The Ethereum upgrade: Musing about the Merge

Overview of the upgrade

The Ethereum upgrade—essentially a move to a proof-of-stake (PoS) from a proof-of-work (PoW) consensus mechanism for validation of ETH transactions—has been in the works since 2018. The upgrade and the rewards generated during the process are sure to have a number of complex and important tax and accounting implications. The objective of this point-of-view (POV) document is to lay out, in a direct and understandable form, some of the main issues and considerations participants and companies should address as a result of the upgrade.

What is Ethereum?

The Ethereum blockchain is a public, permissionless blockchain that hosts transaction data and thousands of computer programs (“smart contracts”) that automatically implement transactions according to rules embodied in its code. Its native cryptocurrency, Ethereum (or “ETH”) serves a variety of functions: a store of value, a digital currency for making and receiving payments and conducting various financial transactions; the required means for paying transaction fees incurred for use of the Ethereum blockchain; and the mechanism for compensating “validators” who provide validation and other support services to the Ethereum blockchain.

The Ethereum blockchain is decentralized as it is not controlled by centralized authority; instead, copies of the blockchain are maintained on independent servers (“nodes”) all over the world. The operators of these nodes work together to validate each new “block” of data and to cryptographically lock the new block onto the existing blockchain. The rules and procedures for doing this are known as the “consensus mechanism.”

The new proof-of-stake consensus mechanism

On September 14, 2022, the Ethereum blockchain upgraded from its legacy proof-of-work consensus mechanism to the new proof-of-stake consensus mechanism that relies upon “staking” rather than “work” to verify and add new information to the Ethereum blockchain. That event is known as the “Merge.” New transactions or other data is broadcast to all nodes in the Ethereum blockchain network. Ethereum holders decide to become validators by staking (depositing) 32 ETH. The validators are collectively responsible for storing the Ethereum blockchain data, processing and validating transactions, and adding new blocks of data. In the Ethereum PoS mechanism, there are 32 slots in an epoch, each of which is assigned a validator and has the potential to form a block. Should a block be formed at a given slot, the assigned validator will have the responsibility for proposing the block. Validators whose blocks become part of the chain are awarded ETH for their efforts.

A validator’s assignment to a slot is done randomly, but the odds are weighted by the relative amount of ETH staked by each validator with no additional impact above 32 ETH. There is no economic benefit to staking more than 32 ETH per validator.

If a validator’s block is incorporated into the blockchain and ultimately finalized, the validator receives a reward. If, however, the validator performs an action that could harm the functionality of the blockchain, such as proposing two blocks for their assigned slot, the would-be validator will be “slashed” and could lose part, or all, of their staked ETH. Self-interest and protection of one’s own assets are the chief incentives behind proof-of-stake. Moreover, it is expected that as the number of participants in the network increases, the more decentralized it will become and the safer from attack it will be.

What are the potential advantages of proof-of-stake for the Ethereum ecosystem? They include but are not limited to:

• Lowering capital requirements in terms of both computing hardware and energy use (the Merge will likely reduce the blockchain’s energy consumption by more than 99%).
• Providing for the ability of the protocol to not only reward good behavior but also punish explicitly bad behavior. As a result, proof-of-stake delivers a larger security margin on the capital securing the network.
• Laying the foundation for the protocol to handle more transactions (increased throughput) via the implementation of subsequent upgrades.

'Beacon' and the transition to proof-of-stake

Upgrading from proof-of-work to proof-of-stake has been a difficult, lengthy, and multistep process. To evaluate and verify the many dimensions and issues of the new proof-of-stake technology, while maintaining the ongoing operations and data integrity of the Ethereum blockchain, Ethereum established the Beacon Chain in late 2020. Beacon is a “consensus layer” that initiated the proof-of-stake consensus logic and block gossip protocol while further exploration and testing took place. This is the chain that was merged with the existing PoW chain during the Merge. Beacon operated independently from, and in parallel with, the rest of the Ethereum blockchain (“Mainnet”) until the Merge.

Using traditional terms, one might characterize Beacon as a pilot that enabled validators and participants, under the guidance of the Ethereum community, to work through a number of different upgrade proposals to ensure proper functioning and effective scaling and security capabilities. As the community members tested and signed off on Ethereum Improvement Proposals (EIPs), they were incorporated into the main body of the Beacon Chain logic.

Validators who volunteered to participate in pre-Merge Beacon were initially required to stake a minimum of 32 ETH. To participate, validators have been obliged to “lock” their staked ETH (i.e., send the staked ETH to an address that does not allow its use or sale until the upgraded network is fully functional). Accordingly, voluntary participation in Beacon represented a serious commitment to the proof-of-stake program.

