Tokenomics 101: Bitcoin & Ethereum
The term ‘tokenomics’ is a hybrid of token and economics and its meaning is quite similar to economics. Tokenomics studies how people interact with tokens. Specifically the issuance, distribution, and burning of tokens of a cryptocurrency. Economics is often divided into micro- and macro-economics. In this article I want to take more of a micro view and explore the inner workings of two specific blockchains: Bitcoin and Ethereum.
Like a central bank applying monetary policy to control its currency, tokenomics applies policies to cryptocurrencies. These policies are the core of a currency. Without carefully thinking through the rules, the currency is likely to fail. The rules of tokenomics are implemented through code and are quite difficult to alter as they require agreement from many network participants. Because of these decentralized agreement protocols, cryptocurrencies are often more predictable than their central bank-issued counterparts. For example: issuance rates and schedules are pre-set, and burn rates (removal from circulation) are somewhat predictable. These traits make investing and owning cryptocurrency more transparent when compared to traditional fiat currency.
The design aspects of tokenomics are: how tokens are created, how tokens are brought into circulation, and how they are removed from circulation. Incentives play a major role in this process too. How do you get network participants to do what you want them to? If you want transactions to be added to the blockchain, you will need to pay miners to include them. If you want people to stake their tokens and validate the network, you will have to pay a fee to them. The design aims to direct how people interact within the network.
Why it’s a good idea to look into tokenomics
Unless you are designing a new cryptocurrency, you might wonder why you should look into tokenomics. Well, if you are thinking about putting your hard-earned and taxed fiat into some digital coin, it would be good to understand a few basic dynamics. There are many different cryptocurrencies to choose from and understanding the tokenomics will help you make a decision. Key points to look into are:
- What amount of coins exist and how many more will be added?
- Is the supply inflationary (increasing) or deflationary (decreasing)?
- Do the coins have utility i.e. can they be used for something other than exchange?
- What’s the real world use case?
- Who owns the majority of coins? Is it well spread out or concentrated in a handful of accounts?
To me, these questions are important to look into before placing an investment. Understanding the supply and demand of tokens will help you form an investment thesis. In this article I want to start with the simplest and, some might say, most beautiful design and gradually work my way up to more complex models. In future posts I want to explore some other, less popular coins, diving into algorithmic stablecoins and potentially moving a bit more macro by looking into cross-chain exchanges. But let’s start with Bitcoin.
The simplicity of Bitcoin’s design is what makes it so beautiful. Let’s walk through the chart above:
- The total supply of 21 million is pre-programmed. A block is mined about every 10 minutes, rewarding the miner 6.25 BTC (when Bitcoin started it was 50 BTC per block, then 25, 12.5, 6.25, etc). Every 210K blocks, the reward is halved — with 10 minutes per block that amounts to a halving every 4 years. Without changes to the protocol, the final Bitcoin will be mined around the year 2140 (supply curve).
- Bitcoin’s inflation rate is cut in half every 4 years and to date we can see that this has caused a price surge in anticipation of reduced supply. During the first and second halvings, Bitcoin’s value climbed ~9000% and ~3000% respectively.
- The current amount in circulation shows we are already at almost 90% of the total supply. The annual issuance can be calculated like this: Total minutes per year/10*6.25. First divide the number of minutes in one year by 10, as a block is mined every 10 minutes. Then multiply this number by 6.25, because every block mined issues 6.25 new BTC. The total annual new supply is currently around 328K BTC.
- Transaction fees are used to pay the miners for adding your transaction into the next block. The basic fee relates to the size of the transaction in bytes and a tip can be added on top to buy priority and process faster (details on fee calculation).
- As shown in the chart, miners receive new bitcoin via mining rewards and bring those into circulation when selling it on the market.
All in all Bitcoin is simple and elegant because the mechanics are predictable. This does not really help predicting the price fluctuations, but if it’s easy to understand and explain, then that helps eliminate surprises in your investment thesis.
Ethereum 1.0 + EIP 1559
Ethereum has started off very similar to Bitcoin. In its current version it relies on a ‘Proof of Work’ consensus mechanism as well. Smart contracts give Ethereum more utility, and a vast ecosystem of decentralized applications (Dapps) have evolved and led to a very high transaction volume. Some issues with this have recently been addressed in an update (EIP-1559) which has also led to interesting new tokenomic dynamics. Let’s look at the chart.
