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As ethereum completes its move to a low-energy proof-of-stake (POS) model, will institutions flock to the world’s second-largest crypto-asset, or are there more challenges ahead?
Ethereum, the world’s second-largest cryptocurrency and largest single blockchain ecosystem, has completed its long-awaited transition from a proof-of-work (POW) consensus mechanism to POS.
“The merge”, as it is being called, will fundamentally transform the way the ethereum network verifies new transactions, adds them to the blockchain and issues rewards to network participants.
Previously, under POW, ethereum miners expended vast amounts of computer processing power to solve cryptographic puzzles, which allowed them to verify and add new transactions to the blockchain, and receive rewards for doing so.
Under POS, however, ethereum miners are a thing of the past. Instead, POS depends on a network of “validators”, each of whom deposit a certain amount of ETH to the network before being able to verify and add new transactions. This is known as "staking".
With no more cryptographic puzzles to solve, the network simply assigns validators to transactions based on how much ETH each validator has staked, and for how long.
In practice, this ensures that the rewards for maintaining the network flow primarily to the most invested participants.
The main benefit of the switch to POS is, of course, the stunning reduction in electricity that will now be required to secure the network.
According to the Ethereum Foundation, under POS the ethereum network will use at least 99.95 percent less energy than before. This is equivalent to a nation the size of Finland turning off its entire electricity grid overnight.
The institutional reception
As ethereum settles into its new greener self, the merge is expected to stimulate new interest from institutions that were previously put off by its carbon footprint.
At Zodia Markets, the UK’s first bank-owned digital asset exchange to register with the Financial Conduct Authority (FCA), there is hope that the merge will open up ethereum and crypto-assets more broadly to a new audience.
Michael Walsh, head of distribution at Zodia, said that for many institutions, sustainability considerations are now a key factor in investment committee decision-making.
“We know of one French financial institution, for example, where the board has formerly refused to countenance cryptocurrency due to its lack of complementarity with its ESG policy,” Walsh told VIXIO.
“But the improvement in ethereum’s energy use will clear hesitation over investment, with ethereum acting as a bellwether for broader investment into digital assets.”
Walsh added that the “smooth transition” of the merge will also provide institutions with the confidence that decentralised crypto-asset networks can implement upgrades with the same rigour as in the traditional finance world.
Trey Zeluff, SVP and director of strategy and innovation at LevelField Financial, a US digital asset specialist, told VIXIO that with the ESG runway now clear, he expects to see particular interest in staking from institutions.
“Companies that find ways to interact with staked ETH and can offer new services to those with stakes have the most potential to benefit from the change to POS,” he said.
"The interesting problem, however, is that these perceived advantages may cause the most complications if the act of staking is determined to be captured by the securities laws."
Security v utility
As noted by Zeluff, although ETH may now be a catch from an environmental perspective, its regulatory status is now less clear, and could easily drive away the would-be newcomers.
Under POW, the US Securities and Exchange Commission (SEC) took the view that ETH is a commodity or “utility”, rather than a security.
Given the “sufficiently decentralised” nature of the network, successive SEC chairs had judged that ETH does not meet the Howey Test criteria of a security. But that could soon change.
Last week, the Senate Agriculture Committee held a hearing on a crypto bill that would see both bitcoin and ETH designated as digital commodities — a new asset category — under the Commodity Futures Trading Commission (CFTC).
However, when SEC chair Gary Gensler was questioned by the Senate Banking Committee, he raised concerns that crypto-asset networks that allow users or intermediaries to stake their coins may be deemed investment contract securities.
“[Staking services] look very similar — with some changes of labelling — to lending,” he said.
“From the coin’s perspective, that’s another indication that under the Howey test, the investing public is anticipating profits based on the efforts of others.”
At present, more than 60 percent of staked ETH is controlled by four entities, which cuts against the SEC’s former view that the network is “sufficiently decentralised”.
The largest of the four, Lido, is a decentralised staking service that connects individual ethereum wallet-holders directly with the staking contract, whereas the other three — Coinbase, Kraken and Binance — are centralised crypto exchanges that act as intermediaries.
The more centralised the ETH staking ecosystem is, the more likely it is that the act of staking will constitute an "investment contract" between individual parties.
Michael Luckhoo, co-founder of tokenised data company Cirus Foundation, pointed out that it is difficult to know how many individuals have staked their ETH due to the closed nature of intermediaries such as Coinbase, Kraken and Binance.
He also said there are concerns over asset custody and legal/beneficial ownership once a user transfers their ETH to an intermediary to stake on their behalf.
“With the centralised exchanges, the saying goes ‘not your keys, not your crypto’, so in the event of a hack or seizure, people’s stake in the network may be broken,” he said.
Michael Jacobs, banking and fintech disputes lawyer at UK-based Locke Lord, added that there is currently “no established legal principle” governing the relationship between customer and exchange with regard to staked tokens.
“I suspect that even if exchanges or staking platforms' terms and conditions purport to describe the relationship in a particular way, that may not be how a court of law actually sees it,” he said.
“One good thing about the various crypto insolvencies at the moment is that they may shed light on the legal relationship between customers and the exchanges and platforms they use.
"We had the same with Lehman Brothers after it collapsed in 2008. It wasn't until years after Lehman's entry into administration that the English courts confirmed the basis on which certain assets/funds were being held by the bank on behalf its customers and counterparties (e.g. client money vs unsecured claims)."
Both the securities question and centralisation are clearly weighing on the minds of crypto-asset market participants, as can be seen from ETH's 20 percent price drop since Gensler’s comments last week.
Further pressure was added on Monday (September 19), when the SEC filed complaints against Sparkster, a crypto-asset issuer, and Ian Balina, a crypto influencer, for their alleged roles in offering and promoting “unregistered crypto-asset securities” that run on the ethereum blockchain.
Some observers have taken the wording of the lawsuits as a hint that the SEC intends to take full jurisdiction over ETH as a security, contrary to the designs of the CFTC.
