Grayscale: An Analysis of the Challenges Facing the ETHW Fork

Original: 《Market Byte: A Fork in the Road》

Author: Grayscale Research Matt Maximo and Michael Zhao

Compiled by: DeFi之道

Background

Ethereum plans to merge to Proof of Stake (PoS) on September 15, 2022, which has sparked speculation about a Proof of Work (PoW) Ethereum (ETHW) fork. While Ethereum forks have precedent, we will explore why this time it may not be feasible and what it means for Ethereum (ETH) and Ethereum Classic (ETC).

Ethereum Classic (ETC) was born in 2016 when a vulnerability in the code of an emerging decentralized autonomous organization (known as "The DAO") was exploited, resulting in hackers stealing over 3.6 million ETH. While the majority of the community supported a hard fork to modify the network's transaction history to invalidate the attackers' actions, a portion believed that no modifications should be made to the chain state. The forked version of the Ethereum network became the Ethereum chain we have today, while the subset of users opposing the fork continued to host the version of the network that the attackers successfully exploited, now known as Ethereum Classic (ETC).

Since then, Ethereum has evolved into a robust on-chain ecosystem for decentralized applications (dApps) and users, while Ethereum Classic largely remains a value storage asset. Despite the differences, Ethereum Classic (ETC) offers a new Proof of Work (PoW) variant of the Ethereum network, allowing users, developers, and miners to seamlessly transition to this variant if the Ethereum merge leads to a hard fork.

In March 2022, news began to spread about Ethereum miners considering a transition to Ethereum Classic (ETC), causing the price of ETC to rise by 103% in just 11 days. Despite speculation surrounding the new ETHW fork after the merge, ETC surged again, increasing by over 198% since July 12. Speculation around the merge has made ETC one of the best-performing cryptocurrencies of 2022, rising 18% year-to-date, while other cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH) have depreciated by nearly 50%.

Source: TradingView, as of August 15, 2022

Historically, forked assets have been very profitable, with many top tokens by market capitalization originating from forks of Bitcoin and Ethereum. For example, in July 2016, when Ethereum (ETH) forked into ETH and ETC, anyone holding tokens on the original blockchain would immediately possess an equivalent amount of new tokens. By the end of the year, ETC ranked sixth with a market capitalization of $124 million, while ETH was at $697 million. Today, Ethereum Classic (ETC) is the 19th largest token by market capitalization, valued at over $5.6 billion.

Despite past precedents of forks creating value, we will explore why creating an Ethereum PoW fork chain may not be a viable solution this time.

Ethereum is More Than Just Currency

It is important to distinguish the Ethereum ecosystem of 2016 (when the network first forked into ETH and ETC) from the more developed on-chain ecosystem of protocols, dApps, and tokens that users experience and interact with today. A PoW fork of the current Ethereum network would create duplicate instances of all these tokens, which could pose meaningful challenges for developers and market participants. In fact, the absolute complexity of DeFi and the number of asset-backed tokens locked in DeFi protocols pose catastrophic risks to the price of ETHW due to attempts to liquidate on-chain positions. To understand how high the stakes are today, let’s look at a key element of the Ethereum ecosystem: stablecoins. In 2016, when Ethereum Classic forked, stablecoins were just beginning to gain attention. In June of that year, the market capitalization of Tether (USDT) was only 0.65% compared to Ethereum (ETH), whereas it is 28.34% at the time of writing.

Source: CoinMetrics, CoinGecko, as of August 15, 2022

Tether and other stablecoin issuers, such as Circle (USDC), have stated that only tokens on the PoS network will be redeemable after the fork. This means that all stablecoin variants on ETHW may become worthless, along with other "asset-backed tokens" like wrapped Bitcoin (wBTC) and staked ETH (stETH).

