Ethereum’s (ETH-USD) Merge upgrade is certainly worth celebrating. It makes for perhaps the biggest upgrade in the history of the blockchain. And, in an era where crypto isn’t just a niche interest but a viable investment avenue, the financial implications are massive. But things aren’t all milk and honey. There are some drawbacks and, as cybersecurity company CertiK points out, these drawbacks may be far reaching. They open up lots of questions and unknowns.
The Merge starts a long process of upgrades for the layer-1 network. But the most hyped aspect of this upgrade has already released by way of Ethereum’s shift from proof-of-work to proof-of-stake. This makes the network much more energy efficient, since it cuts out the arduous process of mining for ETH. It also stands to lower transaction times and gas fees for network users, making lots of investors happier.
In a new blog post, however, CertiK is reminding investors there are risks to such a big transition. The company warns of three particular downsides that could make life much more difficult for users.
Investors already know that hacks and scams are running amok through the crypto space, with billions of dollars in assets stolen just this year. But the Merge opens Ethereum up to a new hack threat called ChainID Replay attacks. A hard fork called EthereumPoW (ETHW-USD) is set to release, keeping a mineable version of Ethereum alive. But by keeping the same ChainID as Ethereum, hackers can duplicate transactions across both chains and take twice as much crypto from an unwitting sender. All it takes is for these bad actors to receive a transaction from a victim.
The second issue — validators not reaching consensus — is not an issue anymore as the Merge went off without a hitch. However, CertiK’s third point, while not the most technical, could actually prove to be the biggest problem down the line.
Ethereum Merge Shifts and Tightens On-Chain Centralization
One of the things that has taken a back seat to celebrating today is the very real topic of centralization on the blockchain. Ethereum wasn’t incredibly decentralized before, to be sure. But the Merge has shifted the balance of power toward a few major crypto companies. Now, traditional stockholders are gaining incredible influence over the network.
While a proof-of-work network, miners had quite a lot of power on Ethereum. As CertiK points out, the top miners had significant control over the hashrate of the network. This meant they had a lot of sway when it came to the speed and cost of transactions.
As the Merge transitions Ethereum to proof-of-stake, though, it’s simply recentralizing that power among even larger entities. Now the network is dictated by staking rather than mining. The more one has staked, the more chain validators they control.
CertiK shows a breakdown of the entire supply of staked ETH. The chart shows that over two-thirds of the network will be controlled by just five entities. These are Lido Finance, Kraken, Bitcoin Suisse, Staked and Coinbase (NASDAQ:COIN). What’s more, three of these companies — Kraken, Staked and Coinbase — are U.S.-based and fall under U.S. Treasury and U.S. Securities & Exchange Commission (SEC) regulations.
Why does this recentralization matter? After all, if power was concentrated before, is it really that different if it’s centralized post-Merge? The answer is more surprising than you might think.
Why Does This Matter?
Back in August, investors posed a question to Coinbase CEO Brian Armstrong on Twitter (NYSE:TWTR): Would Coinbase comply with regulator demands and censor certain transactions if asked to, or would it shut down its staking service completely to preserve the integrity of a censorship-free blockchain? Armstrong responded by saying he would go with the second option, shutting down Coinbase’s lucrative staking tool to “focus on the bigger picture.”
In answering the question, Armstrong called the situation a “hypothetical we hopefully won’t actually face.” But in the days since this exchange, that hypothetical has turned into a reality. The U.S. Treasury has since ordered sanctions against crypto mixer Tornado Cash for aiding crypto activity, setting a precedent in which the U.S. government strong-arms the crypto industry to censor itself or risk being shut down.
As this request — or rather demand — of on-chain censorship becomes more and more realistic, CertiK poses several questions:
“How would Ethereum respond to this sudden evaporation of 15% of the network’s stake? How about Coinbase’s shareholders who see a lucrative opportunity for the company to earn income with OFAC-compliant staking, and aren’t so keen on passing up that opportunity in the name of crypto’s ideological values?”
Another question with more sinister connotations is about whether Armstrong would be true to his word and actually shut down staking. After all, it’s a very profitable venture for Coinbase. Would the company be willing to walk away from this money?
Wall Street’s fingers are wrapping ever-tighter around the market. Now, more companies like Kraken have plans to go public. Something will have to give; one of these companies will not be able to simply shut down to preserve the “integrity of blockchain.” As CertiK makes apparent, this issue is on the horizon. It’s only a matter of time — and the Merge just accelerated things.
On the date of publication, Brenden Rearick did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.