The Ethereum network faces groundbreaking system change

It has been known for years that the Ethereum network will undergo a fundamental system change. Only the exact date was unknown until now. The change has been postponed again and again, but the wait will soon be over, as Ethereum co-founder Vitalik Buterin announced on Twitter. According to his statements, the process, which is called a "merge", should take place around mid-September.

Ether is the cryptocurrency of the Ethereum network and the second largest cryptocurrency with a market capitalisation of over 200 billion US dollars (as of 12.09.2022, Coinmarketcap).

Blockchain background

To better understand the impact and significance of the upcoming system change, it is worth taking a look at how a blockchain works.

Blockchain - decentralised exchange of information

For example, when an email is sent or a banking transaction is made, the required information is processed in a central location, such as a server. In contrast, a blockchain is based on a decentralised exchange of information. A blockchain therefore does without a central exchange of information and handles the processes in a decentralised manner by users of the blockchain communicating directly with each other.

In principle, a blockchain is a decentralised database. Information blocks are linked chronologically in a chain. If a blockchain transaction takes place between person A and person B, the transaction must first be validated. If the validation is successful, the transaction (a "block") is appended to the chain. The updated list is then distributed throughout the network. The blocks cannot be changed afterwards, and everyone has the possibility to see this list because it is public.

Ethereum switches to Proof-of-Stake

Validation using “Proof-of-Work”

The validation process takes on an important role in the blockchain. Until now, this process was carried out in the Ethereum network with the "proof-of-work algorithm" (PoW). In this model, so-called "miners" have to solve complex cryptographic calculation tasks to confirm new transactions. The miner who can do this the fastest receives a reward in the form of the network's cryptocurrency. However, this activity requires the use of a high level of computing power.

Validation by "Proof-of-Stake”

The "Proof-of-Stake Algorithm" (PoS) takes a different approach. To be able to update the blockchain and validate new transactions, participants must deposit the network's cryptocurrency. This step is called "staking" and creates financial incentives for all network participants to behave honestly and maintain the security of the network.

In the proof-of-work system, the required computing power protects against attacks, while in the proof-of-stake system, the deposit of one's own assets serves as a security deposit.

The "merge" will lead to a merging of the existing blockchain - the so-called Mainnet - with the already existing and currently running parallel Beacon chain. As a result, only one core blockchain will remain after the "merge". According to widespread opinion, this switch should have no impact on the underlying cryptocurrency of the blockchain, Ether.

What is the effect of the change?

The most significant impact of the system change is likely to be on energy consumption. Due to the elimination of the intensive computing power in the Ethereum network, the energy demand is expected to drop sharply. The Ethereum Foundation puts the decrease at approximately -99.95% (ethereum.org). Ethereum's annual electricity demand was about 112 TWh, which is comparable to the electricity consumption of the Netherlands (as of 30/08/2022). The general energy demand is one of the big criticisms of the crypto industry. With the change, the environmental balance of the Ethereum network should improve significantly.

The system change is also intended to set the stage for further improvements to the network, which are to be added in future "upgrades". Important issues are scalability and security. Scalability is to be improved through faster transaction speeds and lower transaction fees.

What happens in the case of a (hard) fork?

It is well known that an upgrade had to be made. And Ether is by no means alone in this. More and more blockchains must be upgraded for a variety of reasons. In the process, it can also happen that the upgrades do not continue the same blockchain - but that they split off. In this case, we speak of a fork.

It is important to distinguish between hard forks and soft forks. After the implementation of a soft fork, old and new participants in the network, especially miners and other participants with special monitoring or authorisation functions (so-called "nodes"), continue to work together. Thus, nodes in the network with different software versions can work without compatibility problems.

In a hard fork, on the other hand, old and new participants separate - and two different blockchains are created. All nodes must update their software to the latest version in order to continue to participate. The incompatibility of the software versions leads to a new network being split off, so to speak. Consequently, users who decide to update or not operate on different blockchains.

What does this mean for investors?

According to current knowledge, the merging of the blockchains in the course of the "Merge" should not result in any need for action for investors. The technical adjustments to the network only affect the providers and members of the Ethereum network and the infrastructure providers. Ether remains the cryptocurrency of the Ethereum network.

For products related to Ether or the Ether Future, however, this may mean that there could be restrictions on the tradability of the products due to the outlined ambiguities with regard to possible risks and consequences of the "Merge".

In the event of a hard fork, Vontobel would endeavor to ensure that all investors in the products are placed on an equal economic footing before and after the adjustment event. For such continuity, however, certain conditions must be met, for example with regards to hedging transactions in the possible new currency. For example, it would have to be freely available and tradable. It would also have to be ensured that existing wallets (virtual "purses" through which the cryptocurrency coins are managed) could be converted or would be compatible with the new coins and that it would be technically possible to manage wallets with the new cryptocurrency.

Whether Vontobel, as the issuer of the products, will have to make adjustments to the products in order to adequately take into account any effects of the "Merge" on the underlying of the products (Ether or Ether Future) cannot yet be conclusively assessed. Should this be the case, investors will receive further information via the respective product page.