Clifford Chance

Since 2015, Ethereum has developed into one of the most popular decentralised computing platforms, powering the cryptocurrency ether (ETH) - the platform’s signature currency and the second-most valuable digital asset after Bitcoin - and thousands of decentralised applications. The initial Ethereum infrastructure, known as the Ethereum "Mainnet", was facing scalability and energy consumption issues to match the global need for transaction processing speeds.

To reduce environmental impact, increase security and improve scalability in the network, Ethereum has proposed a series of upgrades. On 15 September 2022, in a highly anticipated upgrade called "The Merge", the Ethereum Mainnet shifted from a Proof of Work (PoW) consensus mechanism to a Proof of Stake (PoS) consensus mechanism.

Technically, the Merge represented the joining of the existing execution layer of Ethereum, the Mainnet, with its new PoS consensus layer, the Beacon Chain. The Merge is the second of a three stage upgrade process and is widely seen as one of the most significant events in the crypto industry to date in the search for a more scalable, energy efficient and publicly accessible Ethereum.

What are Proof of Work and Proof of Stake 

Proof of Work (PoW) and Proof of Stake (PoS) are the two major consensus mechanisms cryptocurrencies use to verify new transactions and add them to the blockchain. PoW, first pioneered by Bitcoin, uses mining to achieve those goals. PoS, which is employed by blockchain platforms such as Cardano, Solana and now Ethereum, uses staking to achieve the same objective.  

In more detail, PoW is defined as a consensus mechanism that requires all miners that are participants to the blockchain to compete in solving complex mathematical puzzles to validate a new transaction, adding a block to the chain and permanently and irreversibly recording a new transaction.

This validation technique is in contrast to PoS which requires users to stake the native cryptocurrency of the blockchain to win the right to validate new blocks. Validators are chosen at random to create blocks and to check and confirm blocks created by others. They are rewarded both for proposing new blocks and for attesting to blocks they have seen; if they attest to malicious blocks, they lose their stake.

Environmental, Social and Governance implications

Greener Crypto

One of the key expected consequences of the Merge is a dramatic reduction in Ethereum's energy consumption. As at the beginning of September 2022, Ethereum's total energy consumption under the PoW mechanism has been estimated as comparable to that of the Netherlands. However, the Merge and move to a PoS mechanism is expected to reduce Ethereum's energy consumption by over 99%. The Merge has left Bitcoin as the only major blockchain using PoW.

As discussed above, the PoW mechanism essentially relies on miners validating transactions by competing to solve very difficult mathematical problems the quickest, requiring vast computing power. Conversely, the PoS mechanism randomly selects its validators, stopping energy wasting puzzle solving and competition. Following the Merge, Ethereum selects at random a block proposer (who will create and send a new block to the other nodes), which will then be approved by a randomly selected committee of validators. Therefore, a key benefit of the PoS mechanism is its relative "green" credentials and lower energy consumption.

Separate from this, the crypto community has been exploring various ways to lower the carbon footprint of mining, such as use of renewable energy to decarbonise blockchains, particularly for networks that retain a PoW mechanism. The Crypto Climate Accord, a private sector-led initiative which launched in April 2021, sets out ambitious targets for decarbonising the cryptocurrency industry, with signatories committing to achieve net-zero emissions from electricity consumption associated with their crypto-related operations by 2030.  These considerations are likely to become more important, particularly as ESG regulation evolves and also as more regulated financial institutions, asset managers and others already subject to ESG regulation become active in the cryptoasset sector.

Potential Vulnerabilities

The Merge does have implications for the security and potential vulnerabilities of the Ethereum network to a so-called 51% attack. In broad terms, under the new PoS system, a would-be attacker (or group of attackers) that owns 51% of ETH would be able to use its majority staking power to control and alter the blockchain. This has been identified as a potential risk in the context of the Merge, though a similar risk already exists under the PoW system; it is just that under the PoW system a would-be attacker (or group of attackers) would need 51% of the total computing power used to mine ETH to control the blockchain (rather than owning 51% of ETH tokens).

