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Three major risks connected to the Ethereum merge

Watch: What the Ethereum Merge means – The Crypto Mile

Ethereum's 'merge' was hailed as a success by the blockchain's co-founder Vitalik Buterin. However, crypto experts warn there are three major risks connected to the long-awaited upgrade, which was carried out to produce a low-energy use proof-of-stake blockchain.

Yahoo Finance asked crypto analysts to explain the threats posed to the Ethereum ecosystem after the merge.

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Ethereum's (ETH-USD) long-awaited merge was completed on Thursday, resulting in the world's second-largest blockchain by market cap stopping using the high-energy proof of work consensus mechanism and changing to a low-energy proof of stake method for validating transactions.

Ethereum Foundation said switching to proof of stake as a way of validating transactions utilises about 99.95% less energy than proof of work.

The use of fossil fuels to power the generators that feed proof of work mining operations has become too much of a contentious issue to be ignored any longer.

So, the whole system of validating Ethereum has switched from favouring those with the most real-world energy to those who have the most staked ether.

Ethereum Foundation has said the switch to using proof of stake as a way of validating transactions will utilise about 99.95% less energy than proof of work. Photo: ??

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With proof of stake, it won't be about how much electrical power can be generated to run computer processors to solve transaction blocks, but how much capital, in the form of staked ether, can be locked inside a validator node.

This move from raw processing power to those with the most capital has led to concerns that the Ethereum blockchain (ETH-USD) could be compromised if nefarious operators manage to accumulate the greatest amount of staked ether.

These operators could then manipulate the entire blockchain to suit their schemes by owning the majority of the staked ether, and so the blockchain that they validate will automatically be chosen as the 'correct' history of transactions, even though the transactional entries may be fraudulent.

1. Threat to decentralisation

Steven Walbroehl, co-founder and CTO of Halborn told Yahoo Finance the main threat is to the blockchain's decentralisation. He said the risk of post-merge corruption by a centralised entity has now increased.

"There is a debate currently ongoing in the cryptocurrency sector as to whether proof of stake will lead to further centralisation.

"I am on the side that believes it will make Ethereum more centralised.

"You can already see on the blockchain the large ether holders who are staking ether to become validator nodes."

Walbroehl described the threat of centralising the Ethereum network's validator nodes on the world's largest cryptocurrency exchanges, such as Coinbase and Binance.

These exchanges let smallholders of ether pool their cryptocurrencies into validator nodes that are stored and controlled by the centralised exchange.

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The centralised exchanges could then amass enough ether to control the transactions on the blockchain, as a majority stake of over 51% of the validator nodes is enough to produce the longest blockchain, which is then one recognised as the correct one.

They could also be a vulnerable point of failure in the entire Ethereum network if a government agency was to order the centralised exchange to block certain transactions.

This threat from state actors to take control of centrally run nodes has become more potent after the US Office of Foreign Assets Control, OFAC, ordered the issuer of the USDC stablecoin to freeze funds after the Tornador Cash affair.

Read more: Crypto: Stablecoins scramble for safe havens as sanctions threat escalates

David Schwed, the COO of Halborn, said that a governmental body, through civil and criminal enforcement options, could effectively shut down crypto firms that do not comply with their censorship requests.

"What I believe will happen is that a litany of legal action fighting sanctions could be used, but if that should not prevail, I believe staking businesses would then be forced to shut down.

"But if they did comply there would be a backlash from the community, as this would be irreparably damaging to the business's reputation if they were to succumb to this type of censorship."

Ethereum mining software
Ethereum mining software detail. Photo: Manuel Medir/Getty

2. Technical risks

Isidoros Passadis, master of validators at Lido Finance mentioned risks associated with any software upgrade, such as possible bugs, technical glitches, or general hiccups.

"It’s important to note that a lot of comfort has been built up from putting client software packages through their paces via actual testnet merges and also testing the software on still-running testnets.

“Another risk has to do with the proper operation of nodes following the merge."

The upgrade allowed the legacy proof of work blockchain to 'dock' with the more energy efficient proof of stake network, called the Beacon Chain.

This docking brought the entire history of recorded transactions on the Ethereum blockchain onto an updated network running on proof of stake.

"The Beacon Chain has undergone three testnet merges, numerous shadow forks and there are multiple client teams working alongside each other to implement the code successfully.

"It’s also important to note that the Beacon Chain had had no major glitches since its launch in December 2020 and it currently has roughly 13.3 million eth securing the network."

3. Risk from an Eth proof of work fork

Passadis added that there could be an operational and financial risk from the high chance that the Ethereum proof of work blockchain will be kept alive by proof of work miners.

"Some miners who have indicated their allegiance to the proof of work method of validating transactions."

These miners who are sitting on a sizeable amount of computer processors dedicated to mining ether via the proof of work consensus mechanism could fork the Ethereum network and begin their own rival chain, which would have a duplicate of all digital assets stored on the Ethereum blockchain.

However, Passadis said: "The impact that this will have to the canonical Ethereum chain shouldn’t last too long."

Watch: The Crypto Mile: Episode 6 – Ethereum insider reveals consequences of 'the merge'

Do the benefits of 'the merge' outweigh the risks?

Despite the risks, Ethereum's 'merge' to a proof of stake consensus mechanism has been hailed as a landmark and historic moment for the crypto market.

CEO of deVere Group, Nigel Green, said in a statement: “This is a far-reaching overhaul of the most commercially important blockchain in the digital asset ecosystem ... it transforms Ethereum from a proof-of-work to a proof-of-stake mechanism, which lowers transaction costs, enables the network to process more transactions in a shorter amount of time, and will slash energy consumption by a massive 99%.”

He said it will fuel prices across the market.

“Besides having a more positive climate impact, The Merge’s effect of reducing supply, cutting costs and speeding up transactions will also appeal to both individuals and institutions.

“We expect the developments to bolster prices across the wider crypto market to some degree.”