- Ethereum currently has an annual supply of ~4.5%. Miners are rewarded 2 ETH per block and 1.75 ETH per uncle block. This reward has been lowered via previous change requests to the software. The math overall is not as easy as with Bitcoin, but the daily block reward of ~13,500 ETH amounts to an issuance of about ~4.9 million ETH per year.
- One big difference to Bitcoin is that not all ETH is mined, in fact the majority was handed out as part of the genesis block pre-mine. The mined and pre-mined ETH adds up to a current circulation of ~116 million.
- EIP-1559 will stabilize transaction fees so they don’t go too high during busy periods. Pre EIP-1559, transactions were auctioned. This means users could bid high fees to have their transactions processed quickly. Miners were incentivized to pick the highest fees that extracted the biggest return for them. Users bidding lower fees were forced to wait or increase their bid.
- EIP-1559, since its implementation on August 4th 2021, has split the fee into a fixed base fee and a small priority fee. The base fee will be adjusted dynamically, but the total fee must not vary by more than 12.5% to the previous block, effectively putting a lid on volatility. The priority fee still allows users to buy priority by tipping miners, but it is limited due to the total gas limit of the block.
- EIP-1559 has not only introduced a base fee, it also burns that same base fee, removing it from circulation. Paying the base fee to miners, instead of burning it, would not have improved the situation as off-chain agreements could have allowed auction-like tipping as we know it from pre EIP-1559 (this paper goes into detail proving this).
- Let’s assume burning around 70% of transaction fees (simulations here and here) which could lead to ~ 2.6 million ETH burned per year. At ~4.9 million new ETH annually, this would cut supply in half. With greater adoption, we might even see Ethereum turning deflationary.
The large ecosystem of apps built on Ethereum has grown quickly, more quickly than the network itself was able to adopt. Transaction fees are high and processing time is slow due to issues in scalability of the underlying network. The Ethereum team has been working hard to introduce a new, more scalable stack. The Ethereum 2.0 beacon chain is already launched, planned to be merged with Ethereum 1.0 ~2021/2022. Let’s look at what 2.0 will change.
- Ethereum 2.0 moves away from a Proof of Work consensus to a Proof of Stake consensus mechanism. Mining becomes obsolete and instead, validators will be securing the network. The mined and pre-mined supply stays in circulation after the merge, so users are not affected.
- Whoever is willing to stake 32 ETH can become a validator or can take multiple validator roles when the stake is multiplied too. Validators are rewarded by an annual return (APR). This payout is the single source of new network issuance in Ethereum 2.0. The more ETH is staked, the lower the annual return for stakers, the more new ETH will be issued. Currently there is ~6 million ETH staked, leading to a potential issuance of between ~0.3 million and ~0.6 million, if Ethereum 2.0 were live today. The APR yields 6.3% (See table for details).
- Since the beacon chain with Ethereum 2.0 is already launched, staking is possible today. The funds, however, will be locked up until the official merge of version 1 and 2. More than 6 million ETH have already been staked and thus taken out of current circulation — a potential supply shock.
- Staking comes with responsibilities: storing data, processing transactions and adding new blocks. If you fail to validate, go offline or act maliciously, you can be penalised, potentially chewing away your profits.
- The burning of fees introduced with EIP-1559 will continue and could potentially lead to a mild inflation or even deflation depending on transaction volume.
Tokenomics is the core of every cryptocurrency project (Blockchain or Dapp). Poor tokenomics design can lead to low adoption, false incentives or, ultimately, to the failure of the whole project. Therefore, understanding how tokens flow within a protocol or blockchain is important and should be part of any evaluation or study of a project.
Bitcoin and Ethereum have been around for quite some time and this can be attributed to the incentive structures that bring users to join the network and miners to validate transactions. People who understand Bitcoin will see great value in the fact that it is so simple, elegant and has a limited total supply. Bitcoin’s tokenomics have created digital scarcity that is enforced (through token incentives) by the network.
Ethereum on the other hand has introduced smart contracts, allowing the execution of decentralised code. The execution costs gas and is paid to miners / validators in ETH, giving the token ETH utility. Whoever owns ETH can use it to pay for execution of a piece of code within an application like Uniswap, AAVE or Maker.
Crypto is a giant experiment and tokenomics is a big part of that experiment. Protocols and blockchains experiment with tokenomics and this rapid experimentation via trial and error is a great way to evolve the systems and their tokenomic models, ultimately creating even better systems.
Interested in collaborating on tokenomics and discovering new protocols? Join our tokenomics discord channel.