Ethereum 2.0 Economic Review

An Analysis of Ethereum’s Proof of Stake Incentive Model

By Tanner Hoban and Tom Borgers. Both authors work in Corporate Development at ConsenSys. This report was an independent research effort to review the network economics of Ethereum 2.0 spec v0.12.

  • Security of the network in Eth2 is dependent upon three key variables: ETH staked, the price of ETH, and volatility. Each of these variables has a direct or indirect impact on the cost of attacking the network. Total ETH staked is the most controllable variable, while the price of ETH has a direct and potentially large impact on network security but is outside the control of the system. Volatility can come from different sources and impacts both ETH stake and price of ETH indirectly.
  • Attacks on Eth2 are easier to scale than on Eth1. In Eth2, the physical and hardware-driven burdens of network participation recede to essentially minimal hardware and power consumption. Moreover, the flourishing of DeFi and eventual connectivity to Eth2 can vastly accelerate and magnify this trend.
  • Capital efficient validators are more predictable. While participation from Ethereum enthusiasts is important for a successful Beacon Chain launch, it is ultimately inadequate to reach sufficient levels of security. Attracting capital efficient validators will lead to higher fidelity in targeting a sufficient level of ETH staked.
  • Targeting 13.8% ETH staked will match security levels of Eth1 at historical prices. We calculate that the target ETH stake rate for adequate security under historical price fluctuations is 13.8%.
  • Economies of Scale for validating exist but are reduced at higher ETH prices. Unlike Proof of Work environments where profitability can only be accomplished by increasingly large-scale operations, Eth2 validating becomes progressively less expensive as the price of ETH increases. We generally find the network economics highly favorable for more decentralized network participation, meeting Eth2’s design objectives.
  • 77.7% of the current ETH supply is in validator ‘qualified’ wallets (holding over 32 ETH). Approximately 86.6mm ETH (77.7% of total supply) is being held by non-exchange wallets with over 32 ETH. An additional 18.7mm ETH is managed by exchanges subject to staking services. This is a compelling serviceable addressable market, and a key objective of the incentive program to maximize network participation should be to convert these wallets into active validators.
  • Eth2 is paying significantly less for security than Eth1. Using current beacon chain specs and 15.5mm ETH staked (13.8%), we estimate network inflation of 0.55% per year, far less than the current 4–4.5% from Ethereum’s Proof of Work network.
  • Network security is heavily reliant on the price stability of ETH. Our primary concern with regards to the economic stability and security of Eth2 is the resilience of the network at low ETH prices. Combined with the ability for an adversary to rapidly scale attacks, we consider this a cause for concern.
  • The lack of liquidity in Phase 0 and 1 might cause unpredictability and centralization. Given the lack of a two-way bridge between Eth1 and Eth2, and the lack of transaction capabilities in Phases 0 and 1, we expect a secondary market to form facilitated through derivatives and centralized exchanges. A high concentration of validators leveraging these platforms creates centralization risk and unpredictability.
  • Beware of Derivative attacks. The Ethereum ecosystem is rapidly evolving and so is Ether as an asset class, with options volume increasing and unique financial instruments like “flash loans” being used in malicious exploits. With this momentum, derivatives could become the favored avenue of attack for adversaries.
  • Explore a more dynamic method to changing Rewards in the event of a shock, such as an ETH price collapse (i.e. explore the implementation of a safety net). We recommend exploring a more dynamic method for scaling rewards or altering the Base Reward Factor in the case of network shocks. This could include using threshold triggers, step functions, or functions related directly to ETH price.

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