The merge: what are the new legal issues following Ethereum’s huge upgrade?

The crypto industry is still buzzing in the wake of the Ethereum Foundation’s recent announcement that Ethereum will start to undergo its most significant upgrade to date on 6 September 2022. In this article, we explain the significance of the upgrade, and then touch on some of the legal issues we expect to arise from it. 

What’s the big deal?

Referred to as ‘the merge’, the upgrade includes the merger of Ethereum’s current execution layer (ETH1) with its new consensus layer (ETH2). At present, they are separate networks running in parallel. The upgrade will combine them, and the merge has been described by the Ethereum Foundation as changing an engine on a spaceship in mid-flight. 

Does that mean holders of ETH will get a new token? No. To them, it will be as if their tokens and the network they inhabit received an expensive facelift overnight. So what is the big deal, then?  

Well, the upgrade will transform the way in which the Ethereum network validates transactions. It will abandon ‘proof of work’ (POW) mining validation to instead rely on ‘proof of stake’ (POS) staking validating. In simple terms:

1. Validation is necessary in a decentralised blockchain. It is the process whereby the network relies on its participants to ensure that transactions are not made up or edited, and that new tokens are created as often as intended. It makes the blockchain secure. 
2. Until now, Ethereum, like Bitcoin (and many other cryptocurrencies) has relied on a POW mechanism. In simple terms, that means the token is mined. Transactions are validated by computers competing against each other to solve difficult cryptographic puzzles. Computers who solve the puzzle are given a reward – new tokens.
3. Ethereum’s new POS model will not involve mining. Instead, holders will be able to ‘stake’ (effectively lock up) some of their ETH in order to create a validator node which, when asked by the network at random, can validate transactions and create new ETH. Instead of getting a mining reward when their computer solves a cryptographic puzzle, stakers will earn a steady and periodic amount of ‘interest’ on their staked tokens.
    

So why is that better? Well, in a nutshell:

1. it creates a steady income stream for stakers. Rewards are given for actions that help the network reach consensus. You will get rewards for running software that properly batches transactions into new blocks and checks the work of other validators. Each validator node must contain at least 32 staked ETH, but there are already tools and mechanisms which allow holders to ‘pool’ their ETH to reach the limit together.  We also expect that exchanges will allow holders to collectively ‘stake’ their ETH for a small fee (effectively pooling with other users behind the scenes);
2. it uses a lot less electricity. Mining required powerful computers, but validator nodes (let alone contributing to someone else’s validator pool) will not. In fact, the merge is expected to reduce the network’s power consumption by more than 99%; and
3. the merge is intended to drastically increase the Ethereum network’s speed, scalability and security.

That said, such a significant facelift will bring with it some new legal issues that crypto businesses or secondary service providers will need to be particularly alive to.  

Legal consequences

Ownership

There is ongoing legal debate as to what marks and proves ownership of a crypto asset. The consensus is typically that the holder of the private keys owns the asset, subject to any express, implied or constructive trust arrangement. It needs to be assessed on a case-by-case basis, but most crypto exchanges or other custodians do not provide their users with access to private keys.  

In light of the merge, this hazy ownership situation could lead to complications where a user wishes to hold ETH on an exchange, or contribute it to a pool, but still retain exclusive rights to the ETH at the end of the day. For example:

1. What if an exchange does not allow its users to stake ETH, but instead, the exchange wishes to use its control over the relevant private keys to stake the ETH itself and keep the profits generated by the exchange acting as a validator node and validating transactions? While perhaps morally dubious, that may well be permissible – depending on who owns the ETH and whether a trust relationship exists; or
2. Similarly, what if a user wishes to contribute ETH to a validator pool, but wants to ensure it retains ownership of said ETH after it intermingles with someone else’s ETH? Some pools ensure that ownership of the ETH stays with the contributor. Others ask users to give up their ETH in exchange for another token and different rights (i.e. a derivative linked to the value of an underlying ETH). There are a number of iterations. Again, the question of ownership will be key to navigating the new world of validator pools. 
    

Collective Investment in validator nodes and financial services regulation

As noted above, while each validator node must contain at least 32 staked ETH, they do not need to all be held by the same entity. Instead, a number of holders may pool their ETH together to reach the 32 ETH threshold necessary to establish a validator node and gain access to staking rewards.  

In this regard, businesses should be aware that Australian law regulates collective investment (referred to as “managed investment schemes”). There are two types of managed investment schemes, those that include retail investors and those that do not (i.e. wholesale managed investment schemes). Additional conduct and disclosure requirements apply where financial services are provided to retail clients under the Australian financial services regulatory regime. 

Relevantly for pooled ETH staking, there are, broadly, three common elements to a managed investment scheme:

1. people contribute money or assets (such as ETH) to obtain an interest in the scheme;
2. any of the contributions are pooled or used in a common enterprise to produce financial benefits or interest in property for purposes that include producing a financial benefit for contributors (i.e. persons pooling ETH to create a validator node in order to accrue validation rewards); and
3. the contributors do not have day-to-day control over the operation of the scheme but, at times, may have voting rights or similar rights. 

At the time of writing this article, a single ETH trades at approximately A$2,300, meaning that a minimum outlay of around A$73,600 is required to establish an individual validator node. We expect that this level of investment is likely to render individual establishment of a validator node outside of either the means or risk tolerance of Australian retail investors. In which case, an offer from a crypto exchange or similar secondary service provider to pool an investor’s ETH with those of other investors in order to receive validation rewards, is likely to be very attractive for Australian retail investors.  

Accordingly, businesses offering pooled ETH staking services to Australians should be particularly cautious that they are appropriately licensed in Australia (or otherwise fall within a relevant exemption to the requirement for such licensing).  

All in all, in our view the merge is well timed to coincide with the Australian Government’s efforts to map tokens and to provide further regulatory clarity in the digital assets space.  

If you would like to discuss the legal consequences of anything mentioned in this alert in the meantime (or related to digital assets generally), please contact our Digital Assets team, who are experienced in advising on matters of ownership, possession, trust relationships, and financial services regulation.