffs they're in. And two, the shift actually reduces the political pressure around Bitcoin energy consumption because it's the only major chain using energy in that way. Dan McArdle, the co-founder of Masari and the leader of case for Bitcoin, wrote a thread

saying something similar. He writes, The Ethereum Merge is bullish for both ETH and BTC. Merge being bullish for ETH is pretty much a consensus view. And I think Merge will differentiate Bitcoin from ETH even more, which is long-term good for both. Yes, short-term, I think a lot of people see Merge as a negative for BTC, specifically because it reduces Ethereum's energy use by about 99%, thus making Bitcoin more of a lone ESG target. That is indeed annoying and will have an impact near-term.

But over the longer run, I think proof-of-work will be an asset to Bitcoin, while proof-of-stake will be an asset to Ethereum. The two assets and networks have fundamentally different goals, designs, and approaches. Proof-of-work and proof-of-stake have fundamentally different trade-offs and guarantees. Proof-of-work can be optimal for Bitcoin while proof-of-stake is for Eth, no contradiction here. And so, I think this makes Bitcoin core's properties more clear. While Ethereum is executing an extremely complex in-flight change to core properties of the network and monetary policy, Bitcoin keeps both simple and reliable.

Coming out of this, Bitcoin will be the sole large network with a simple, battle-tested, and more clearly egalitarian consensus model. ETH will come out with a brand-new monetary model and a lot of new complexity. That's fine for ETH. The merge optimizes the network for being a widely used tech platform, while Bitcoin's simple, battle-tested, egalitarian proof-of-work model, is better for something trying to scale socially as global money and store of value. Additionally, I think the narrative on proof-of-work will change over time. The ESG-based attacks are ludicrous on many levels, and enough people and politicians will see that eventually, and the remaining haters will matter

even less. Also, proof-of-work brings geopolitical advantages. We'll see both power companies and nation-states generally wanting to use Bitcoin mining to both monetize stranded resources and act as grid-stability technology. This is happening now. Proof-work is therefore a vector for Bitcoin to become more geopolitically relevant and embedded. That offers a form of long-term security that I still think is pretty underappreciated. Anyway, I think it's more clear than ever that Bitcoin and Ethereum are not competitors. They're going after different markets with fundamentally different tech and approaches. The merge will make the differentiation even more clear, which is good for both. couldn't have said it better myself, Dan.

So what in the end happened? Were there big disasters, technical challenges, fireworks? Not really. Hash rate slowed down a little bit in the hours leading up to the merge, and so it was pushed back to late, late, or early early, depending on where you were, East Coast time, where the biggest issue was disrupted sleep. At 244 a.m. East Coast time, however, it happened. Anthony Sassel wrote, the consensus in execution layers have been merged,

which means Ethereum is now a full proof-of-stake network. A heartfelt thank you to all the people that made this happen. Your names will forever be etched in the history books of Ethereum. The merge is here. Vitalik after the merge said this is the first step in Ethereum's journey to being a mature system. To me, the merge symbolizes the difference between early stage Ethereum and the Ethereum we've always wanted. The ultrasound money thesis kids also got some early juice, aka there was a small reduction

in supply over the initial post-merge period. But really the most notable thing was that there wasn't all that much notable. It simply happened. and now we live in the post-merge era. There's going to be a lot to discuss on this in the weeks and months to come, and we're in a lot of uncharted territory. But for now, congrats to everyone who worked on this for years and years and years. I want to say thanks again to my sponsors, nexus.com.

And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and asset summit or ideas. The event facilitates capital flow and market growth by connecting the digital economy with traditional finance. Join CoinDesk October 18th and 19th in New York City for a 360-degree investment experience, where you can source, invest, and secure the next big deal in digital assets.

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