Based on the market value of ETH as at September 2022, a 51% attack under the PoS mechanism would require a would-be attacker to purchase several billions of dollars' worth of ETH, so this risk appears fairly remote. In addition, the PoS mechanism that the Ethereum network has adopted includes safeguards against 51% style attacks, including financial penalties for misbehaviour to make such attacks exponentially more costly for an attacker compared to PoW, and a last resort solution whereby the Ethereum community can resort to "social recovery" of an honest chain if such an attack were to be successful (e.g. by continuing to build on the honest chain, even if it is the minority chain). Ensuring that there are robust mechanisms to safeguard against such attacks will be crucial to maintain trust in the Ethereum network to facilitate its broader use and adoption. We expect this to be an aspect of the Merge that will be monitored closely.

Governance

From a governance perspective, the Merge can be seen as a test of how a significant change to the operation of a decentralised blockchain may be effected, placing added significance on its success. More broadly, governance of blockchains and their applications remains an important topic, particularly as regulatory regimes for cryptoassets develop. With PoS, a simple laptop can be used to run a validator node, which allows for greater and more diverse involvement, promoting access and decentralisation, especially as you can join a staking pool if you do not have 32 ETH (what you need to pay to stake as a validator). But will validators with more ETH have more power (i.e. are they more likely to be selected if they stake more)? Some argue that the Merge will make the governance of the Ethereum blockchain more centralised. This is something that will also be monitored closely after the Merge.

Regulatory comparison: PoW vs PoS

As countries around the world remain divided on how to regulate digital assets, so it is the case that the stance taken by different governments with regards to PoW assets, and crypto mining, varies from country to country.

Crypto mining is banned in China, and India has proposed a law that would also shut the door on the industry. In other counties such as Iran, the situation is more complex. While a licensing regime has been established for crypto mining businesses, the authorities have imposed temporary bans on mining operations in the past as blackouts caused by the intensive energy consumption from mining have forced government interventions.

Below is a summary of the current regulatory positions in certain key jurisdictions:

Australia: To date, the Australian government has largely taken a non-interventionist approach to the regulation of blockchain and cryptocurrency, and the law does not currently distinguish between PoW and PoS assets. On 20 October 2021, the Senate released its Select Committee on Australia as a Technology and Financial Centre report, focussing on the regulation of cryptocurrencies and digital assets. One of the recommendations is that relevant legislation should be amended so that businesses undertaking crypto mining and related activities in Australia receive a company tax discount of 10 per cent if they source their own renewable energy for these activities. This recommendation reflects the intention to incentivise these businesses to source their own renewable energy to guarantee that mining and related activities do not undermine Australia's net zero emissions obligations.

Japan: The Japanese government has not proposed any specific green-related regulation which restricts the PoW mechanism, and no regulations differentiate between PoW and PoS mechanisms. However, Japan (like the other jurisdictions mentioned in this section) is a member of the Intergovernmental Panel on Climate Change which recently highlighted the issues of excessive energy use associated with the PoW mechanism. Therefore, there is a possibility that new regulation could be suggested to address the environmental impacts of cryptoassets in the future. 

EU: During the development of the EU Markets in Crypto Assets Regulation (MiCA Regulation), the EU Parliament considered whether to ban cryptoassets using PoW mechanisms. However, this proposed ban was not taken forward. Instead, the final text of the MiCA Regulation is expected to include recitals encouraging the development of environmentally friendly consensus mechanisms, and may also introduce specific disclosure requirements for cryptoasset issuers where a PoW model is used, including an independent assessment of the likely energy consumption and information on its sustainability credentials.

Singapore: There is no legislation in Singapore that specifically relates to crypto mining, or which distinguishes between PoW and PoS assets. Although crypto mining is not done on a large scale in Singapore, the government appears alert to the potential conflict between sustainability goals and certain blockchain-related uses. In a written parliamentary reply in February 2021, Grace Fu, Minister for Sustainability and the Environment, noted that "the government will continue to monitor the development of cryptocurrencies and the risks they pose", when asked whether authorities have considered restricting cryptocurrency mining in Singapore.

