Network Analysis Series Part 1: Examining the Ethereum Network — Key Economic Takeaway
Monetary Supply — Burning, DeFi, Staking
Authors: Lukas Bruell, Chris Smalley, River Fields
One interesting aspect of Ethereum often discussed is its potential to maintain a monetary premium due to its evolving monetary properties. A closer examination of the impact of EIP-1559, DeFi activity, Shapella upgrade, L2 developments, and MEV burn reveals improvements in these monetary properties, thereby enhancing its value as a form of digital money. Key factors such as scarcity and liquidity have seen significant improvements and are likely to continue on this trajectory, further solidifying Ethereum’s role as a key asset.
As previously mentioned, EIP-1559 introduced a burning mechanism, resulting in Ethereum becoming net deflationary, thus increasing scarcity. Since the implementation of EIP-1559 on August 5, 2021, the Ethereum network has burned approximately 3.3 million ETH in base fees. Moreover, following the Merge on September 15, 2022, the network has burned around 551,000 ETH, resulting in a net deflationary effect of -145,000 ETH, as demonstrated in the diagram below.
Source: Ultrasound.money
The 145,000 ETH burned since the Merge corresponds to an annual decrease in the total ETH supply of -0.19%. This net deflationary characteristic makes Ethereum particularly appealing, especially when compared to other Layer 1 solutions expected to remain inflationary for the foreseeable future.
In addition to burning and reducing the total tokens outstanding, ETH’s float (freely traded tokens) is further restricted when locked up inside DeFi smart contracts, either as collateral or for providing liquidity. At present, over 15 million ETH, or approximately 12.5% of the total circulating ETH supply, is locked in DeFi. However, it is worth noting that this figure has decreased from its all-time high of 30 million ETH locked away in 2022, as depicted below.
Source: DefiLlama
The 12.5% of ETH locked in DeFi smart contracts effectively reduces Ethereum’s overall velocity, which in turn elevates the price and liquidity of Ethereum. This principle stems from the quantity theory of money and monetary policy, where (Money in Circulation) * (Velocity of Money) = (Price Level of Goods) * (Quantity of Goods Sold). Based on this equation, it becomes evident that by lowering the velocity of ETH through smart contract lock-ins, the market cap of ETH will increase, with all other factors remaining constant. Note, the quantity theory of money originated in Western economic thought in the 16–17th centuries and was popularized by Milton Friedman’s book A Monetary History of the United States. Critics of the theory argue that money velocity is not stable and that prices are sticky in the short run, so the relationship between money supply and price level does not hold. However, irrespective of whether that theory shall be discounted, it remains valid that DeFi adds more utility to Ethereum and improves ETH’s function as premium collateral.
Furthermore, staking has become a significant factor limiting the circulation of ETH since The Merge, when Ethereum transitioned from Proof of Work (PoW) to Proof of Stake (PoS). As a result, around 21.3 million ETH, or approximately 17.8% of the total ETH supply, is currently deposited for staking. Following the Shapella upgrade (also known as “Shanghai” for Ethereum execution clients) on April 12, 2023, ETH withdrawals from staking contracts were enabled, now leading to a net inflow of 2.1 million ETH or about 9.9% of the total ETH staked.
It is essential to consider that as the total network stake grows, the overall issuance also rises, as previously mentioned. This effect would make Ethereum somewhat more inflationary than at present, but the decreased velocity could drive up ETH’s price. For example, if the amount of staked ETH were to double to 42 million, with 15 million locked in DeFi contracts, this would leave approximately 63.3 million ETH for account holders, or about 53% of the total supply. This decreased velocity would further enhance ETH’s monetary premium.
Layer 2s, Modularity, and MEV Burn
The increasing adoption and expansion of Ethereum’s L2s are progressively driving demand for Ethereum blockspace, subsequently fueling both the price and liquidity of Ether. As of now, $8.9 billion USD is locked into Ethereum L2s as seen below.
Source: l2beat
Contrary to the perception that L2s might detract from Ethereum’s expansion by diverting users, they are, in fact, contributing to and strengthening Ethereum’s network effect and enhancing Ethereum’s revenue generation. This is mainly due to L2s utilizing ETH to pay for blockspace. Consequently, all fees accrued on L2 networks translate into demand for Ethereum’s base layer. The integration of L2s is likely to attract more first-time users to the Ethereum ecosystem.
New users are more prone to explore blockchain technology that is name-recognized and features affordable gas fees. Take Whiteboard Crypto, for instance, a top-tier web3 educational platform with a YouTube subscriber base of 860,000. A significant portion of its content recommends and guides users on how to bridge assets to Ethereum L2s and begin using those applications. These videos cater to newcomers who, while willing to experiment with an initial $100, are reluctant to spend $5 — $10 on gas fees for a single base layer transaction. Such new users can instigate a positive feedback loop for L2s by attracting more developers to create applications on the L2s, which, in turn, can result in lower gas fees for L2 users. ZK rollups, for example, have a single initial computational gas cost. As a result, the more transactions each batch includes, the more dispersed and reduced the fee becomes on a per-transaction basis, as illustrated below.