The Beacon participants used proof-of-stake to validate and record staking-related transactions on the Beacon consensus layer only; none of these transactions were recorded on Ethereum Mainnet. The transactions that were being recorded and validated included the following:

• The establishment of new Beacon validators coming online (new tranches of 32 ETH)
• The allocation of block rewards for successfully recording and validating blocks of transactions on the Beacon Chain
• Penalties for poorly performing validators (i.e., inactive node)
• Slashing for malicious validators with a minimum amount of 0.5 ETH for each occurrence (If a validator’s balance reached 16 ETH, they were removed from the validator set.) 

Block rewards in Beacon are subject to the restrictions and limitations applicable to staked ETH generally. 

The 'Merge' and its aftermath

The general upgrade of Ethereum to proof-of-stake on September 14, 2022, is known as the “Merge” because it represents the integration of the Beacon Chain with the Ethereum Mainnet. The nodes that served as Beacon validators now validate new blocks added to the Ethereum Mainnet. 

The Merge leaves at least two major issues unresolved. First, some nodes would like to continue a version of the Ethereum blockchain on a proof-of-work basis. This would typically result in a hard fork. But unlike a traditional fork, for the proof-of-work chain to continue, a number of things were required to happen:

1. A different chain ID had to be established.
2. Participants on this proof-of-work chain have to solve what is called “the difficulty bomb,” a mechanism that seeks to incentivize the participants to forgo the proof-of-work chain by systematically increasing the difficulty level of puzzles to be solved for mining. 
3. Participants will have other upgrades to perform in order for this proof-of-work chain to continue to function effectively.

So, while a fork, it is unlike conventional forks. One might say there is an inherent contradiction here because this fork is at once new but also represents an older validation technology.

Second, the status of the staked ETH (both the initial stake and the block rewards earned by validating on the Beacon consensus layer) remains unresolved. The specs of the next scheduled upgrade to Ethereum (called “Shanghai”) represent the anticipated mechanisms or EIPs that will enable the participant stakers to access their original staked 32 ETH and/or take possession of their earned rewards to sell, exchange, etc. 

The Shanghai specs represent new specifications that are under discussion. But at this stage, the community of users has yet to reach a full consensus. In layperson's terms, that means the code that will “liberate” the 32 ETH and earned rewards has yet to be agreed upon, written, or implemented. But once the agreed Shanghai specs are implemented and integrated into the Mainnet (which is now proof-of-stake) they will enable participants to trigger a withdrawal to a designated address, and rewards and 32 ETH will no longer be reflected simply as a validator balance.

How to view the upgrade

With the September 14 Merge, the Ethereum Mainnet continues with its newly integrated proof-of-stake consensus mechanism. No transaction data or historical transaction data is lost in the Merge. All existing smart contracts still function without updates to the code. And with the Merge, the Beacon consensus mechanism and its validator nodes are recording every transaction on the blockchain, whereas, during its pre-merged state, Beacon was recording only staking-related transactions.

Ethereum has already undergone a series of upgrades over the years. Following the Mainnet Frontier launch in July 2015, there have been many upgrades from Bellatrix to Tangerine Whistle, and several of them bore the names of European capitals such as Berlin, London, and Istanbul. So, the Ethereum community has often envisioned that the Ethereum blockchain would undergo continuous improvements and upgrades. And although it began as a PoW-based blockchain, from the outset, changes were anticipated in terms of how it performed the consensus of the transactions.

A limited set of transactions was recorded on Beacon. In essence, its main goal was to test the new consensus mechanism in a live setting. Again, bear in mind that there was no transferability or any other kind of transaction—such as withdrawal—possible with the staked ETH and any earned rewards. So, it is worth repeating that when participants staked their 32 ETH on Beacon there was as yet no mechanism for recovering that 32 ETH, nor the rewards. And so they were, for all intents and purposes, “locked up.”

That reality raises a fundamental question: What do these rewards represent? With other proof-of-stake blockchains, participants can pull down these rewards and transfer or sell them. At present, with Ethereum, you may not.

Conclusion

The Ethereum upgrade is a complex, ongoing process. And as the Ethereum community continues to work further on the details of the Shanghai specs and related EIPs, greater clarity is likely to emerge regarding the dynamics touched on in this POV. In the meantime, it’s important for all participants on the Ethereum platform and users of ETH to carefully consider the topics as outlined earlier. Tax and accounting considerations are complex, and the apparent answers are often subject to various interpretations and applications depending on the specific business and tax strategies that inform your or your company’s position and “stake.”

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