Deflationary Ethereum
Ethereum will switch to proof-of-stake consensus mechanism after the merge that combines the Beacon Chain with the existing Ethereum Mainnet is finalized. A test on Kiln was successfully executed but the date of the final merge is expected to occur in the third quarter.
One of the prominent appeals of Ethereum upgrades is the network transitioning from Proof of Work to Proof of Stake, and through that, the Beacon Chain will eventually connect to the current Mainnet of Ethereum 1.0.
On March 15th, the Ethereum Foundation announced that a test on Kiln Network for merging the current mainnet with a Beacon Chain was successfully executed. “Like the Ethereum mainnet, Kiln’s execution layer was launched under proof-of-work in parallel to a Beacon Chain running proof-of-stake.” The foundnation wrote, “The Merge happened on Kiln on March 15, 2022. The network is now running entirely under proof-of-stake!”
The Beacon Chain will pave the foundation for sharding. Shard chains, as indicated by the Ethereum Foundation on its website, provides “extra, cheaper, storage layers for applications and rollups to store data,” and are part of the layer 2 solutions for upgrading Ethereum’s scalability and capability.
With shard chains, validators only need to run data for the shard they’re validated, not the entire network as what is happening now for Ethereum 1.0. In an Ethereum context, sharding will reduce network congestion and increase transactions per second by creating new chains, known as “shards”
Currently, we aren’t sure when Ethereum will officially operate on Proof-of-Stake protocol, but the news regarding the test merge is definitely a critical step towards the final transition to Ethereum 2.0 — an upgraded version of Ethereum supposedly with much less traffic congestions, substantially subtracted gas fees, and higher scalability.
The merge is particularly important not only from a technical perspective but from a monetary perspective as well. After the merge, Ethereum, the second largest cryptocurrency that has no limit on its market cap, will reduce 90% of its issued tokens, meaning that the supply will drop drastically. As claimed by an Ether expert on Twitter, this change of tokenomics will cause a price impact equivalent to “three bitcoin halvings occuring all at once.”
However, this cut of issuance could be traced back to last summer, in which EIP ( Ethereum Improvement Proposals) 1559 was implemented on the Ethereum Network.
EIP 1559
Last August, the London hard fork upgrade included a set of “improvement proposals”, whose main purpose was to resolve the overhauled high gas fees for transactions on Ethereum. Among all the proposals, EIP 1559, which restructured the fee mechanism in the network, captured the most amount of attention.
So, what’s so special about EIP 1550?
Ethereum Blockchain currently is still operating on the Proof-of-Work consensus mechanism, meaning that miners use computational power to create blocks and validate transactions initiated by Ether users. Mining, in this sense, is considered as a sort of getting work done through the power of electricity. Miners are rewarded with both Ethereum and transaction fees, for securing the blockchain and transactional records on the public ledger.
Anyone who has processed transactions on Ethereum during rush hours must have experienced the difficulty of waiting to get the transactions through. This is because a high volume of transactions causes congestions for miners to include transactions in blocks on time. The gas fee went up as miners needed to put out more work to process the transactions.
Whenever the transactions are “pending” as shown on decentralized wallets, one gets to prioritize their transactions to be processed by paying additional gas fee. The additional part is the tips added on top of the base fee required for transactions on Ethereum. Whoever offers the higher tips has advantages over other users.
But there is a loophole of miners potentially gaming the system, explained by Tim Beiko, an Ethereum developer, by filling the blocks with scam transactions and thus pushing up the gas fee for others. Due to their identity as miners with advantages over regular users, they could pay for scam transactions that will end up returning back to their own pockets.
As indicated in the graph below, which had been created slightly before August, 2021, with EIP 1559, base fee is burnt for preventing the massive inflow of scam-oriented transactions, and only the tip plus the block reward in the form of ETH gets to be received by the miners.
The Ethereum community welcomed this improvement since it put a large sum of ETH out of circulation and lowered the overall supply of ETH in the market. Until the time of writing, more than 2 millions of Ethereum tokens, worth nearly $6 billions, have been burnt and wiped out of the market, leading to a net supply reduction of 65.2%, according to data retrieved from Watch the Burn, an Ether data dashboard.
The Consensus Layer
Where is it such a big deal that Ethereum is finally transitioning to Proof-of-Stake protocol as early as this summer?
First, Ethereum switching to POS will greatly lower its energy consumption.When the energy used for mining bitcoins has reached as high as 0.1% of global energy consumption, Ethereum operating on POS reportedly would be 99.5% more energy efficient than the current version. Plus, a switch to POS will be exempted from the risk of being targeted by regulatory authorities due to environmental concern.
For validating transactions, POW-powered networks like the bitcoin blockchain, incentivize miners to solve cryptographic puzzles through vast computational power by rewarding them with bitcoins. The Ethereum network currently works in a similar way. In order to pay miners, Ether supply is being inflated roughly 4% annually. With Proof of Stake, however, emissions are set to be around 1%, meaning that the block rewards for stakers is much less than what it has been under the Proof-of-Work protocol
Secondly, Ethereum, with a market cap over $350 billion, is bigger than all the layer 1 networks combined together. DeFi activities and minting and trading NFTs have made up the major use cases of Ethereum Network, which continues to be the dominant player of DeFi and NFTs.
Meanwhile, as the network has destroyed $6.9 billion in Ether via EIP 1559, the biggest on-chain gas burner is the NFT marketplace Opensea, reported by Bitcoin.com. The leading NFT market has burned nearly 230 thousands of ether worth nearly $800 millions. Therefore, if Ethereum can switch to a gas-friendly mechanism that lowered the cost of transacting and minting NFTs, the mania of NFTs may resurrect as gas fee will no longer be a barrier for people to step into this wild west.
Thirdly, staking will be the critical pillar for Ethereum Network because it determines the issuance rate of ETH token.
Staking
As of the time of publication, a bit more than 320K validators are staking a total of more than 10.2 millions of Ether on the Beacon Chain. The total lock-up value has gone up to around $30 billion — around 8% of Ether’s total market capitalization.
The cost to become a validator today is 32 Ether or its multiplied numbers of ether, and the yield varies among lockup periods.
From the graph above and below, we can see the staked value and the number of validators have gone up steadily since the Beacon Chain was launched in the December of 2020.
According to the blog post by Lucas Outumuro, the Head of Research at IntotheBlock, the staking rewards following the merge of Ethereum depends on three major factors. The Ethereum fees and the percentage of fees getting burnt all vary in different market conditions. Usually, high fees indicate that more fees will be burnt, but will also result in higher earning for validating transactions. And the third one is the number of Ether being staked — as more tokens being locked up results in lower yields.
“Through the merge with the proof-of-stake chain, fees previously earned by miners will pass on to being earned by those staking. This is expected to result in staking rewards between 7% and 12%," Outumuro wrote. Currently, there are only around 8% of the circulating supply of Ether being staked for yield. The rewarded tokens derived from the staking, as well as the transaction fees paid in ETH are the only two ways of issuances that generate new ETHs on a regular basis.
Justin Drake, an Ethereum 2.0 Researcher, believes the annual supply change will be -1.6million ETH, reducing the annual supply rate by 1.4% Transitioning to Proof of Stake, Ether is expected to become deflationary as the annual supply falls behind the burning rate dictated by EIP 1550. Monetary deflation tends to trigger the price of ETH surging, a phenomenon expected and welcomed by the Ethereum community.
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