Source: Celestia Forum
From an economic perspective, the business model for L2s has been proven effective, particularly for industry leaders such as Arbitrum, which posted a profit of $2.5M in March 2023, as seen below.
Source: Messari
Two main revenue streams drive cash flows for L2s. Firstly, sequencer profits represent the difference between transaction fees paid by users and the cost of acquiring L1 blockspace. As L2 networks are volume-dependent, this margin might be small for individual users but can accumulate to substantial amounts as the network expands and processes an increasing number of transactions. Secondly, sequencers can generate maximal extractable value (MEV) by reordering user transaction requests. While the current Arbitrum sequencer does not capture MEV, the DAO may potentially monetize MEV by auctioning off rights to block production once decentralized sequencing is operational.
Furthermore, with the implementation of EIP-4844, which aims to cut the cost of calldata on the base layer by a factor of 5x, the profit margin of L2s like Arbitrum is expected to grow substantially. This structural modification will significantly enhance the economic feasibility of L2s on the Ethereum chain, thereby further accelerating the adoption of the Ethereum network.
Apart from L2 scaling solutions, there are several other modular data availability mechanisms that aim to reduce the data storage costs associated with Ethereum transactions. One such solution is Validiums, which post transaction data off-chain, typically a centralized database while posting proofs to Ethereum.
Data availability platforms like Celestia are unique in that they are designed to solely manage data without handling computations. Celestia’s pricing model is centred around bytes instead of computation and storage, given its primary role in organizing and ensuring the availability of transaction data. Consequently, this design allows Celestia to achieve a higher data throughput than Ethereum.
A comparison chart from Celestia effectively illustrates the trade-offs between Security/Decentralization and Gas per Byte for various solutions, including Validiums, Data Availability Committees, Celestiums, and Rollups.
Source: Celestia
By integrating Celestia to handle data availability, Ethereum is effectively outsourcing functions where it does not have a competitive advantage. Ethereum can instead focus on its core competencies to become the global settlement layer. Disaggregating core elements of a single blockchain system — namely execution, settlement, consensus, and data availability — will permit unique expertise in specific areas, thereby enabling substantial optimizations. Echoing the outsourcing paradigm that revolutionized business economics in the 1990s, we anticipate that modular outsourcing will enhance the efficiencies of blockchain networks. In the long term, the highest value will gravitate toward those that become ingrained as one of the core functions.
Moreover, Ethereum is reinforcing its role as a foundational consensus layer by integrating the “MEV Burn” mechanism into its long-term roadmap. This feature introduces an auction system for the right to build a block, with the intent of redistributing MEV back to ETH holders by burning the MEV. Once an auction winner is determined, their proposed execution block will be required to demonstrably burn an amount of ETH equivalent to their bid. This design aims to ensure that the highest bid aligns with the MEV within the block, leading to a substantial proportion of the MEV being directly burned. Currently, MEV rewards are uneven due to priority fees and network congestion. However, the new structure is designed to distribute MEV more evenly, ensuring validator rewards align more closely with the protocol’s guaranteed issuance.
In terms of game theory, potential collusion among proposers to maintain 0 ETH bids and partition the MEV amongst themselves would be unproductive. A single dissenting party could disrupt the collusion by submitting a 1 gwei bid and keep the MEV for themselves. Subsequently, another bidder could bid 2 gwei and keep the MEV, and so forth. The potential existence of unidentified dissenters should ensure that winning bids correspond closely to the total MEV in a block.
Interestingly, incorporating MEV burn could cause validators to leave the network, especially if they were participating in validation primarily to seek outsized abnormal MEV returns. This in turn would decrease total issuance on the network but at the same time would increase yield for individual validators as there are now fewer validators to reward in total. Furthermore, individual yields would increase further, in terms of USD, if the increased deflationary pressure from the burn drives up ETH’s price.
Ultimately, the act of burning MEV will enhance the premium of ETH. Every value-extracting opportunity would necessitate burning an equivalent ETH value. For instance, if a trader aims to take advantage of a 100 DAI arbitrage opportunity, they would need to bid and therefore burn up to an equivalent value of ETH to win the arbitrage opportunity — in a competitive environment, arbitrageurs will need to compete against each other to ensure their trade is first and will thus have to burn more ETH to win the trade (up to the value of the opportunity). Currently, ETH is issuing around 690,000 ETH annually, with the introduction of MEV Burn projected to further cut this issuance by 400,000 to 500,000 ETH. Just as EIP-1559 cemented ETH as the required currency for gas on the Ethereum network, MEV burn solidifies ETH’s role as the currency for block building.
Token Burning
*Note, this section applies to all protocols with a token burn design and is applicable to NEAR, Avalanche, and Solana analyses in Parts II, III, and IV.
