Ethereum’s Next Big Upgrade Comes With the Risk of Added Turbulence

Crypto enthusiasts are about to get some good news: The Ethereum blockchain’s next big software upgrade is poised to happen on Wednesday. But like almost everything else in the digital-asset world these days, the long-anticipated tweaks won’t come without complications.

(Bloomberg) — Crypto enthusiasts are about to get some good news: The Ethereum blockchain’s next big software upgrade is poised to happen on Wednesday. But like almost everything else in the digital-asset world these days, the long-anticipated tweaks won’t come without complications. 

The overhaul, dubbed Shanghai, follows last year’s game-changing “Merge,” which replaced power-hungry computers with a process involving staked, or pledged, Ether tokens and so-called validators to order transactions on the most commercially successful crypto network. Now, Shanghai will allow withdrawals for the first time by owners of Ether who have staked their coins since December 2020. Owners of the cryptocurrency who stake earn a yield that is paid out in additional Ether tokens. 

Currently, about 18 million Ether is being staked, worth about $36 billion, according to Etherscan. Of this amount, it’s estimated that 1.2 million Ether — worth $2,2 billion at current prices — will be withdrawn in the five days after Shanghai, according to researcher Coin Metrics. 

The big question is whether the update will spur a broader exodus by holders over time or prompt an influx of fresh demand when the tokens are unlocked. A cloudy regulatory outlook adds further uncertainty to the mix — the US Securities and Exchange Commission has warned in recent months that staking services offered by some trading platforms essentially constitute the illegal sale of securities. 

“The market is going to whipsaw back and forth as they are trying to analyze what the increase in withdrawals is going to look like,” said Henry Elder, head of decentralized finance at Wave Digital Assets. “There’s no doubt in my mind we are going to see a lot of withdrawals.”    

Many Ether holders may simply switch between different staking services, or move from operating their own staking equipment to outsourcing the work to a staking service that would operate the gear for them, Elder said.

It could take weeks or even months to take tokens out because withdrawals will be limited to maintain Ethereum’s security. Tests leading up to the upgrade have gone relatively smoothly.

“I am pretty confident in withdrawals,” Tim Beiko, who coordinates Ethereum developers, said in an interview. “There’s not a single thing that keeps me up at night.”

An added wrinkle: Staking provider Lido — which accounts for about a third of all staked Ether — is expected to only start enabling withdrawals in May. Another potential issue could involve some of the various computer nodes that support Ether staking-wallet services. Once withdrawals are enabled, node operators will need to retrieve the keys needed to unlock users’ deposits. If they have misplaced them or are unable to locate them for some reason, staking services the nodes belong to could find themselves insolvent, and that could put pressure on tokens associated with these services, Elder said. 

“Nobody knows that the bank is insolvent until people start to pull their money out,” he said. “That’s a little bit of a black swan that’s on the horizon.”

There’s also the risk of nodes getting hacked or going rogue, and trying to hold users’ funds up for ransom, said Mike Silagadze, chief executive officer of Ether.fi, which lets stakers keep control of their keys.

“Most people have this incorrect perception that when Shanghai goes through, that staking risk is reduced,” Silagadze said. “It’s actually the exact reverse, the risk exponentially grows at this point.”

Ethereum developers point out that there has always been a chance that a service provider or a node would be hacked or lose keys, and Shanghai doesn’t increase that risk.

“A possible threat exists if a third party were to gain an operator’s withdrawal keys,” said Ben Edgington, Teku product lead at ConsenSys, which works on Ethereum infrastructure. “Any large operator should be taking the security of their keys very seriously, so I would be very surprised if there were any widespread leaks.”

Once such issues have been resolved, the withdrawals feature may ultimately make Ether a more attractive investment, beckoning retail investors and institutional investors looking for yield. But much will also depend on regulators’ views of the cryptocurrency and staking.

“The risk element that gets de-risked is execution risk,” said Darren Langley, general manager at staking service Rocket Pool. “There’s a lot of FUD, (claims that) Ethereum will never ship withdrawals. That puts that to bed.” 

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