Some major use cases for asset-backed tokens include loan collateral, providing liquidity, facilitating leveraged trading, and other DeFi applications. In 2016, this ecosystem was virtually nonexistent. Today, DeFi on Ethereum includes over 530 protocols, with nearly $40 billion in value locked in smart contracts. Currently, over $25 billion in asset-backed tokens are locked in smart contracts. If the ETHW fork goes live, users of these protocols may attempt to liquidate leveraged positions using previously asset-backed tokens for ETHW tokens, while ETH holders rush to sell their free ETHW tokens for dollars or ETH on centralized exchanges. Therefore, we may see disproportionate selling pressure on the forked assets.

Source: CoinMetrics, August 15, 2022

So far, the speculative market for ETHW has not reflected strong support for the fork. The price of ETHW can be seen as a representation of how much support the potential fork may have; since the launch of ETH IOU trading on Poloniex on August 10, the fork has been on a downward trend. ETHW traded at a peak of 0.08 ETH before continuing a steady decline to 0.03 ETH.

While there may be a rebound in the short term, the price of ETHW suggests that support may be driven by speculation rather than the true perceived value of the asset. Although ETHW has fallen over 50% since its launch, ETC has risen about 9% during the same period.

Source: CoinGecko (Ethereum POW on Poloniex), as of August 15, 2022

Unnecessary Complexity for Protocol Teams

In addition to the loss of value for non-redeemable asset-backed tokens on the ETHW chain, the ETHW fork may introduce new operational issues for many Ethereum-based protocols. When the token holders of a protocol vote to deploy on the new blockchain, the circulating supply of the protocol's tokens does not change, preventing dilution of value and utility. However, on a PoW fork, the protocol will be duplicated, along with any native tokens. This means they may trade at different prices than their counterparts on the PoS chain.

As a result, protocols will need to determine how to manage value tokens held by duplicate treasuries, duplicate tokens, NFT ownership, etc. How will governance rights be consolidated? Can someone purchase the cheaper variant and still retain the same number of voting rights? Will duplicate tokens in the protocol treasury be held or sold? Protocol teams may find it much simpler to deploy new protocol instances on Ethereum Classic (ETC) without any token variant issues.

The Bull Case for Ethereum Classic (ETC)

The success of the ETHW fork requires not only users, funding, and development work but also strong support from existing blockchain infrastructure. Major exchanges and DeFi protocols are currently deciding whether to support ETHW tokens, although this does not necessarily indicate a preference or endorsement of ETHW technology.

As the potential ETHW fork gains attention, miners may play a more critical role. After the merge, miners will no longer be able to earn rewards from the Ethereum network and will seek to shift their resources to the new network. With about a month remaining until the expected merge, there is still no documentation or anticipated timeline on how miners need to adjust their machines and software to mine the ETHW chain. Meanwhile, Ethereum Classic (ETC) is fully documented and operationally ready to absorb the current mining power of Ethereum.

Regardless of whether the ETHW fork is successful, Ethereum Classic (ETC) will continue to operate normally. Supporters of continuing to use the Ethereum Proof of Work (PoW) version may find that the complexities of the ETHW fork are not worth the effort when a stable version of the network exists in Ethereum Classic (ETC). While users may be attracted by the promise of free tokens, the ability to liquidate ETHW tokens for dollars may be short-lived as exchange liquidity dries up. Once there is no more value to extract, users are less likely to continue supporting the ecosystem.

Conclusion

Due to the complexities of DeFi and the proliferation of asset-backed tokens, the ETHW fork will face significant challenges. While the chances of success are low, some support for the PoW fork has emerged from miners and exchanges. So far, speculation around ETHW tokens has led to a steady decline in price of over 50% since launch, while the price of ETC has risen about 9%. In addition to the declining interest in ETHW tokens, major Ethereum protocols and participants, such as Tether and Circle, have expressed support for ETH PoS as the canonical chain—an important sign of support, as the two companies are responsible for nearly $120 billion in on-chain asset-backed tokens. If protocols find that token holders indeed wish to have a protocol variant on Ethereum's PoW chain, they are likely to prefer ETC rather than getting caught up in the complexities of the replicated on-chain ecosystem on ETHW.