Everything You Need to Know About Ethereum’s Monetary Policy
The Merge has been the third most important event in cryptocurrency history, coming only behind the original launch of Ethereum and Bitcoin which happened in 2015 and 2009 respectively. Now that it has been successfully finalized, Ethereum’s issuance rate is attracting a lot of attention, confusion and fud. If you are confused about how terms like “gross issuance”, “net issuance” and “burned ether” or why Ethereum’s inflation rate is fluctuating, then this article will provide the answers you are looking for.
What Is the “Merge”?
The Merge happened on September 15th, 2022 and it marked the transition of Ethereum’s move from PoW (proof-of-work which relies on mining) to PoS (proof-of-stake). Mining was discontinued in favor of “staking” which requires users to lock 32 ether in order to run a validator that periodically processes a batch of transactions.
One of the advantages of PoS is that the network no longer relies on expensive equipment and high electricity consumption. Proof-of-Stake leverages cryptography and the value of ether to establish redundancy of trust. This was a fundamental change that simultaneously affected Ethereum’s security model and monetary policy. This article focuses on the latter as we briefly explore the purpose of issuance, the historical changes and the current state of Ethereum’s monetary system.
A Brief History of Ethereum’s Monetary Model
- Ethereum launched in 2015 with a pre-mined supply of 72 million ether.
- Issuance continued with mining which distributed another ~50 million ether through 2022 which means the pre-mine represents roughly 59% of Ethereum’s current circulating supply.
- The first change to the monetary policy happened in 2017 when block rewards were reduced from 5 to 3 ether per block. (EIP-649)
- A second issuance reduction happened in 2019 that lowered block rewards down to 2 ether per block. (EIP-1234)
- The “fee burning” mechanism was introduced in August 2021 which affected net issuance. (EIP-1559)
- The Merge transitioned Ethereum to PoS and with it the third change to monetary policy. It again reduced issuance, but the exact amount is dynamically adjusted depending on the number of validators that are participating in staking. However, a maximum issuance rate has been established and capped at ~1.7%.
Ethereum’s issuance rate has changed three times since the network went live in 2015. Coincidentally, it matches the number of times Bitcoin’s issuance rate has been changed. Notably, all changes to monetary policy have reduced ether’s inflation rate. This explains why they were received with overwhelming support and were readily embraced by social consensus.
Ethereum was able to reduce issuance without compromising security for two reasons:
- Revenue from transaction fees increased dramatically as a result of the accelerated adoption and demand for block space.
- PoS aligns the interests from stakeholders with that of users while at the same time eliminating the need for capital expenditure in depreciating assets (mining equipment) and operational costs (electricity consumption). This dynamic allows for financial incentives and operational costs to be reduced without compromising the security of the network, and it is the reason why the Merge was able to implement the biggest issuance cut in the history of Ethereum.
We will explore the connection between these things in more detail, but first we need to understand the purpose of issuance in the context of cryptocurrencies. When paired with PoW, issuance works as a distribution mechanism, but it also subsidizes the security of the network that use either PoW or PoS.
Issuance Is a Method to Kickstart Supply Distribution
In PoW, miners buy coins directly from the network by publishing cryptographic receipts of computational work which prove the incurrence of capital expenditure in the form of depreciating equipment and electricity consumption. In a really funky way, mining operates as a decentralized exchange and issuance guarantees a minimum level of liquidity. For this reason, issuance served a critical role during the initial distribution of coins that used PoW in that it enabled anyone with access to the internet to participate in a permissionless auction to acquire coins with the equivalence of a primary sale. This was very important in the early days of crypto since there were very few people who owned these coins and exchanges were non-existent.
This function as a decentralized variant of primary sales is now almost entirely irrelevant in established networks because most of the supply has already been issued and most of the liquidity is provided via innumerous exchanges around the world. According to Messari, the real trading volume of Bitcoin (excluding wash trades) over the past year has averaged at around $6.1 billion per day while daily mining rewards corresponded to less than 0.5% of that. The numbers don’t lie, global liquidity is ample and the narrative that PoW is still an important means of coin distribution is blatantly misaligned with reality.
Issuance Is a Security Subsidy
This leaves us with the second, but still very critical purpose of issuance which is to subsidize the security of the network. Put simply, crypto networks are like decentralized central banks that print their own currency and use that newly printed money to pay for security services that are provided by freelancers called “miners” and “stakers”.
FUN FACT: the name of the function that retrieves the amount of new Bitcoin to be minted for each block is “GetBlockSubsidy”.
Mining is commonly portrayed as an activity that creates new coins, but this is categorically false. Miners are simply processing batches of transactions, nothing else. Miners partake in a lottery-like system where the prize is the right to process a batch of transactions, and within that is the right to claim newly minted coins as well as fees paid by the users whose transactions are included in that batch, aka a “block”.
The average cost that it takes to “win” the rights to process a block can be thought of as the security budget assigned to upkeep the permissionless and immutable properties of the network. In PoW networks, this is what ultimately establishes the cost of a “51% attack”, and it is what protects transactions from being arbitrarily reversed and/or that balances from being arbitrarily frozen.
