The Merge is on and this risk expert recommends securing digital assets with ‘enforced segregation’
If Blockchain’s True Believers, the Crytpo Crusaders and the Evangelicals of Ethereum, were already clenching up a little ahead of Ethereum’s big moment (The Merge), then the overnight action on Wall Street – or perhaps reaction is a better way to put it – just raised the already fabulously high stakes to preternatural levels.
The Ethereum Network which controls and hosts the world’s No. 2 most important digital currency is about to undergo elective surgery of the most profound nature.
For absolutely everything you need to know and some things you probably don’t, please check out what The Badman has been covering, like The Legend he is.
Either way, some time in the next 48 hours Ethereum is booked in for a terribly critical – transformative – software upgrade known – in typically mystical Crypto-language as “The Merge”.
The process – if successful – will see the network transform its essential DNA via the adoption of an entirely different mechanism for producing tokens and executing transactions.
According to Rob Badman, The Merge is the single-most talked about event in crypto, “since a Korean scientist invented a toilet that turns poo into energy and rewards depositors with digital currency.”
Oh, there’s tension alright, because what happens to Ethereum will have ramifications across the very interconnectedness of the cryptoverse. Everyone is on the hook for this – from the digital currencies themselves to the tokens they make, the punters and institutional investors who buy them, the miners, the networks and … Venezuala comes to mind… anyone with trust in the business of the blockchain.
The driver for this great switcheroo is the simple, and now very urgent destruction of energy required by blockchain businesses to sustain transactions and create new tokens.
Great warehouses of super computers hoover up the power grid of small island nations to achieve “proof-of-work” (PoW) puzzles for a financial reward.
Rob says The Merge, is actually “hard fork” upgrade and represents the protocol’s biggest renovation it’s likely to ever undertake – the monumental and long-awaited shift from its proof-of-work model to proof-of-stake.
The PoW consensus mechanism, most famously employed by both Bitcoin and Ethereum, leans on that energy-intensive crypto mining to validate block transactions and secure the network.
Proof-of-stake (PoS) eliminates the need for a computer mining rig to do exactly this.
After the upgrade, the network will operate under a much less energy-intensive PoS model, with transactions ordered by “validators,” who lock up Ether on special wallets.
According to Bloomberg’s crypto-whisperers David Pan and Olga Kharif:
“…investors will be enticed to contribute to the post-Merge network by locking up, or staking, some of their tokens in exchange for yield (expected to be around 5.2% right after the Merge). One estimate suggests that as much as 80% of Ether’s total supply — worth around $170 billion at present — could be staked in future.”
Ethereum has already fallen below US$1,600 Tuesday following the release of the heinous US August inflation data.
Geoff McAlister, Managing Director and Head of Risk & Control at Hex Trust told Stockhead that in the wake of Crypto’s “Great Deleveraging” there needs to be “a renewed focus from investors on ensuring their digital assets are kept safely.”
All the coinage in crypto land continue to be as volatile as ever — only more so – considering their link to equity markets and their link to the ongoing macroeconomic dramas.
Even in the last fortnight, Ethereum has been pendulating across $1,380 and above $2,000.
While a terrific merge could catapult Ethereum’s value heavenwards, the outside clamour and the uncertainty is making for sleepless nights.
“It’s pretty basic: investors need to understand the change and various methods with which they can hold and secure their digital assets.”
Cryptocurrencies and equity markets have been shadowing one another during the highs and lows of will-it won’t-it inflation. But amid the shaken investor confidence, the anxiety of fast-rising cash rates, and the growing US likelihood of recession, markets have fallen hard – with the tech-heavy Nasdaq down 25% year-to-date.
But after the last six months, for many crypto investors a 25% loss would be heaven.
“The crypto winter has exposed the fallibility of systems assumed to be fool-proof and even led to crypto lenders declaring bankruptcy.
“Retail investors who thought their cryptos were safe with these lenders – whilst enjoying high returns – are now dealing with the grim reality that crypto deposits are exposed to much greater risk compared to bank deposits,” McAlister says.
“Bank depositors long understood the risk of deposits; they know from history banks can fail and now crypto investors learnt the same lessons. A depositor takes the credit risk of the deposit-taker. The problem here is that crypto lenders are not regulated, nor do they have the benefit of deposit protection.
Widespread losses have been accompanied by increasing calls for regulation, but McAlister says we’re yet to see a standard set of coherent global approaches to this problem.
“And crypto-holders are already in the thick of it and can’t necessarily wait for regulations to catch up with industry developments like ‘The Merge’.”
McAlister warns that now is when investors just need to take more active responsibility of their risk exposure and own it.
“Now they need to perform their own due diligence – including the risks relating to how their digital assets are held.”
Digital asset custodians provide investors with an alternative for safe storage of digital assets.
“By ensuring the client’s digital assets are securely segregated from the custodian’s own assets and also the assets of other clients, the digital assets are held free from the risk of insolvency of the party holding the assets.”
Consequently, he says, investors can have “a refuge from the credit risk” of the nascent markets and can focus instead on the fun bits – of trading risks and returns.
McAlister says these custodians don’t offer the high returns of crypto lenders and may in fact lead to a cost for investors in the form of custodian fees.
“But at least investors can have some peace of mind knowing that their investments are kept safely quarantined from the unregulated wilderness outside.”
The custodian’s business is solely focused on holding client assets safely for a fee culling risk of the custodian falling into bankruptcy. And nor can a custodian use the depositor’s assets to gain a return.
“This is a different situation to crypto lenders who are taking their depositors’ assets and using them to get a return, e.g. by lending out such digital assets to Centralised Finance entities, deploying them to staking opportunities or into Decentralised Finance protocols or ‘yield farming’ strategies.”
While this principle has some similarities with banking, the key difference is that banks are highly regulated and have strict capital adequacy requirements, per the Basel Accord recommendations on Capital Adequacy adopted and implemented by almost every country and banking regulator in the world.
“Even if a custodian goes bankrupt, such client assets are segregated from the custodian’s own assets. Consequently, client assets cannot be used to pay the creditors of the bankrupt custodian but must instead be returned to such clients.”
McAlister says these custodians typically purchase insurance to cover risks of investor loss.
“Segregation is the key principle in this model and can be reinforced by using distinct legal principles such as holding assets on trust.”
In any event, robust legal documentation must be established to ensure that such assets are legally segregated and protected from the custodian’s bankruptcy.
“To safeguard crypto investments it is vital that the segregation of assets is not merely a theoretical concept that can be established with legal agreements alone. It needs to be supported in practice to ensure that there is no commingling of client assets together with the custodian’s own assets.
“Organisations need safeguards to ensure their investment assets can never disappear due to the failure of a crypto platform,” he warns.
“With technically and properly secured segregation of assets, an investor’s assets cannot be repurposed or reused by the custodian and, in the event of bankruptcy, cannot be claimed by creditors.”
“The demand for crypto assets and currencies such as Bitcoin will not diminish. Unlike bonds or shares, cryptocurrencies such as Bitcoin are not issued by a company or government and consequently its value is not linked to the fortunes of an individual company or government. Therefore, similar to gold, Bitcoin cannot default or be debased and it is Stateless, which offers huge appeal.
“After the events of the past six months, however, investors now need to at least recognise the need to be careful not only about how they trade but where they keep their assets.”