Network Analysis Series Part 1: Examining the Ethereum Network — Introduction
Authors: Lukas Bruell, Chris Smalley, River Fields
This article is the first installment of a four-part series, where we will analyze the Ethereum network, focusing on its design, implementation of gas and token supply, validator incentives, and key economic takeaways. In parts two, three, and four we will similarly evaluate the Avalanche, NEAR, and Solana networks, respectively.
If you are already familiar with the basics of Ethereum’s background, feel free to skip through to the Economic analysis.
An Overview of the Ethereum Network
On July 30th, 2015, Ethereum was launched as a decentralized, open-sourced blockchain network for the deployment of decentralized applications (dApps) through the efforts of its co-founders Vitalik Buterin, Gavin Wood, and Joseph Lubin, among others. With its flexible smart contract capabilities, the platform provides developers with the opportunity to create innovative applications on the Ethereum blockchain.
The emergence of Bitcoin gave rise to a new type of monetary system that was decentralized and operated through peer-to-peer transactions that were immutable and could be trusted without the need for intermediaries. Despite Bitcoin’s popularity as an alternative payment method, it did not provide a platform for developing decentralized applications with computational logic for wider usage. However, the introduction of Ethereum changed that by creating a blockchain designed specifically for computation. The Ethereum Virtual Machine (EVM) lies at the heart of the Ethereum network and is a software environment running on every node. It is responsible for executing smart contracts, maintaining consensus, gas management, and ensuring the overall security of the blockchain network.
Ethereum’s native token Ether (ETH) is the second largest cryptocurrency after Bitcoin with a market cap of approximately USD 221.6 Billion at the time of writing this article. ETH has many use cases within the Ethereum network including serving as a medium of exchange, a store of value, a unit of account, an incentivization for validators to execute transactions and secure the network, and as collateral within decentralized finance (DeFi) markets. The utility of ETH is multifaceted, and it is essential to both the functioning and development of the Ethereum network and the broader Ethereum ecosystem.
As a general-purpose Layer 1 blockchain, Ethereum implements a Proof-of-Stake (PoS) consensus mechanism where validators create new blocks and collaboratively work together to validate the information contained within them. On September 15th, 2022, The Merge was completed, marking a monumental shift in the Ethereum network. The consensus algorithm transitioned from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) model, which brought significant benefits to Ethereum, including reducing the costs of securing the network by approximately 90% and providing a substantially more environmentally-friendly approach to network consensus, consuming about 99.95% less energy. Validators stake Ether (32 ETH) to participate in validating transactions and proposing new blocks. The staked ETH serves as an incentive for validators to behave honestly and effectively as their ETH can be slashed for misconduct or unreliableness (not being available when called upon by the network). The time interval for blocks being proposed and added to the network is fixed: slots (12-second periods) and epochs (groups of 32 slots and thus lasting 6.4 minutes). A validator is chosen randomly in every slot to be a block proposer — create a new block and share it amongst other validators within the network. Similarly, during every slot, a committee of validators is randomly selected to attest to the proposed block and verify it before adding it to the blockchain.
The Ethereum network has experienced extensive growth since its launch in 2015, which can be attributed to several key factors, with Etheureum’s first-mover advantage and user-friendly developer experience based on Solidity serving as some of the most important. Solidity’s syntax is similar to other high-level coding languages such as C++ and JavaScript, thus providing developers with a familiar development environment while providing a range of resources including debugging tools, integration with development tools such as Truffle and OpenZeppelin, and community support which help make it easy for developers to write complex smart contracts and build decentralized applications. The graphs below indicate the user and transaction count growth on the Ethereum network from inception to April 24th, 2023.
Source: Dune Analytics
Source: Dune Analytics
Ethereum has a robust and very active community of developers (approximately 197 active core developers contributing to roughly 1,460 code commits over the last 30 days) and users (about 368,000 average DAUs) who continually look for opportunities to improve the protocol and build new applications. The community has also been instrumental in driving greater adoption of Ethereum, with many developers and users contributing to the growth of the network through open-source development, education, and advocacy.
Ethereum Economics
Network Supply — validators
Validators on Ethereum fulfil two primary roles 1) checking new blocks and “attesting” to them if they are valid, and 2) proposing new blocks when selected pseudo-randomly from the total validator pool. If a validator fails to do either of these tasks when they are chosen then they miss out on Ether rewards. Additionally, validators can be tasked with signature aggregation and participating in sync committees.
The Ethereum validator rewards are designed to promote correct action in a timely manner to ensure the security of the network. Validators receive rewards when they cast votes that are consistent with the majority of other validators when they propose blocks, and when they participate in sync committees. Their rewards consist indirectly of the base fee, which is burned and thus increases the value of their ETH stake, everything else being equal, tip fees, and token issuance.
ETH Token Issuance
New ETH token issuance, refers to the creation of new ETH tokens that previously did not exist within the Ethereum ecosystem, with new tokens distributed to validators who secure the Ethereum network. Token issuance is analogous to the block subsidy miners received when Ethereum was based on PoW. However, under PoS, the number of new tokens issued will depend on the number of ETH tokens staked in the ecosystem, and the overall issuance rate will be higher as more ETH is staked. As more tokens get staked, validator yield issuance decreases over time, resulting in a reduction in an individual’s overall return. The table below shows how validator interest decreases as total ETH staked increases.
