In our last article, we outlined the upcoming roadmap to Serenity, including all of the implementations throughout the transition to Ethereum 2.0. While it’s important to recognize how Ethereum will evolve on a technical level, here at Fitzner Blockchain Consulting we also wanted to take a deeper look at the economics behind the Ethereum network and how issuance and rewards will gradually shift as we progress towards Serenity.

Ethereum 1.X Issuance Logistics

Unlike Bitcoin’s predetermined schedule to reduce block rewards in half every 210,000 blocks, Ethereum has dynamically reduced block rewards through hard forks. Over the past few years, we have seen a few forks including but not limited to the Byzantium fork in October of 2017, reducing block rewards from 5 ETH to 3 ETH (-40% change), and the most recent Constinople fork in February of 2019, reducing block rewards from 3 ETH to 2 ETH (-33.33% change). Generally speaking, these forks have been used to implement network upgrades as well as to delay the “difficulty bomb”.

The difficulty bomb was originally embedded into Ethereum’s code to create a mechanism for miners and developers to have some accountability to transition away from proof-of-work consensus to proof-of-stake. With this said, the difficulty bomb exponentially increases the difficulty (and in turn cost) on the proof-of-work chain to the point where it becomes nearly impossible to successfully mine a block and earn a reward. As such, the recent Constinople fork pushed back the effects of the difficulty bomb another 12 months as we prepare for the mainnet launch of the beacon chain.

As you can see, Ethereum’s issuance rate is currently the lowest it’s ever been, and it will continue to go lower following a full transition to Serenity. Ethereum’s current issuance rate is set at approximately 4.5% per year. In comparison, Bitcoin’s current issuance rate is approximately 3.75%, where it is set to halve to 1.875% in about a year from now. With that in mind, here’s a look at how Ethereum’s the issuance schedule has played out since 2016:

We’d like to note that since the Constinople hard fork in February 2019 which reduced the issuance by 33%, Ether’s price has increased from $125.29 to $283.52 as of May 30th, 2019. In percentage terms, this has lead to a 126% increase over the past four months.

The Transition to Serenity

As Ethereum migrates to Serenity, miners will be replaced with validators who must stake 32 ETH to be eligible for block rewards (or use a staking pool). As computing power is replaced with capital, it allows Ethereum to enjoy the lowest possible issuance rate while providing the same security to the network.

As it currently stands, the issuance rate will be directly linked to the total amount of Ether being staked as collateral. Seeing that issuance is only spread across active validators, it’s estimated that 5–10% of total Ether being staked will allow the network to be just as secure as it is now. This means that the total issuance rate for the network can be a lot lower than the proof of work chain on Eth 1.x. With this said, validators may largely rely on transaction fees as staking becomes more accessible to users.

The current discussion surrounding issuance rewards are centered around making sure that staking is still profitable for individuals running a single node. With the proliferation of DeFi projects such as Maker, Compound and Dharma offering mechanisms to lock your ether through their platform, Ethereum must find the right balance to allow smaller fish to participate in the greater overall ecosystem. Ultimately, the end goal is to effectively enhance the decentralization of the network as a whole.

Combined Issuance

As of now, Ethereum has a few nuances which we can expect to affect the issuance rate and supply curve as we migrate from Eth1.x to Eth2.0 over the next few years. As stated on EthHub, this can be seen as:

Serenity Phase 0 : A small increase in the issuance rate due to Beacon Chain launch.

A small increase in the issuance rate due to Beacon Chain launch. Serenity Phase 2: A large drop in the issuance rate due to the PoW chain fading away.

Here’s a little bit of background from our last article on the behind the scenes with this transition:

In order to successfully migrate to Proof of Stake, block rewards throughout Phases 0–2 will be distributed to both validators and miners on each respective chain (Eth 1.x & 2.0). Therefore, the combined issuance rate is going to be slightly higher throughout the early phases of Ethereum 2.0 where it will ultimately decrease over time towards 0–1%. Users who are interested in becoming validators on Ethereum 2.0 during Phase 0 will migrate their 1.0 ETH to ETH 2.0 through a one-way deposit contract. This contract will burn the 1.0 ETH and mint new 2.0 ETH on the Beacon Chain. In order to successfully bootstrap the beacon chain, there’s a threshold which will require a total 16,384 validators to be live, aggregating around 524,288 newly staked ETH. Once this threshold is reached, validators who deposit ETH on the 2.0 chain will earn 11% interest given these parameters*.

