Network Analysis Series Part 2: Examining Avalanche

Authors: Lukas Bruell, Chris Smalley, River Fields

In the second instalment of our four-part series, we analyze the Avalanche network, focusing on its network design and implementation of token supply and validator incentives. Part one, which analyzed Ethereum, can be found here.

If you are already familiar with the Avalanche’s background, feel free to skip through to your desired topic.

An Overview of the Avalanche Network

Avalanche is a Proof-of-Stake-based heterogeneous blockchain network that provides a more scalable and customizable infrastructure, catering to a wide array of applications. Its unique architecture, consisting of multiple different subnet chains, allows for greater flexibility and improved performance and security in comparison to homogeneous networks where all applications exist on a single chain.

It is a general-purpose layer-1 blockchain aimed at improving network efficiency by increasing throughput and reducing latency in addition to providing a more cost-effective alternative relative to other prominent layer-1 blockchain networks.

The Avalanche network is centered around the Primary Network (an Avalanche Subnet), which validates Avalanche’s built-in blockchains including all custom Subnets of the ecosystem. A node can become a validator for the Primary Network by staking a minimum of 2,000 AVAX tokens.

As part of the Primary Network, validators must validate transactions and provide network security to the following three main Avalanche blockchains:

1. Exchange Chain (X-Chain): The X-Chain handles operations involving digital smart assets known as Avalanche Native Tokens. These smart assets are digital representations of real-world resources governed by specific rules, such as trading restrictions during designated hours.
2. Platform Chain (P-Chain): The P-Chain coordinates validators and creates Subnets within the Avalanche ecosystem. Its API allows for the creation of new blockchains and Subnets, the addition of validators to Subnets, staking operations, and other essential platform-level functions.
3. Contract Chain (C-Chain): The C-Chain is built on the Ethereum Virtual Machine and supports the execution of smart contracts through its API. The EVM compatibility enables developers to create and execute smart contracts in Solidity seamlessly.

Source: Avalanche Docs

Thus, all Avalanche validators must run a minimum of three virtual machines: Avalanche VM for the X-Chain, Platform VM for the P-Chain, and Coreth for the C-Chain. Validators can install additional virtual machines to provide network security to other subnets on the network.

Avalanche’s heterogeneous network of specialized blockchains offers a scalable and adaptable infrastructure, with each chain serving distinct purposes. This innovative design aims to achieve better performance and security while supporting various applications and use cases.

Avalanches’ native token AVAX is the twentieth largest cryptocurrency with a market cap of approximately $3.2 Billion at the time of writing this article. AVAX is primarily used to cover transaction fees on the network, to facilitate network security through staking, and to serve as a unit of account across Avalanche Subnets.

AVAX has a hard-capped supply of 720M tokens and serves as the lifeblood of the Avalanche ecosystem. Indeed, AVAX is used to secure the network through incentivizing validator participation with token rewards and is required for the execution of all transactions on Avalanche blockchains. AVAX is also used for governance, measuring a given validator’s voting rights based on how much they have staked on the network. Finally, all gas fees paid to execute transactions are burned, removing those AVAX tokens from the circulating supply and contributing to the long-term sustainability of the network by ensuring AVAX remains a scarce asset.

The following two charts indicate key metrics regarding the Avalanche network and the greater ecosystem from Q2 2022 to Q2 2023.

Source: Messari

Source: Messari

Avalanche Economics

Network Supply — validators

The Primary Network in Avalanche is responsible for validating the built-in blockchains: Platform Chain, Exchange Chain, and Contracts Chain. To become a validator, users must stake 2,000 AVAX, worth $19,740 at the time of this writing, for a minimum of two weeks.

In addition to validating the Primary Network, validators in Avalanche can choose to validate custom Subnets. Subnets are a dynamic group of validators working together to achieve consensus on the state of multiple blockchains. Each Avalanche blockchain is validated by one Subnet, and a single Subnet can validate multiple Avalanche blockchains. This feature has significant implications for compliance and private blockchains, as it allows specific Subnets to enforce validator requirements, such as location, KYC, licensing, and more. Moreover, different blockchain-based applications may necessitate validators with specific properties, such as substantial RAM or CPU power, or meeting certain hardware requirements, to prevent performance degradation due to slow validators. Although validating custom Subnets does not increase a validator’s rewards from the Primary Network, validators can receive incentives and custom tokens for helping to validate a particular Subnet.