UAE: Many are beginning to view the UAE as an emerging global tech hub, and recent legislative measures, such as the creation of the Dubai Virtual Assets Regulatory Authority (VARA) - licensing several of the world's major crypto exchanges amongst others (in MVP phase) - have shown the government’s support of a virtual economy. The regulatory landscape remains under development, and similarly to Japan and Singapore discussed above, there is currently no suggestion of any policy to promote a more ESG friendly crypto over another. Nevertheless, the UAE has repeatedly stated its commitment to promoting sustainable finance across all sectors and it may therefore be a case of “watch this space” for the development of sustainable digital policies in the UAE. Regarding the Merge itself, for clients conducting virtual assets business in the Abu Dhabi Global Market (ADGM), guidance from the ADGM's Financial Services Regulatory Authority sets out actions providers should take in dealing with a fork ("changes in the underlying protocol"), including certain customer notifications. VARA licensing conditions in Dubai will also require disclosures to customers of such events.

UK: The UK has not proposed any specific crypto-asset regulation which differentiates between PoW and PoS mechanisms. However, the development of a cryptoasset-specific regulatory framework in the UK remains at an early stage, and the UK government has indicated it will be looking closely at energy usage associated with certain crypto-technologies. Therefore, it is possible that future regulatory rules could address environmental impacts of cryptoassets, either directly or via the impact of broader ESG-related requirements on regulated market players.

US: In the US, some states such as New York have proposed banning or imposing moratoriums on cryptoasset mining operations due to their climate-related impacts, while others such as Texas and Wyoming have sought to attract cryptoasset companies with attractive rates of electricity and crypto-friendly regulations.   

At the federal level, no legislation has been passed that specifically regulates the use of PoW as a consensus mechanism for cryptoassets. However, a recent report issued by the White House Office of Science and Technology Policy has pointed to cryptoasset mining as a significant contributor to greenhouse gas emissions, and recommends federal agencies work with states, communities, the industry and others to set standards for environmentally responsible cryptoasset technologies. The report notes that if such measures prove ineffective, the administration could explore using executive actions or for Congress to pass legislation limiting the use of high-energy consensus mechanisms such as PoW. 

Impact on Capital Markets – digital bonds

In the capital markets context, there have been digital bond issuances under French law which have been registered on the Ethereum blockchain. Given that from the effective date of The Merge, the PoW consensus mechanism will be replaced by the PoS consensus mechanism, such digital bonds will be directly impacted by the change of the consensus engine for all network data, including the execution layer, transactions, account balances and block validations of Ethereum.

This may present risks for the holders of digital bonds which have been registered on the Ethereum blockchain, as recognised by the notice sent by Société Générale SFH in relation to a series of fixed rate digital bonds which highlighted that some miners may fork Ethereum and push for a PoW alternative to continue to receive rewards on mining activity and not to lose money on computing hardware in which they invested. Given that this would lead to two different versions of the blockchain coexisting, this would necessitate the duplication of the smart contract designed for the digital bonds issuance and mean that the digital bonds, the related holdings, and the transfers of the digital bonds could theoretically evolve differently between PoS and PoW versions of Ethereum. The approach taken by Société Générale SFH was to clarify that were such a fork to occur, the registrar, pursuant to its business continuity plan and French law, would maintain its off-chain register and record any further transactions only on the PoS version of Ethereum, which would constitute the sole valid and binding register of the digital bonds.

Conclusion

The Merge is part of a series of major Ethereum ecosystem upgrades, which will also include The Surge, The Verge, The Purge, and The Splurge. While there are no official calendar announcements on these subsequent upgrades, Ethereum is working on "Sharding" which introduces shard chains that are similar to regular blockchains, except they each contain only a portion of the blockchain data. Thanks to the specific subset of data provided by shard chains, nodes can verify transactions more efficiently, which will in turn also reduce the fees required to conduct transactions in ETH.

While further scalability upgrades are still to come, the Merge has shifted Ethereum to a more energy friendly network, addressing the widespread criticism that crypto's climate impact outweighs its possible benefits. Many “second layer” projects that are built on the Ethereum blockchain (such as NFTs and Metaverse platforms) will be affected by the Merge, likely significantly reducing their carbon footprint. If energy use and environmental concerns had been a stumbling block to their adoption in the past, then a “greener” Ethereum may potentially open the door to new users of digital assets.

As the market awaits the next and final stage of upgrades to complete, the Merge could represent the first step towards increased institutional adoption of Ethereum's tech offerings. The Merge has set Ethereum apart from most other platforms that still run on a PoW mechanism, meaning that financial institutions and investors may no longer reject crypto on environmental grounds.