Guide to Ethereum Economics: Introduction

Davide Crapis

Blockchain economics comprises the mechanisms, incentives, and macroeconomic policies that orchestrate value creation and distribution in crypto-economic networks. It is a new field because blockchains allow to design new currencies and open up a whole new class of markets. It is a hybrid field that marries economic design and software development. It is also a dynamic field with lots of problems that are not yet understood, with abundant open data that can be used for measurements and evaluations, and with a system of composable markets that is upgraded at every hard fork or smart contract deployment.

This is a practical guide for people that are interested in learning more and contribute to research and development. We focus on Ethereum, which is the largest ecosystem with the most advanced economic mechanisms. In this introduction, we start with goals and the importance of making progress in blockchain economics to realize the promise of the internet of value, describe different sub-fields that have recently emerged in blockchain economics, and provide resources to get involved in building a better economic system via open collaboration.

Why does this matter?

We can start from the economy we wish to build and its core values. The internet of value, also known as web3, is a system for value transfer over a communication network that is internet-native and far better than the current financial and payment systems. Success in early experiments with blockchain technology, from Bitcoin to Ethereum and followers, show that building such system is possible. However, we are in the early innings of a long game and we need to keep improving the system to the point where we can be certain that the promises of a better internet are realized. What are these promises?

• Security: 51% and other attacks on the blockchain are extremely costly, to the point that it is not economically viable to carry them out; risk of losing value to a malicious actor is extremely low for users and smart contract applications are robust.
• Equity: anyone can access the system and the cost of censorship is high, so that censorship is infeasible or cannot be sustained for a meaningful amount of time (this is censorship resistance or equity in access); providers are remunerated only for services that add value to the network, and cannot exploit their position to manipulate the market and extract additional value from users (equity in distribution).
• Cost-efficiency: transactions are orders of magnitude cheaper than in the traditional payment system; cost fluctuations are low and they only reflect the externalities imposed on the network, i.e. costs rise when the network is more congested.

We are going to call this triad of properties the blockchain SEC, not to be confused with the U.S. Securities and Exchange Commission! Note that this is related but different from the blockchain trilemma (simultaneously achieving security, decentralization, and scalability). The trilemma is about technical properties of a blockchain system, while SEC is about properties of the economy built on top of blockchains. SEC is more restrictive than the trilemma, for example: if a blockchain is very decentralized it is costly to censor transactions, but if the cost of censorship is too low it will still happen; if a blockchain is scalable then transaction costs should be low, but if a group of service providers can collude to limit blockspace and artificially inflate gas prices, then the system will not be cost-efficient.

Our goal is to build a system that can robustly maintain these properties. Blockchain technology allows us to encode rules, rewards, and punishments for users and service providers into a public immutable protocol. It turns SEC into economic properties that we can achieve and maintain via sound economic design. There is one additional property that is required for the success and mass adoption of the internet of value: utility. Also in this case, sound economic design is central for core applications like crypto assets, stablecoins, and financial protocols.

How do we make progress?

Divide and conquer

Here is an overview of the most important subfields of blockchain economics. We can divide the economic constructs that make permissionless blockchain stack possible into three groups: (1) mechanisms for resource allocation and value (re-)distribution; (2) aggregate outcomes and market structure; (3) economic apps such as stablecoins and lending for user experience. Different areas require different expertise, from economics to engineering design to data analysis. We break them down in the sections below.

Research and collaborate

We have only explored a small area of blockchain economics compared to what is possible. It is important that research and development progress hand in hand because economic mechanisms require careful design and their complexity is only going to increase over time.

On the research side, there are two areas of work:

• Fundamental research: mapping the design space of crypto-economic mechanisms, proving fundamental properties or impossibility of new relevant classes of mechanism, defining fundamental concepts and drawing connections between them.
• Applied research/R&D: defining a new mechanism that solve a practical and important problem; studying an existing mechanism to identify good properties, bad properties, and potential improvements; designing feasible implementations that take into account practical constraints; simulating and testing mechanisms for robustness; analyzing data from mechanism in testing and production environments to verify correct behavior.

Personally, I am going to focus primarily around the second area and collaborate with academic researchers to further the first, especially where the fundamental research is of practical relevance and can unlock practical innovation. In R&D, most relevant problems are motivated by priority of roadmap items and challenges faced by real-world systems like Ethereum. It is therefore important to understand development process, work on timely solutions, and be nimble as priorities may shift.

I am very excited because open research, open data, and the permissionless nature of Ethereum allow for unprecedented levels of collaboration between applied researchers and academics working on fundamental problems, core R&D and teams building apps/infrastructure in the ecosystem, community researchers providing data analyses and other explorations.

Focus on real problems

Many real blockchain economics problems have recently emerged. Especially in Ethereum, where a developed decentralized finance system and the rise of L2s poses new economic challenges such as MEV or resource pricing. We provide a sample list of fundamental problems that are currently being worked on, together with some links to get started. In follow up posts we will provide a more in depth guide and get closer to the state of the art for each of these areas.

