【BP In-Depth Analysis】Ethereum and ETH- Part 3 $ETH Economic Model
This article is the third part of【BP In-Depth Analysis-Ethereum and ETH】, which introduces the $ETH Economic Model. The article will be divided into 2 main parts, the Economic Model before the Merge and the Economic Model after the Merge. Don’t forget to follow us before you read.
Other Parts of 【BP In-Depth Analysis-Ethereum and ETH】:
Part 1 The Development History of Ethereum
Part 2 Powerful Ethereum Ecosystems
Economic Model before The Merge
Deifinition
Ether ($ETH) is the native cryptocurrency of Ethereum Network. The purpose of $ETH is to allow for a market for computation. Such a market provides an economic incentive for participants to verify and execute transaction requests and provide computational resources to the network.
Any participant who broadcasts a transaction request must also offer some amount of $ETH to the network as a bounty. The network will award this bounty to whoever eventually does the work of verifying the transaction, executing it, committing it to the blockchain, and broadcasting it to the network.
The amount of $ETH paid corresponds to the time required to do the computation. These bounties also prevent malicious participants from intentionally clogging the network by requesting the execution of infinite computation or other resource-intensive scripts, as these participants must pay for computation time.
$ETH Generate Details-Block Rewards
New $ETH are generated via block rewards, initially set at 5 $ETH per block. Those block rewards incentivize miners to secure the network. Miners that find an uncle block also receive 87.5% of the base block reward. Uncle blocks occur when several distinct miners simultaneously mine a block. In this case, the block that has the most accumulated PoW is conserved, and others are rejected.
In 2017, the difficulty bomb increased block times drastically, thus reducing the issuance rate. Indeed, the difficulty bomb, also known as “ice age” was initially designed as a mechanism to disincentivize miners to continue mining the Ethereum chain by making it exponentially harder to create a new block. This was meant to accelerate the transition from Proof-of-Work to Proof-of-Stake.
The Casper development and transition to Proof-of-Stake being delayed, Vitalik Buterin and Afri Schoeden proposed to delay the difficulty bomb and reduce the block rewards from 5 $ETH to 3 $ETH, thus leaving the system in the same general state as before. This proposal, EIP 649, was included in the Byzantium hard fork which was implemented on October 16, 2017, at block 4,370,000, thus effectively reducing block rewards from 5 $ETH to 3 $ETH and delaying the difficulty bomb for approximately 1.4 years.
On February 28, 2019, at block 7,280,000, the Constantinople hard fork further reduced block rewards from 3 $ETH to 2 $ETH, and once again delayed the difficulty bomb for approximately 12 months with EIP 1234.
Token Functions
$ETH used to provide crypto-economic security to the network in three main ways:
1) it is used as a means to reward validators who propose blocks or call out dishonest behavior by other validators;
2) It is staked by validators, acting as collateral against dishonest behavior — if validators attempt to misbehave their $ETH can be destroyed;
3) it is used to weight ‘votes’ for newly proposed blocks, feeding into the fork-choice part of the consensus mechanism.
Launch & Initial Token Distribution
Ethereum’s original token distribution event, managed by the Ethereum Foundation, sold roughly 60 million ethers (80% of the initial 72 million ETH supply) to the public. The sale took place between July 22, 2014, and September 02, 2014. However, the Ether purchased by crowdsale investors were not usable or transferable before the launch of the Genesis Block on July 31, 2015. The price of ether was initially set to a discounted price of 2000 ETH per BTC until August 05, 2019, before linearly declining to a final rate of 1337 ETH per BTC, reached on August 28, 2014.
- 3,700 BTC were raised in the first 12 hours of the sale;
- Over 25,000 BTC were raised in the first 2 weeks;
- The sale eventually allowed the Ethereum Foundation to raise over 31,000 BTC, equivalent to $18.3 million.
The remaining 12 million ETH (20% of the initial supply) were allocated to the Foundation and early Ethereum contributors. Of the ether sent to the Foundation:
- 3 million were allocated to a long-term endowment;
- 6 million were distributed among 85 developers who contributed prior to the crowdsale;
- 3 million were designed as a “developer purchase program” which gave Ethereum developers the right to purchase ether at crowdsale prices.
Supply Schedule
General Emission Type: Inflationary
Precise Emission Type:Fixed Issuance
Economic Model after The Merge
New Definition and Token Functions
After The Merge, $ETH will be required to validate and propose blocks on Mainnet. $ETH is also used as a primary form of collateral in the DeFi lending markets, as a unit of account in NFT marketplaces, as payment earned for performing services or selling real-world goods, and more.
Ethereum allows developers to create decentralized applications (dapps), which all share a pool of computing power. This shared pool is finite, so Ethereum needs a mechanism to determine who gets to use it. Otherwise, a dapp could accidentally or maliciously consume all network resources, which would block others from accessing it.
The $ETH cryptocurrency supports a pricing mechanism for Ethereum’s computing power. When users want to make a transaction, they must pay ether to have their transaction recognized on the blockchain. These usage costs are known as gas fees, and the gas fee depends on the amount of computing power required to execute the transaction and the network-wide demand for computing power at the time. Therefore, even if a malicious dapp submitted an infinite loop, the transaction would eventually run out of ether and terminate, allowing the network to return to normal.