These concepts also apply to staking in PoS networks. Stakers are responsible for processing batches of transactions, and they are rewarded with newly minted ether and a portion of transaction fees for providing their service. The cost of participating as a validator in PoS is shifted from mining’s capital expenditures to the staking cost of locking up capital denominated in ether. In practice, ether attains properties that are similar to a bond in that it requires capital to be locked in a contract over a period of time in exchange of yield, but instead of financing the operation of a centralized government, staking in the Ethereum framework is the act of servicing the operation of a decentralized network.
Gross Issuance
The raw number of new coins created by the protocol is rereferred to as “gross issuance”. The decision of how many coins need to be minted as a form of subsidy is driven by primarily two factors:
- The higher the value of assets “stored” in the network, the higher is the incentive for bad actors to attempt to attack or disrupt it, and the more security will be needed to protect the network against them.
- There are two ways to finance the security of the network: issuance and transaction fees. In theory issuance should be reduced as revenue from transaction fees increase. If issuance is excessive, then it will result in the debasement of the network’s native asset (inflation). If issuance is insufficient, then the network may become exposed to attacks that can censor and/or reverse transactions.
One way to scale the security budget along with the value of “stored” assets is by designating a “minimum viable issuance” denominated in the network’s native coin. This is part of Ethereum’s monetary model and this concept was used to derive the issuance curve.
Ethereum’s issuance model is equivalent to an adjustable minimum wage that is affected by the number of staking validators. The less validators there are, the more vulnerable to attacks it becomes, and the more financial encouragement is needed to encourage more users to become validators. In this case the “minimum wage”, aka minimum yield, is increased. The more validators are active, the less financial incentives are needed since security goals have been met, and the minimum yield is decreased.
More validators will always result in a higher overall issuance rate, but the adjustments to yield result in a logarithmic issuance curve. These adjustments are based on mathematical formulas that are fixed and defined directly in the protocol. Dynamic issuance is now part of “code law” and it is designed to automatically adapt security subsidies to different circumstances and ensure that no further manual changes will be needed.
Burning Ether and Net Issuance
At the time of writing, Ethereum is creating around 600,000 ether per year. This means that it should have an annual inflation rate of 0.5%, however the real inflation rate since the Merge went live has been ~0.01%. How is this possible?
This is the effect of “burning ether” introduced by EIP-1559. What exactly does it do? It destroys a large portion of the transaction fees instead of paying them out to validators. That means that while Ethereum’s gross issuance is minting new coins, EIP-1559 is taking them out of circulation, and the net result between these two forces determines the final inflation rate, aka net issuance or monetary inflation.
Why Does Ethereum’s Inflation Rate Fluctuate?
Ethereum’s inflation rate is determined by subtracting the total amount fees that are “burned” (destroyed) from gross issuance (newly minted ether to be used as validator rewards). If gross issuance is greater than burned fees, then net issuance is positive and Ethereum is inflationary. If gross issuance is lower than the amount of burned fees, then net issuance is negative and Ethereum is deflationary.
It is somewhat difficult to predict the inflation rate because it is affected by a combination of the number of active validators and the user demand for Ethereum’s block space. While the number of validators does not change rapidly, user demand for block space does. This causes short-term fluctuations of transaction fees, which affects the amount of ether that gets burned and ultimately impacts the inflation rate.
Flipping Mental Models
The fee burning mechanism is a source of confusion, but we can bypass it with a simple change to accounting. In theory, issuance should be dynamically adjusted depending on the amount of revenue generated by transaction fees. The more money is being generated from fees, the less subsidies are needed, which means that less coins should be minted. This is actually how Ethereum behaves.
It is easier to think that transaction fees are actually paid to validators, and that they are never burned. With this accounting model, issuance is only introduced when fees are less than the determined “minimum wage” (the yield guaranteed by the gross issuance curve). What happens if fees exceed the minimum wage? In that case, the network taxes the exceeding amount.
The taxed revenue is kept in Ethereum’s treasury which is reserved for the single purpose of subsidizing security in case it may be needed in the future. In summary, fees are never destroyed, they are either distributed directly to validators or taxed by the network, and issuance only occurs when fees are insufficient and the treasury from previously taxed fees has been exhausted.
This is a change to accounting perspective, but it is an economically sound explanation that is easier to digest. When the issuer of money holds a balance in their own treasury that balance ceases to exist in practical economic terms, as if it were “burned”. That’s because money that sits in the treasury of the original issuer is effectively taken out of circulation. It is only when that money is applied or distributed that it becomes economically active, and pertaining to the original issuer, it makes no difference whether it came from their treasury or if it was freshly created out of thin air.
Conclusion
Ethereum has devised an elegant monetary model that is adaptive to the circumstances of the network. The combination of the issuance curve and the burning of fees ensure that manual intervention will no longer be needed in the future. This approach prioritizes security as opposed to enforcing a supply cap. Ethereum’s dynamic model guarantees security while a fixed issuance schedule like Bitcoin’s guarantees supply predictability.
For perspective, Bitcoin will continue to cut its issuance in half every four years. It will take Bitcoin another four halvenings to approach Ethereum’s current issuance, and a fourth one to become marginally lower. Every time issuance is cut in half, it potentially jeopardizes the security of the network since these cuts are reducing the security subsidy without taking into consideration the actual progress of cash flow coming from transaction fees. When you factor in the yield that is provided to Ethereum stakers, which is inexistent in Bitcoin, then Ethereum is the uncontested winner in economic terms.
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