The main problems and threats of the “Merge” Ethereum. Part 1

The community remains doubtful that the transition of the altcoin to the PoS algorithm will be beneficial. Gathered the main arguments against updating the cryptocurrency network

The transition of Ethereum from the PoW (Proof of Work) algorithm to PoS (Proof of Stake) is close to completion. Among the possible threats is not only the loss of a large army of miners (who will be forced to support some other project), but also an increase in the centralization of the network. According to the so-called blockchain trilemma, while maintaining the same security, the acceleration of transactions (provided by PoS) should increase the centralization of the project. At the same time, in practice, all currently existing PoS projects with a claim to decentralization (like Cardano) are far behind in popularity both from slower PoW projects (Bitcoin) and from fast, but strictly centralized projects (for example, USDT and Ripple) .

• What will happen to the Ethereum rate during and after the Merger ?

Will Ethereum be able to break this pattern and create a truly decentralized and popular PoS project?

Maximum decentralization vs maximum scalability: two extremes with their own drawbacks

According to the blockchain trilemma, the network can only fully perform two of the three functions: decentralization, security, scalability (closely related to the speed and ease of network management). Most successful projects are very careful about the issue of security, so the “pull of the blanket” is mainly between two alternatives – decentralization and scalability.

Classic cryptocurrencies that use the PoW principle with mining on computing power – Bitcoin, Litecoin, Dogecoin, the current version of Ethereum and others – put decentralization at the forefront, but have repeatedly had problems with speed and in general with scalability. The most famous example is the multi-day BTC transaction times in 2017, which required an urgent reform of the network. It was then that compromise technologies SegWit and Lightning Network were introduced into BTC, deviating from Satoshi’s original principles of recording all transactions in the blockchain.

A reverse example of currencies with high transaction speeds, but without decentralization, are digital assets issued by specific corporations (and not by a “swarm” of miners around the world). For example, the Ripple (XRP) interbank system from Ripple Inc, the USDT stablecoin from Tether Ltd (both use the PoS principle instead of PoW, which we will discuss below), the unlaunched Libra project from Facebook, as well as central bank digital currencies (CBDCs) being developed today, such as digital yuan.

These designs have two related drawbacks. The first drawback is the vulnerability of issuing companies to the repressive actions of national governments. Tether has been repeatedly accused of the opacity of reserve funds, and Ripple is at the center of disputes over the status of the XRP token as a security.

Perhaps, over time, the legal status of such blockchain companies will be settled and they will simply take their place among other officially registered payment systems. State stablecoins have a good chance of displacing conventional national currencies in the future. However, all of them fundamentally cannot compete with bitcoin and other decentralized systems where it is important for users to be independent from emission centers. Centralized digital assets do not fulfill the original purpose of cryptocurrencies and cannot replace them for the same reasons that national currencies or private securities cannot replace gold. This is their second and key drawback.

Decentralized PoS – an attempt to sit on two chairs?

Technologies like SegWit, while violating the ideals of Satoshi, do not encroach on the central principle that the development of the network is determined by the vote of the miners. Only those who single-handedly collect energy sources sufficient to power an average European country can gain control over it. The current BTC can be considered completely decentralized, and it cannot be destroyed by the bankruptcy of one or even many companies associated with it. At least in a number of countries, miners will continue to support the network.

A more radical solution to the problem of decentralized network scalability is the transition from the PoW principle to the PoS principle, but without a central issuing company. In PoS, there are no miners as such, but there is a staking mechanism. The validator allocates a certain number of coins, which are blocked, and he receives rewards for confirming transactions. Validators, like miners, vote for certain initiatives to develop the network.

On the one hand, PoS provides a number of obvious advantages. In addition to allowing you to make transactions very quickly, it is environmentally friendly. A PoS blockchain can consume orders of magnitude less electricity than PoW. However, the downside of this simplicity is the threat of losing decentralization.

In PoW blockchains, the largest coin holders (whales) do not have to be the largest miners. The power over the development of the blockchain does not belong to those who have more coins, but to those who have provided the network with more computing power. In PoS, however, the power is in the hands of the largest validators who have staked as many coins as possible. In other words, whales decide everything, and in order to gain influence and income on the network, one must strive to own the maximum number of coins. Therefore, despite the initially decentralized mechanism, such blockchains are prone to increased centralization.

For example, in the currently most popular non-corporate PoS blockchains Cardano (ADA) and Solana (SOL), only a few dozen of the largest wallets contain 50% of the total money supply, which is not even close to BTC. Moreover, a significant place among them is occupied by wallets of centralized crypto exchanges.

Does the market trust decentralized PoS blockchains?

By itself, the concentration of control over the network in the hands of dozens of the largest whales does not yet turn it into a centralized one. However, it also hurts security by increasing the likelihood of a 51% attack, when one user (or coordinated group) gains control of the network and can single-handedly control it, committing theft and other destructive actions. Theoretically, dozens of the largest ADA or SOL whales could conspire and carry out such an attack. In practice, this is unprofitable for them, since the likely gain does not cover the negative from discrediting the blockchain. Because of this, ceteris paribus, a 51% attack is less likely in PoS than in PoW. But in reality, the conditions are unequal, and in PoS the technical possibility of collusion is higher due to the concentration of capital.

For this or some other reason, but the popularity of decentralized PoS in the modern crypto market is not great. In the top ten capitalization, the vast majority of the market is occupied by PoW blockchains – bitcoin, the current Ethereum and Dogecoin. Their total capitalization is $580 billion, that is, 59% of the market. In second place are stablecoins and other centralized projects of corporations, such as XRP, BNB, USDT. Their capitalization is $ 200 billion – almost 20% of the market. As for decentralized PoS blockchains, there are only two of them in the top ten – Cardano (ADA) and Solana (SOL). They occupy 8th-9th places with a total capitalization of $36 billion, that is, less than 4% of the market. And this is despite their widely “promoted” environmental friendliness.

Perhaps the lack of powerful leaders among decentralized PoS is only due to the expectations that Ethereum 2 will become such a leader, and so far there is no point in competing with it. But perhaps the market is still afraid of the concentration of capital in a small number of people and does not believe in the ability of such projects to satisfactorily solve the blockchain trilemma. It cannot be ruled out that in the historical perspective, decentralized PoS does not have much prospects. For reliable decentralization, the market prefers PoW projects, and for the speed and flexibility of the system, centralized systems like BNB.

After the transition of ether to PoS, we should expect a particularly high concentration of capital on crypto exchanges that will organize staking for users. At the same time, the largest centralized exchanges are officially registered with financial regulators, and if necessary, the state can put pressure on them. A very significant part of the Ethereum coins and power over the entire network may end up with centralized players. As a result, Ethereum 2 may lose popularity among DeFi projects, the main feature of which is the decentralization of everything and everything. A significant portion of DeFi projects may choose to continue collaborating with PoW networks, and Ethereum Classic (ETC) and PoW (ETHW) forks of Ethereum can be especially useful here.

The main problems and threats of the “Merge” Ethereum. Part 2

• Why Ethereum 2.0 Mining will reduce industry profitability