Diving Into Ethereum 2.0 — Part I
Analyzing ETH 2.0 with IntoTheBlock’s new analytics
Since its early days, the Ethereum Foundation and community have laid out plans towards a more scalable and sustainable blockchain for decentralized applications (dapps). In order to achieve this, Ethereum has been rolling out a series of upgrades making up the grand upgrade dubbed Ethereum 2.0.
For the first part of this series, we will focus on the upgrades within the ETH 2.0 umbrella that have already been implemented. Particularly, we will discuss the Beacon Chain, EIP-1559 and their impacts on Ethereum focusing on key indicators from IntoTheBlock. In the near future a second piece covering the merge and sharding will be added and linked to within this piece. To better understand the timeline for these upgrades, here is a tentative roadmap based on Ethereum Foundation’s Trenton Van Epps.
Beacon Chain — The Beginning of the Transition to Proof of Stake
Transitioning to proof of stake has been discussed by Vitalik and the Ethereum community since as early as 2014. This transition to proof of stake has already begun with the launch of the Beacon Chain and aims to bring three key improvements to Ethereum: a more environmentally sustainable, secure and scalable blockchain.
One of the main reasons behind moving from proof of work to proof of stake is the reduction in environmental footprint. The negative externalities arising from mining have been a key reason for Ethereum’s push to proof of stake since the beginning and are now more relevant than ever. Since staking replaces miners for validators, the environmental costs from mining are foregone, resulting in the Ethereum proof of stake blockchain projected to consume 99.95% less electricity.
The implementation of proof of stake also aims to increase the security of Ethereum. In order to attempt a 51% attack on proof of work, one would theoretically require more than half of the computing power of the blockchain. In a proof of stake blockchain an attacker would require over half of the amount being staked — currently worth over $12 billion with nearly 8 million ETH on the Beacon Chain.
Realistically, though, acquiring this amount of Ether an attacker would drive up its cost, making it prohibitively expensive to exploit past a certain point. In addition, validators are incentivized to act in the best interests of the blockchain since they are holding and earning Ether, which means that potential attackers would see a reduction in the value of their assets if they compromise the network. Finally, validators voting against or deviating from consensus are “slashed”, effectively penalizing and disincentivizing bad behavior.
Since the launch of the Beacon Chain, a proof of stake blockchain has been operating in parallel to the ETH 1.0 network. Initially, only validators setting up their nodes or trusted staking services were able to participate in the Beacon chain. However, decentralized staking services such as Lido have opened up the doors of staking to many more users looking to remain in custody of their funds without having to lock them. Through stETH, users staking positions on the Beacon Chain are tokenized and made available for anyone to access. This has led to the rise of the number of depositors in the staking contract, which recently surpassed 50,000 addresses.
The increased number of depositors and ETH staked in the Beacon Chain is also a positive sign for Ethereum’s security. As previously mentioned, potential attackers require 51% of staked ETH in order to exploit the network; thus more ETH being staked makes the blockchain more costly to attack. Moreover, a higher number of addresses staking points to greater decentralization as a larger number of validators make the network more resilient. Although decentralization is more nuanced than simply a measure of addresses staking, the rising number of depositors does suggest greater network security.
With the Beacon Chain up and running for nearly ten months now, the full transition to proof of stake is getting closer. Prior to achieving greater scalability, Ethereum first needs to merge the Beacon Chain with the ETH 1.0 blockchain where dapps are currently hosted. Before that, however, Ethereum implemented one of its most anticipated upgrades, EIP-1559, in the recent London hard fork.
London Hard Fork — Improved “Tokenomics” Through EIP-1559
The London hard fork took place on August 4, 2021 and included the implementation of five Ethereum Improvement Proposals (EIPs), EIP-1559 being the most prominent of these. The much-awaited EIP restructured fees on Ethereum by introducing a base fee. In contrast to “normal” transaction fees, the base fee is burnt as opposed to earned by miners. This means that the ETH paid for the base fee is effectively removed from circulation and reduces selling pressure from miners, which experienced a decline in their earnings.
Like existing fees, the base fee also adjusts dynamically based on demand. With EIP-1559 the base fee adapts along with the block size, targeting a specific level of gas usage close to the gas limit.
When gas usage is below the target, base fee decreases to encourage demand; when gas usage is above the target, the base fee (and the amount of ETH being burnt) increases. This aims to make gas fees more predictable, while also having Ethereum holders benefit from spikes in fees. So far, over 350,000 ETH has been burned, representing approximately 80% of all fees paid by users.
As of September 23, 2021 through IntoTheBlock’s Ether supply indicators
Prior to EIP-1559, Ether had virtually no issuance limit nor reduction mechanism. This meant that Ether had no upper bound on its supply, which led to many’s concern of its ability to capture value long-term.
Now that roughly 80% of ETH paid in fees is being burnt, there has been a noticeable decrease in Ether’s net issuance. By net issuance we refer to the amount of supply issued to miners minus the Ether removed from circulation from the burn mechanism; this is Ether’s effective rate of inflation.
As can be seen from the graph above, Ether’s net issuance has dropped from just over 4% to a 30-day average of 1.36% since the implementation of EIP-1559. It even reached deflationary levels on three separate occasions.
Asides from simply reducing selling pressure for Ether, EIP-1559 strengthens its proposition as a store of value and has the potential to further improve the blockchain’s security. “Tokenomics” is a popular term used to describe the economic mechanisms leading to value accrual of a token. With EIP-1559, the burning of fees can be seen as a way for Ether to capture value from the activity taking place on its blockchain. In short, the more demand there is to use Ethereum, the greater the decrease in its net issuance.
The sustained demand for NFTs and DeFi on Ethereum is therefore translating into more favorable supply growth for Ether. By doing so, Ether’s potential as a store of value has been improving. Going back to proof of stake, the networks security relies on the value of ETH being staked. Hence, by allowing ETH to capture value from its adoption, EIP-1559 also enables greater security for Ethereum.
Overall, these two main upgrades have already had significant positive effects on Ethereum. As the merge approximates, we will witness if the transition to proof of staking turns out as promising as it was presented. To better understand how the merge and future upgrades are likely to affect Ethereum make sure to stay tuned for the second part of this series. Look forward to discussing this soon!