Unlike Ethereum, Avalanche does not penalize validators by slashing their staked tokens for negligent or malicious behavior. This absence of slashing lowers the barrier for potential bad actors; however, validators are unlikely to attempt to do harm to the network because they would expend their node’s computing power for no reward. Avalanche’s approach to not slashing validators for negligent behavior relies on token toxicity, or rather if the protocol gets successfully attacked then the token will subsequently lose value so it is in the best interest of validators to not misbehave.

AVAX Token Issuance

AVAX token issuance refers to the creation of new AVAX tokens that previously did not exist in the Avalanche ecosystem. At Avalanche’s token launch date on September 21, 2020, the max supply of the token was capped at 720 million with half of the supply reserved for staking rewards. Further, Avalanche devised a supply schedule to reward stakeholders of the community, incentivize engagement, and push the adoption of Subnets.

Validators who remain online and responsive for more than 80% of their validation period are rewarded with newly minted AVAX at the end of their staking period. Validators can also set their delegation fee, with a minimum of 2%, which allows delegators to share in the validator’s rewards without having to run a validator node themselves.

At its inception, 360 million AVAX were minted and distributed among Avalanche community stakeholders. An additional 360 million AVAX were reserved to reward validators, with new tokens continuously minted over an extended period. The minting process depends on the amount and duration of validator stakes. For instance, if the entire AVAX supply were staked for one year (maximum duration) instead of two weeks (minimum duration), the protocol would mint 11.11% more tokens annually — for reference, only 59% of the total AVAX supply is currently staked. To counterbalance the inflationary pressure from validator rewards, Avalanche burns both the base fee and priority fee. Similar to Bitcoin, reward rates will decrease over time as the capped supply of 720 million AVAX is approached. However, since Avalanche is governed, the supply cap and validator rewards could be modified in the future. A diagram of Avalanche’s AVAX circulation and supply cap, as envisioned by its developers, can be found below.

Source: Avalanche Native Token Dynamics

Avalanche currently relies on its minting schedule to reward validators and secure the network. The maximum supply of 720 million AVAX could be nearly reached in 20 years if more validators and delegators stake their AVAX to earn competitive yields. Presently, the protocol is minting almost 40 times as many tokens as it is burning, indicating a long-term imbalance. For example, over the past year, the protocol burned $10.0 million worth of tokens while issuing $317 million in AVAX tokens, as illustrated below.

Source: Token Terminal

Furthermore, we can see from the past year that Avalanche had about 38,229 daily active users with each user spending roughly $0.84 in transaction fees. Extrapolating on this, Avalanche would need to increase its daily active users from 38,229 to 1,270,170, or 33.2x increase, to reach equilibrium between transaction fee burning and validator incentives. Of course, this simple analysis assumes that transaction fees per user would remain constant as more users join the network; however, transaction fees per user would increase because of congestion and priority fees (priority fees are burned on Avalanche) just as we have seen on Ethereum. Additionally, users would be likely to perform more complex transactions as Avalanche becomes their main network for web3 commerce. Also, AVAX’s supply issuance rate will decrease in the future as seen below. These factors would mean that Avalanche wouldn’t actually need 1,270,170 daily active users to reach equilibrium, much less likely, but presently Avalanche experiences sustainability challenges.

The supply of AVAX is expected to be fully vested by July 2030. The current vesting schedule is illustrated below.

Source: Token Unlocks

Today, Avalanche has unlocked approximately 390 million AVAX with another 330 million AVAX to be unlocked. At the current AVAX price of ~$10 per AVAX, this represents $3.3 billion of vesting and staking rewards to be unlocked — roughly 70% of the $3.3 billion is reserved for future staking rewards.

Network Demand

Fees (Base + Max fees)

Similar to Ethereum, Avalanche measures the computation used by a transaction in units of gas. Each unit of gas is paid for in AVAX at the transaction’s gas price. The gas price for a transaction is determined by the type of transaction and the base fee of the block in which it is included. Total fees paid by a user can be calculated using the formula gas consumed * gas price, which is referred to as gas fees. Likewise, maximum gas fees can be calculated as gas limit * gas price.