What Does this Mean?

If you’re interested in becoming a validator, here are some of the things you can expect with Ethereum 2.0:

At minimum users will need to run validators client(s) and possibly beacon node(s).

Beacon Nodes are similar to running geth/parity today while the validator client is a fairly lightweight client.

Current cost estimates are roughly $120/year to run a beacon node and $60/year per to run a validator clients

There’s a minimum amount of time before validators can withdraw their funds following the initial deposit. As it stands, the minimum withdraw queue wait is 18 hours.

Burning Mechanisms

As we migrate towards the envisioned Serenity specs, we will begin to see the inclusion of a burning mechanism(s). The primary mechanism as of now is through validator inactivity and the respective burning penalty. In addition, there are several other EIP’s in discussion to implement other burning functions in order to improve the long term sustainability of the ecosystem.

Validators Inactivity: Validators who are inactive or offline will be subject to penalties in which the system automatically withdraws the staked ETH and burns it. However, Vitalik Buterin stated in a Reddit thread that chances of inactive nodes is fairly low but, “every 1% of validators offline cuts total issuance by around 3%”.

Validators who are inactive or offline will be subject to penalties in which the system automatically withdraws the staked ETH and burns it. However, Vitalik Buterin stated in a Reddit thread that chances of inactive nodes is fairly low but, “every 1% of validators offline cuts total issuance by around 3%”. EIP 1559: This proposal suggests burning a small percentage of transaction fees to mitigate economic inefficiencies associated with miners having the ability to choose the highest-paying transactions. Ultimately, this plays a more important role as validators begin to rely transaction fees rather than block rewards as the driving incentive.

State Rent

State Rent requires users to pay “storage rent” to the network in order to limit state size. As of now, the state size is increasing at an unsustainable rate and this proposal would require contracts to pay rent based on total size. With this, there exists a “poke” operation which can be used to delete contracts that have not paid rent. In general, we would rely on voluntary pokes by miners to clear out old accounts. This mechanism could possibly be tied into the gas burning mechanism proposed in EIP 1559.

Conclusion

In summary, Serenity is a massive milestone for Ethereum. Assuming the core team can successfully transition to the beacon chain, the inherent argument for Ether (ETH) as a Store of Value (SoV) becomes much stronger in tandem with the proliferation of DeFi applications.

Ethereum’s issuance rate has drastically reduced since its creation in 2016. Despite the fact that there is currently no fixed supply such as Bitcoin’s 21,000,000 BTC, Serenity provides a unique opportunity to increase scarcity through gradually diminishing issuance rates with staked Ether.

As such, the short term scarcity of Ether in Serenity can quickly become more attractive than that of Bitcoin. In fact, arguments can be made that by the time we reach Phase 3, Ethereum’s growing demand and maturity within DeFi (many of which require Ether to be locked) combined with a large portion of the existing supply being staked for rewards may eventually make Ether even more scarce than Bitcoin.

For now, Fitzner Blockchain is closely watching Ethereum as other smart contracting platforms aim to capture some of its market share as new dApps enter the space. For Ethereum bulls, it’s important to recognize that Ether was the first cryptocurrency that the SEC said wasn’t a security. With this in mind and the notion of the Lindy Effect, it’s safe to say that unless some catastrophic event happens, Ethereum is here to stay for the next few years.

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Writers: Lucas Campbell — https://twitter.com/0x_Lucas

Cooper Turley — https://twitter.com/Cooopahtroopa

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Website: http://fitznerblockchain.consulting/

Resources

https://medium.com/ethhub/the-basics-of-ethereum-2-0-economics-3bd2ffc7fd0e

https://media.consensys.net/the-thirdening-what-you-need-to-know-df96599ad857

https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/eth-2.0-economics/

https://docs.ethhub.io/ethereum-roadmap/ethereum-1.x/

https://ethresear.ch/c/economics

https://www.delphidigital.io/ethereum