The integration of EIP-1559 has conferred numerous key economic advantages to the Ethereum network, thereby fortifying its competitive edge for the foreseeable future. Firstly, EIP-1559 introduced a reliable and credibly neutral mechanism, governed by code, through which transaction fees are burned via the base fee, concurrently enabling network congestion to be relieved through the priority fee. By mandating the burning of the base fee, payable in ETH, Ethereum ensures that ETH is perpetually required for transaction payments rather than potentially substituting it with a stablecoin. This fundamentally reinforces ETH’s utility value. Moreover, validators only receive the priority fee, eliminating any incentive to manipulate the base fee or inflate the block size towards its 30 million gas limit.
One of the most notable aspects of EIP-1559 is the incorporation of token burning into the Ethereum protocol. Since the implementation of EIP-1559, the protocol has burned 3.3 million ETH, equivalent to approximately $6 billion USD (considering ETH at $1,800). The law of supply and demand would suggest that the price of an asset should increase if the outstanding supply is reduced, everything else being equal. However, as traditional finance and academic research on share buybacks demonstrate, the outcome of a supply reduction is not always that straightforward. Token burning in the crypto world may not be comparable to share repurchases in traditional finance, but both reduce the number of shares or tokens in circulation.
Corporations undertake share buybacks for various reasons:
Perceived Undervaluation: If the management believes the company’s stock is undervalued, they may buy back shares as a form of self-investment.
Earnings Management: Reducing the number of shares outstanding can make a company appear more profitable on a per-share basis.
Optimal Capital Allocation: Management may consider share buybacks as the best use of capital, compared to other investment opportunities or dividend payouts.
Dilution Offset: Companies often counterbalance the dilution resulting from employee stock compensation through share buybacks.
Leverage Increase: Reducing outstanding shares increases financial leverage (total debt to equity ratio).
Control Consolidation: Share buybacks can help a company resist takeover attempts or enable major shareholders to consolidate their control.
Confidence Signaling: Share buybacks can signal management’s confidence in the company’s future prospects to the market.
However, share repurchases are not without their drawbacks. They can artificially inflate financial metrics, favour insiders over long-term value, and may indicate a lack of productive investment opportunities. Importantly, these varying perspectives mean that the impact on stock price isn’t always predictable. Generally, academic studies show that share prices do experience a modest increase. For instance, research by Hua Zhang reveals that the initial 3-day market response to actual repurchases averages around 0.43%. Conversely, other reports indicate that the market reacts negatively when companies spend excessive cash flow on share repurchases, or that repurchases can boost stock prices but lead to diminished long-term profitability, growth, and innovation.
The thorough research of traditional finance could serve as an educational tool despite the substantial differences between share repurchases and token supply reduction. As demonstrated, traditional companies can undertake share repurchases for a myriad of reasons. Generally, share buybacks tend to increase a company’s share price; however, numerous factors can influence whether a share buyback is received positively by the market and whether it will be beneficial for the company in the long run. Similarly, token burning may be beneficial for the network, although it is only one aspect of a complex equation. Just as traditional companies can signal strength to the market with a share buyback, they can also limit future growth by using excess cash for repurchases. Each company and each protocol must consider its unique set of factors to determine the optimal strategy for share or token management.
For instance, a company must evaluate its current financial standing, future investment opportunities, and market sentiment before initiating a share buyback. Similarly, a blockchain protocol may need to assess network usage, transaction fees, and its protocol treasury before implementing a burn mechanism.
Notably, one significant difference between share buybacks and token burning is that share buybacks are orchestrated and executed by a management team. This aspect inherently brings in psychological factors such as confidence signalling and perceived undervaluation which then get interpreted by investors and drives stock price reaction. In the world of crypto, this does not happen, as token burning is orchestrated by an algorithm. Protocols burn the tokens based on some metric like base transaction fees which removes the human decision-making element and makes it credibly neutral. Arguably, this is a more effective way to control token supply and the economics of a protocol. In the future, protocols could implement artificial intelligence to determine the appropriate rate of issuance reward or protocol burn; however, that is a debate for another time.
Data Analysis
The discussion above is further evaluated based on correlation and regression analysis of fundamental metrics on the Ethereum network, with a focus on Price as the dependent variable. We observe that as the Total Circulating Token Supply decreases, the Price tends to increase and vice versa, indicating an inverse correlation between these two variables with a correlation coefficient (r) of -0.7. A comprehensive correlation matrix between Price and other fundamental metrics can be seen below.
Moreover, an ordinary least squares regression analysis using the above fundamental metrics (excluding Circulating Market Cap and Total Transaction Fees) yields an r-squared value of 0.873, as shown below.
These results indicate a strong explanatory power of the independent variables on Price. An increase in burned ETH has a positive price impact on ETH. Likewise, token incentives distributed in ETH to validators positively impact price, while a decrease in token supply positively increases ETH’s price.
The first instalment of this series has analysed the Ethereum network and its economics. In Parts II, III, and IV we will examine the Avalanche, NEAR, and Solana networks, respectively.