Main Changes/Impacts Summary
1) The Merge will decrease $ETH supply, with estimates suggesting a high likelihood of periods of negative net issuance rate.
2) Deflationary periods are likely to put positive pressure on $ETH price, which in turn will increase network security and blockspace value.
3) The economic negative feedback loop will provide a sustainable economic model to incentivise all actors in periods of both economic expansion and contraction.
Changes/Impacts Details
ETH Issuance Rate
Before the merge has been completed, Ethereum PoW and PoS chains would operate in parallel (Attention: not possible to use the PoS chain), and if people want to send a transaction on Ethereum, it would still execute on the PoW chain. Nonetheless, validators on the PoS chain are already getting rewarded for securing the soon-to-be fully operational PoS network. This situation leads to two separate sources of $ETH issuance:1) Validator rewards on the Ethereum PoS chain, 2) and Miner rewards on the Ethereum PoW chain.
After the Merge, PoW miners will stop operating, eliminating miner rewards. Finally, validator rewards will remain as Ethereum’s only source of new $ETH issuance.
The Magnitude of the Impact
It should be already clear that the transition from Proof-of-Work to Proof-of-Stake impacts $ETH’s issuance rate. $ETH’s nature is inflationary, 2 $ETH get printed every block (roughly every 13 seconds) to go to miners. Once Proof of Stake is adopted and the Proof of Work system is left behind, the Ethereum network will be hit by an evident supply shock. After the merge, the yearly $ETH issuance will decrease from about 4.9 million $ETH (~4.13% of outstanding supply) to an estimated 0.6 million, or ~0.49% issuance (with 13M staked $ETH projected).
Ether Issuance — Market Dynamics
Despite its inflationary tendency, $ETH can become deflationary. Due to a mechanism implemented with Ethereum Improvement Proposal (EIP) 1559, the gas fee structure is split into two parts: 1)A base fee, set by the Ethereum protocol, 2) and A priority fee, a tip set by the user to expedite the execution of the transaction.
The base fee varies according to the demand for blockspace. In other words, it varies based on how much users want their transaction to be included in the next block (and have their transaction executed quickly). The peculiarity of the base fee is that it is burned, or removed from circulation, rather than rewarded to miners or validators. As mentioned in the above bullet point, the base fee is set algorithmically by the protocol itself, and the $ETH burn rate is not a fixed, hard coded parameter. The base fee targets 50% full blocks, and it will increase or decrease by up to 12.5% after blocks are more than 50% full. In simpler terms, the burn rate is dictated by how much the market values Ethereum’s blockspace.
$ETH is inflationary at its core, but there are also deflationary forces coming into play as usage of the Ethereum Network increases. Heavy activity on the network will cause higher base fees, and as base fees are burnt and removed from circulation, $ETH supply is reduced. So can $ETH become deflationary, despite inflationary rewards being continuously issued to validators? The short answer is yes.
Ethereum would get a deflationary rate of 0.7% annually. Of the 2.2 million in commissions, 70% (1.5 million) will get burned. The remaining 700,000 $ETH would go to validators.
Market Participants Expectations
The new Ethereum economic system is designed for a negative feedback loop to naturally establish. The more people use the network, the lesser the $ETH issuance, as more $ETH gets burned when gas fees are high. Lower issuance, from basic economic theory, will then eventually lead to a higher $ETH price. In turn, this expectation of profit due to high asset prices will cause people to hold on to their $ETH, rather than spending it on transaction fees. Thus, less usage will lead to a smaller burn rate and more issuance, which in turn means a lower $ETH price. Expectations for increased dilution translate in a deterioration of holding incentives, which completes the cycle leading to the higher usage starting point.
The cycle is the following: Less usage -> more issuance -> lower price -> lower incentive to hold -> higher spending -> more usage -> less issuance -> higher price -> more holding -> less usage -> and so on.
What this cycle describes is a self-correcting mechanism that provides an all-season, multi-party incentive mechanism. This self-correcting mechanism converges to a proper valuation of $ETH given the value of Ethereum’s block space.
Staked $ETH
Cryptocurrency issuance depends inversely on the amount of ETH staked — — The issuance of new cryptocurrency units will now remain in the hands of validators and not miners. The mechanism has its roots in a compensation structure dependent on the number of validators, as explained in the Ethereum 2.0 roadmap.
The chart shows that $ETH issuance dilutes as users stack more $ETH (i.e., deposited as collateral) on the network. Using this math, with a total of 15 million $ETH staked (currently, there are 12.7 million, according to beaconcha.in), by which can compute that validators will earn around 700,000 $ETH a year for their contribution to the network.
Epilogue
The merger of Ethereum 2.0 can be regarded as a key milestone for the network, which has brought dramatic changes to both the Ethereum Network and the $ETH Economic Model . In the next article, we will introduce the $ETH Application Scenarios. Don’t forget to follow us to get more information.
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