(1) Mechanisms for resource allocation and value (re-)distribution

• Protocol emissions, burn, and other provider incentives — validator rewards design document;
• Congestion pricing for L1 — EIP-1559 original idea, economic analysis and ethereum implementation;
• Blockspace auctions — seminal paper and ethereum implementation by flashbots;
• Multi-resource pricing for L2 and other L1-L2 interactions — multi-resource pricing idea and rollup economics framework;
• Sources of MEV and other L1-Apps interactions — cross-domain MEV definition.

(2) Aggregate outcomes and market structure

• Cryptocurrency monetary policy for sustainability and security — original PoSt on ethereum issuance and circulating supply equilibrium model;
• Industry structure and dynamics for economic decentralization — builder market data, MEV-induced market structure and MEV resiliency;
• Robustness to attacks and censoring — PoS attacks summary paper and cost of censorship idea.

(3) Economic apps such as stablecoins and lending for user experience

• Decentralized stablecoins — RAI interest rate controller implementation, LUSD borrowing mechanism implementation and stablecoin theory framework;
• Secure and efficient lending and exchanges — AAVE safety module implementation and Uniswap v3 article;
• Liquid staking derivatives — staking pools introduction and security risks and staking derivatives paper.

How you can contribute

The beauty of a permissionless and open system like Ethereum is that it widely enables contributions. Virtually anyone who is excited about solving these problems can access theory/data and contribute according to their expertise. Wide contributions are not only possible, they are necessary to make sure we build a robust and inclusive economy, an open infinite garden that fixes the exploits and distortions of closed private gardens — such as most traditional platforms.

There is no right or wrong way of adding your contribution. But here are some suggestions and examples of things that seem to work well.

A recipe for new contributors

• Pick an area where you have some expertise or can get up to speed easily given your background;
• Learn about the current state of the technology/research. What are the most important problems that still need to be solved? For fundamental research the focus is on increasing understanding, while for applied research is to generate practical impact and foster development. If you are just getting started, here are a few resources/ideas: (1) explore the ethereum research blog, (2) attend/volunteer at one of the topical research conferences (e.g., SBC, CCE, FC-DeFi), (3) follow researchers on social media where they often share new work updates and summaries;
• Start small, share your work, and iterate. Especially when you are a beginner on a topic, it makes sense to start from a problem size where you can make concrete progress quickly. Pick a type of contribution that suits you and share your results early to collect feedback and learn about which directions are more important to dive deeper.

Types of work

Here is a review and some examples of types of work that are useful for R&D as well as fundamental research. It is exciting how the Ethereum’s open code-data-research ecosystem allows for different types of contributions that are traditionally siloed in proprietary company IP or academic publishing pipelines.

• Data analysis. This type of work can be very useful before there is a major change to the system to help with its design, after a change to evaluate actual behavior, or to learn system parameter configurations and their effects. See the merge data challenge results, Barnabe’s gas analysis, or Vitalik’s elasticity estimation.
• Simulation. Simulations are a key step in the development of new economic mechanisms and for deciding parameter updates. While testnets and other test types ensure correct implementation, simulations help gauge and evaluate aggregate economic effects. They can be used to show that the mechanism will work as intended under “normal conditions” or stress test the mechanism with extreme scenarios. See EIP-1559 simulations.
• Research idea. Sharing an idea early to clarify a problem or propose a partial solution has proven to be very useful. Especially when working on larger problems or mechanisms that require a few sub-components, sharing early helps gather feedback the broader community and orient progress towards a full solution. See Vitalik’s post on multidimensional EIP-1559.
• Paper. This is the traditional and preferred type for fundamental research. The longer form allows to extensively describe the work and contextualize it within the literature. Since blockchain economics is a green field, contributions such as definitions, frameworks, or analysis of a new mechanism are often very useful. See DeFi SoK paper.
• Peer Review. Peer reviewing an article and publishing it as a blog post or in other forum (e.g., the smart contract research forum) can be very useful. Especially since the velocity of research is so high that influential work is often published online and popularized without a thorough review (e.g., the Terra stability paper).

Guidance and support

The Ethereum Foundation has several programs to support research and provide guidance to problems that are most important in practice. The main ones are:

• Yearly academic grants round
• Topical grants round for different types of ecosystem projects and research, for example Layer 2 Community Grants 2022
• Recurring Ethereum Protocol Fellowship (EPF)

The links above contain information on how to get support as well as wishlists and ideas on the research topics and types of work that are most needed. You can also use the Ecosystem Support Program page to monitor topical grants (like the Layer 2 above) and apply to ad hoc grants and RFPs. The Ethereum Foundation also maintains a list of grants offered by other organizations in the ecosystem. Last but not least, our Robust Incentives Group at Ethereum Foundation maintains an up-to-date list of open problems in Ethereum Economics.

You can also reach out to relevant research groups or individual researchers for further guidance or discussion on an area that you are already working or planning to work on. Different groups have open channels of communication with the broader research community. Ethereum researchers are generally active on the Eth R&D Discord server and on twitter and you can always find us at one of the main research conferences.