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Sunday, October 2, 2022

What The Merge Might Mean for Your Ethereum Holdings

An upgrade called The Merge is coming to Ethereum (ETH -0.88%) as early as September, the final stage for Ethereum to become a proof-of-stake (PoS) blockchain. After this upgrade, anyone will be able to stake their ether coins and earn a reward for helping secure the blockchain. Interest rates will fluctuate, but between 5% to 12% is the expected range.

There are many perceived benefits to this final upgrade to Ethereum, such as faster transactions at lower cost. However, there are a few implications of The Merge that need a closer look.

Image source: Getty Images.

An Ethereum split

It is possible that some of the community of miners who run the existing proof-of-work (PoW) side of Ethereum might want to fork the network. This means rather than stop mining Ethereum at the time of The Merge, they will continue to mine Ethereum via proof-of-work, effectively creating a separate parallel chain. The miners would keep their energy-hungry computers on, and they would continue to solve the complex math problems that help secure the network.

In this case, there would be the PoW-based Ethereum run by the miners, and the PoS-based Ethereum run by ether (ETH) holders who’ve staked their coins. People holding any amount of ether at the time of the split would suddenly hold the same amount of a new type of ether, perhaps something called ETHPOW. There is no choice as to whether or not people have both copies: If the chain splits, then people automatically will hold a new token.

There is a historical precedent for splits, known as forks in the cryptocurrency community. In 2017, Bitcoin (BTC -0.43%) forked into two chains over a disagreement on how to operate Bitcoin.

One group thought that Bitcoin’s blocks should be larger so it could fit more transactions within a block. We now know Bitcoin Cash (BCH 1.75%) as the version of Bitcoin that has bigger blocks. At the time of the fork, anyone holding BTC also became owners of BCH. This is ultimately because, up until the time when the fork occurred, the chains were the same.

Another less accurate way of thinking about a fork is like a dividend. It’s money received as a result of holding on to a particular token. Before the fork actually happens, it is impossible to tell how much the new tokens will be worth. When Bitcoin forked and spawned Bitcoin Cash, the new tokens (BCH) were were about 10% of the price of BTC. If the Ethereum fork is any comparison, then 1ETHPOW might be worth 0.1 ETH.

Many people simply parted with their BCH, as they saw no point in having a second version of Bitcoin. Others kept their BCH in the off chance that Bitcoin Cash would dethrone Bitcoin.

It is possible that The Merge will play out in a similar fashion. In the event that Ethereum does fork, it is the PoS version that is favored. If I were holding ETH at the time of a fork, I would sell the newly spawned asset.

Volatile staking rewards

Annual percentage yield (APY) returns after The Merge could be as high as 12% and as low as 5%. The reason for the variation is that no one knows how many people will rush to stake their ETH once the upgrade is complete. There are some technical risks and uncertainty when it comes to executing The Merge. Some risk-averse investors are sitting on the sidelines until it is clearer whether it will be safe to stake ETH. Those who choose to stake their ETH will be unable to withdraw after the deployment of the Shanghai upgrade. The Shanghai upgrade does not currently have a launch date, but after the upgrade is when stakers will be able to withdraw their ETH. So investors must be sure not to lock any more funds than what they might need in the short term.

In the event that lots of people stake their ETH, then APY rates would be on the lower end of the predictions. However, if there is a lack of interest in staking ETH, then rates will float in the higher range. The longer the rates are high, the more time will have elapsed, which could allow people’s perception of risk to fade. Then after the enabling of withdrawals, people will be able to deposit and withdraw their ETH fluidly. There is no official date for the launch of the Shanghai upgrade.

Avoiding the risk

I am not an investor in Ethereum. I used to mine ETH in 2017 and 2018, but have since exited my position due to lack of enthusiasm for the direction of the project and the perception of technical risk around the planned upgrades.

The scenario that I wish to avoid is one in which the upgrades don’t go as planned. If the PoS chain is buggy, and there is a fork at the same time, then this is fragmentation in the community that spells uncertainty. My risk appetite for seeing this play out with money on the line is quite low. I would rather sit on the sidelines and wait to see what happens when the dust settles.

If the upgrade succeeds in reducing fees, then I would consider reentering a position in Ethereum.

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