For non-atomic transactions, transaction fees are determined using a model similar to Ethereum’s EIP-1559 Dynamic Fee Transactions, which consist of a gas fee cap and a gas tip cap. The gas fee cap sets the maximum price a user is willing to pay per unit of gas, while the gas tip cap, or priority fee, indicates the maximum amount above the base fee a user is willing to pay per unit of gas. As in Ethereum, the tip is used to prioritize a user’s transaction for inclusion in the next block. The base fee mechanics in Avalanche are akin to Ethereum’s, with network utilization measured over the past 10 seconds. Base fees can range from as low as 25 nAVAX (Gwei) with no upper limit. The below diagram shows how users can set their gas fee cap and gas tip cap and which transactions will be included.

Source: AVAX Network

For atomic transactions, which involve imports and exports between chains, dynamic fees are charged based on the gas used by the transaction and the base fee of the block containing the atomic transaction.

In contrast to Ethereum’s EIP-1559 proposal, which only burns the base fee and leaves the priority fee as a tip for the validator, Avalanche burns both the base fee and the priority fee, benefiting the entire ecosystem. This is a unique aspect of the protocol, especially when compared to other protocols such as Bitcoin, which pays transaction fees to the elected leader. Additionally, AVAX is burned for other operations, including asset creation, blockchain creation, and Subnet creation.

For block issuance, Avalanche employs asynchronous issuance, which means that block times are not strictly consistent. Although the protocol aims for a block every two seconds, the actual frequency depends on the volume of transactions. If there are sufficient transactions to cover the cost of producing a block earlier, another block can be generated.

Key Economic Takeaway — Slashing Design

The Avalanche network distinguishes itself from many other Layer 1 protocols by not implementing slashing for validators. This feature can be appealing as it prevents validators from being penalized for honest mistakes, such as running outdated software. Additionally, the absence of slashing may encourage more users to operate validator nodes, thereby increasing the decentralization of the validator network. As mentioned earlier, Avalanche relies on token toxicity, which represents the potential loss of value in the underlying token if the protocol is successfully attacked. While this concept seems reasonable in deterring validators from attacking the network, relying solely on token toxicity may not be sufficient to secure the network against future attacks.

For instance, consider a scenario where an adversary convinces 34% of stakers on the Avalanche network to collude. Under the Snowman consensus protocol (more details on Snowman here), a 34% attack isn’t guaranteed to succeed but has a higher probability of doing so. The mere chance of success is enough to entertain the possibility of an attack, especially given the absence of slashing. Now, suppose the adversary bribes other validator nodes to execute a strategy that benefits the adversary, such as a double-spend attack. The adversary could set up the bribe so that the payoff is greater than the reward from validating. The payoff matrix would look like the below for a validator node, assuming that an attack would cause the value of staked tokens to fall to zero.

In this situation, the dominant strategy for a node would be to accept the bribe from the adversary, as they would receive less if they rejected it, regardless of other nodes’ actions. Although this scenario may seem implausible, financially, it is in the best interest of the node. If the attack is successful and they don’t accept the bribe, they are left with nothing. If the attack fails, nodes can still increase their payout by accepting the bribe. The mere knowledge that other nodes might accept the bribe could encourage more nodes to do the same.

An adversary might be inclined to pursue this attack strategy if they believe that the potential profit exceeds the cost of bribing validator nodes to participate. The adversary would only need to offer bribes large enough to outweigh the rewards, effectively incentivizing nodes to accept them. However, when a protocol enforces slashing, the adversary and their allies lose their stake, causing the lower-left cell in the payoff matrix to switch to just the bribe amount. This change significantly raises the attack cost for an adversary and enhances the network’s resilience.

While Avalanche could eventually modify its validator penalties to include slashing, its current absence represents fragility in the validator framework and a potential vulnerability in the security of the network.

Key Economic Takeaway — Data Analysis

In addition to our validator research of Avalanche, we analyzed the correlation and regression analysis of fundamental metrics on the Avalanche network, using the same methodology as we used for Ethereum in Part I. We observe that Daily Active Users and Burned Tokens have the strongest correlation with Price, revealing a correlation coefficient (r) of 0.82 and 0.76, respectively. A comprehensive correlation matrix between Price and other fundamental metrics can be seen below.

The ordinary least squares regression analysis using AVAX Trading Volume, Burned Tokens, Daily Active Users, and Active Developers as independent variables yields an r-squared value of 0.908, as shown below.

These results indicate a strong explanatory power of the independent variables on Price, confirming similar patterns that we identified in the Ethereum network. For instance, burned tokens measured in USD demonstrate a positive relationship with price.

The first two instalments of this series have analysed the Ethereum network, Avalanche and its respective economics. In Parts III and IV we will examine the NEAR and Solana networks, respectively.