Source: The Tokenomics of Ethereum
Validators can also get penalized for missing votes or be more severely punished for dishonest behaviour. The penalty for missing a target or source vote is equivalent to the amount that a validator would have received if they had properly executed the target or source vote. Note, that this is a minor infringement and is penalized accordingly. However, “slashing” is a more severe action that results in the forceful removal of a validator from a network and results in the loss of their staked Ether. A validator can be slashed in three different ways:
- Proposing and signing two different blocks for the same slot
- Attesting to a block that “surrounds” another one (effectively changing history)
- Double voting by attesting to two candidates for the same block
If a validator is slashed then 1/32 of their staked ether is immediately burned and then their 36-day removal period begins. The maximum amount that a validator can be slashed is their full effective balance, although it is more likely that it would be a single, isolated slashing in which case only a small portion of the validator’s stake is burned.
The reward, penalty, and slashing design was created to encourage individual validators to behave correctly. Since the Merge and Ethereum’s switch to Proof-of-Stake, only 248 validators have been slashed out of approximately 695K validators, or roughly 0.04% of validators. This negligible amount shows that validators are much more inclined to behave in the best interest of the protocol and promote the security of Ethereum.
Network Demand
Gas
Users pay in Ether for blockspace. The Ethereum network uses “gas” to measure the cost of transactions with gwei (a denomination of Ether) used to measure the cost of the gas. One gwei is 0.000000001 Ether, or one billionth of an Ether. Gas itself has a market rate and it is not equivalent to Ether. Gas can be thought of as the amount of power needed to process certain transactions on the Ethereum network such as executing smart contracts. To incentivize node operators around the world to spend time and electricity validating transactions, users must spend a bit of gas or Ether to get the transaction processed. Below is a chart that outlines the breakdown of Ethereum’s gas cost by typical operations.
Source: Ethereum Yellow Paper
Source: Dune Analytics
Each operation is recorded and its gas price is calculated when the contract is executed. Today, a standard ETH transfer requires a gas limit of 21,000 units of gas. The current number of gwei per unit of gas can be found online, including Etherscan. For example, assuming 50 gwei per gas unit and $1,800 per ETH, a standard transaction of 21,000 units of gas would cost 0.00105 ETH or $1.89.
Base Fee and Burning
Following the London upgrade which introduced burning to the Ethereum protocol (EIP 1559), the base fee in each transaction would be “burned” or removed from circulation. The base fee is calculated by a formula that compares the size of the previous block with the target block size. The size of the block is determined by the amount of gas used for all transactions with the target block size being 15 million gas and the block size limit being 30 million gas. As network activity increases on the protocol, the block size will increase. If the block size is greater than the target block size, then the protocol will increase the base fee for the following block, resulting in more ETH being burned. Therefore, as network activity increases on the Ethereum network, the base fee per transaction will increase, resulting in more ETH being burned. Importantly, the base fee calculation and burning mechanism help make transaction fees more predictable for users and increase the feasibility of using the protocol. The base fee will increase by a maximum of 12.5% per block if the target block size is exceeded. For that reason, it is economically non-viable for the block size to remain high indefinitely even with network activity on Ethereum increasing.
Also, it is important to understand that the block size having a limit plays a subtle but key role in the Ethereum protocol. The total amount of gas expended by all transactions in the block must be less than the block gas limit (30 million gas) which prevents the blocks from being arbitrarily large. If blocks could be arbitrarily large, then less performant full nodes would gradually stop being able to keep up with the network due to space and speed requirements. The larger the block, the greater the computing power required to process them in time for the next slot. This is a centralizing force, which is resisted by capping block sizes.
Priority Fee
On top of the base fee, users can also pay a priority fee or a “tip” to incentivize validators to process their transactions faster. Hence, the total fee for a transaction consists of units of gas used * (base fee + priority fee). Adding onto the above gas example, a user could include a tip of five gwei which would increase the cost of their transaction to 0.001155 ETH, or $2.08.
Notably, the priority fee will increase economic incentives for validators to secure the network as it is an additional reward on top of the base validator reward (more on validator rewards discussed below). For example, the average total priority fee per day is currently about $700,000 or roughly $256 million per year. For context, if this priority fee was split evenly among all 18.5 million ETH staked then that would equate to an annual tip of $14 per ETH staked. In reality, some validators are receiving a larger percentage of the tips because of optimization for Maximal Extractable Value (MEV). This additional reward for validators is an important component of the longevity of the network as it compensates validators without issuing new tokens. Note however that the tipping rewards will fluctuate depending on transaction volume and congestion on the network.
Lastly, gas is a vital function that helps guarantee the security of the network by providing economic barriers for bad actors. The ability for malicious actors to spam the network or abuse it is largely diminished because every transaction on the network has a real economic cost of execution.
Next, we will look into the Economics Analysis of the Ethereum Network. Click here to get to the next part.
