Ethereum leaves mining behind

On 15 September 2022 Ethereum completed ‘The Merge’, moving from proof of work, based on mining, to proof of stake. Its energy consumption fell drastically. It was a long-awaited technical change within the sector, and also a demonstration that the operating rules of a crypto-asset network can be modified, with economic consequences for those who relied on them. It is worth separating the technical debate from the economic reading: it is the latter that matters here.

For those who do not follow the crypto world, the episode may seem a technical matter. But it has a reading of general interest: it shows how a change of technology can leave idle infrastructure in which a great deal had been invested. It is a lesson applicable to any business that depends on specialised equipment or processes, and a reminder that the currency of the technology should be assessed before committing capital. The episode also shows how fast an ecosystem can change when its participants agree on a change of rules.

Two ways to validate a network

In a proof-of-work system, the network is secured by computers that consume energy to solve calculations. In a proof-of-stake one, validators put up assets as collateral instead of computing power. That is why the change drastically cut Ethereum’s energy consumption. Both rest on cryptography and on incentives for participants to act honestly, though in different ways.

Both systems seek the same thing: for participants to agree on which transactions are valid without a central authority. They differ in how that security is achieved and in which resources it consumes. Each has advantages and limitations, and the debate over which is preferable is part of the technical and political discussion around these networks. For ordinary users of the network the change did not alter the essentials, but for those who earned income from mining it meant the end of that activity on this network.

Machines left idle

Thousands of machines dedicated to mining Ethereum were left idle overnight. These machines are designed for a specific function, and when that function disappears their value depends on whether they can be turned to another activity or simply become obsolete.

A specialised machine is worth as much as the activity it was designed for. If that activity disappears or changes, its residual value can fall sharply. It is the risk of specialisation: it brings efficiency while the rules do not change, but reduces the capacity to adapt when they do. That is why it is prudent to consider from the outset what alternatives exist to reuse or resell the assets. Mining machines can be used on other networks based on the same system, but with a return that depends on factors outside the owner’s control, such as price and difficulty.

The lesson for infrastructure

Bitcoin remained mining-based. The lesson: an asset’s technology can change, and with it the value of the infrastructure. Before investing in equipment or in projects tied to a specific technology, it is worth assessing what would happen if the rules changed, and how much flexibility exists to redirect the investment.

A prudent analysis of this kind of investment includes several scenarios: one in which everything stays the same, another in which the rules change and another in which demand changes. Each should have an exit or adaptation plan. And, as with any capital investment, it is wise not to depend on a single hypothesis or a single technology for the project to be viable. Flexibility has a value that rarely appears in a project’s spreadsheet but is paid for when conditions change.

Specialised infrastructure is worth as much as the technology that uses it.

This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.