by Collin Myers at ConsenSys Solutions.

Since the formal announcement of Serenity at DevCon4 in November we have seen a strong self organization of minds come together to debate and better define the specs of Ethereum 2.0. Topics such as network inflation, economic incentives, slashing, withdrawal period, attack vectors and worst case scenarios are all receiving a healthy debate, amongst many others.

With the recent surge in participation in Ethereum 2.0, it is now timely and critical that we effectively incorporate diverse viewpoints to arrive at the best solution. The beauty of an open source protocol is that anyone can participate in its journey and shape the network. A blockchain protocol involves a symphony of differing yet overlapping motives, all of which must be aligned in harmony.

Over the past several weeks, I have focused on the economics of the spec from the perspective of a rational validator — both small scale and large scale.This piece will focus on the net yield of Ethereum 2.0 at the proposed spec from the viewpoint of a small scale validator. I will address the economics of a large scale validator in my next post. I hope that this preliminary analysis will lead to healthy discussions around the spec and inform further analysis across the blockchain community.

“In general, this is still an active area of research, and more research on counter-strategies is desired.” Vitalik Buterin — Discouragement Attacks

Small Scale Validator (1 Validator Client)

Cloud Based Approach

Hardware Based Approach

At the core of Ethereum 2.0 is a system chain called the “beacon chain”. The beacon chain stores and manages the registry of validators. In the initial deployment phases of Ethereum 2.0 the only mechanism to become a validator is to make a one-way 32 ETH deposit contract on Ethereum 1.0.

Activation as a validator happens when deposit transaction receipts are processed by the beacon chain, the activation balance is reached, and after a queuing process. Exit is either voluntary or forced as a penalty for misbehavior.

In return for staking ETH, attesting to correct blocks, signing off on the validity of a block, and proposing blocks, the validator will be rewarded with ETH through a network wide interest rate as well as receive a portion of network transaction fees.

For more reading on Ethereum 2.0 check out the following articles:

Below you will find a list of the teams actively researching or developing a beacon chain / shard client:

Economics & Risk

When discussing the economics of anything (especially financial products) one of the first areas we should address is the risk profile of an opportunity. Modern portfolio theory makes the assumptions that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. In mature markets the risk return profile is normally (with a few exceptions) up and to the right — the more risk involved should lead to a higher reward.

Sovereign Debt Yield Curves

The graphs below represent the yield curves for different nations sovereign debt. Global sovereign debt markets are some of the most liquid and deep markets in the world. Magnitudes more liquid than ETH, especially ETH that is locked in a staking contract. In the examples below investors are compensated for the risk that a specific nation will be able to repay its national debt at maturity. Sovereign bond yields are primarily affected by creditworthiness, country risk, and exchange rates.

Investing in sovereign debt is considered to be the most ‘riskless’ investment in global financial markets, with the three-month US treasury yield (2.43%) used globally in various valuation models and risk adjusted return ratios every day as the ‘risk-free rate’.

When incentivizing actions it is important to remember that a rational validator has a decreased chance of participation if the opportunity exhibits:

Weak profitability

Risks outweighing rewards

High barriers to entry (knowledge, time or resource based)

Uncompetitive yields (on a risk adjusted basis)

Eric Connor recently published a piece on ethhub that addresses the risks of performing validation, which can be summarized below.

Staking Costs and Risks

Computing cost

Users will need to run validator clients and likely beacon nodes. This requires computing resources.

Beacon Node: similar to running geth/parity today

Validator client: lightweight and need one per 32 ETH stake

Capital acquisition and lockup

The user must first acquire 32 ETH..

There exists a grace period before users may withdraw their funds. However, this time has come down considerably in the latest versions of the spec. The minimum withdraw queue wait is currently 18 hours, subject to delays imposed by network congestion.

Code Risk

Programs may have been incorrectly constructed. This risk is mitigated over time through correct usage despite substantial economic incentive to compromise the system. Consensus-level code is simpler to remediate through forking, while client code running across thousands of nodes is prone to added difficulty in pinpointing defects and distributing changes.

General uptime and maintenance cost

Users need to make sure their validator doesn’t have downtime or they risk a quadratic leak on their stake.

If a user has multiple validators, maintenance cost and worry of the infrastructure comes into play.

Security risk

Beyond failures in the client code, stakers are responsible for the security environment of their validator clients (internet connection, operating system, hardware, etc.). If a validator client is compromised, there is no way to recover funds or returns.

Market Competition

In aggregate, participants staking on Ethereum 2.0 will face a universe of competing yield opportunities. It would be wise to assume that a portion of total stakers will be driven by return potential and not the joy of securing the Ethereum network. The macro categories of competing opportunities are laid out below:

Decentralized Finance

Some of the most exciting adoption activity seen recently in the crypto space has been the volume increases in Defi applications. These applications offer users different ways to lock up their ETH and earn a reward (interest). Examples of current Defi applications are Compound Finance, Dharma, Maker and dYdX. Christopher DeLuca of Bloqboard recently wrote a great Defi lending report comparing the changes in volume seen month over month for the Defi applications listed above (highly recommended).

Traditional Investment Vehicles

Mature interest based opportunities that have lower fiat denominated price volatility such as bonds (corporate & sovereign), CDs, and savings accounts should be considered when determining network opportunities. The crypto space could use a steady inclusion of institutional capital over time, but to achieve this risk profiles and returns of crypto based opportunities must be in line with traditional products — when discussing institutional capital I am referring to the type of money that is put to work on the behalf of someone else and driven by structured investment mandates (not pure crypto funds).

Alternative Staking Coins

Currently there are over 500 alternative POS coins, with their own reward structure. The majority mindset for this category of staking participants is to dedicate their resources towards whatever is yielding the most and then liquidate immediately into their favorite major.

Total Incentive to Stake = Validator Rewards + Network Fees — Cost to Run a Validator

At a high level, the minimum requirements to stake are

Minimum of 32 ETH (per validator)

Computer

Internet Connection

There are three different types of participants that can exist when running Ethereum 2.0 software. This article will focus on the net yield for small scale validators.

Beacon node only

Beacon node + validator client (small scale)

Beacon node + multiple validator clients (large scale)

Small Scale Validator Analysis

The purpose of the sensitivity analysis’ below is to look at the net yield potential for a small scale validator using a cloud or hardware infrastructure on a yearly basis. All network assumptions are based on the current ETH 2.0 Master Spec, while cost assumptions have been sourced independently. Further sensitivity analysis’ for each infrastructure option can be found below.

Cloud Economics

Hardware Economics

Conclusion

To wrap up, let’s look at a few scenarios that result in a ~2.59% net yield, which represents the current yield of a one year US treasury.

Cloud Economics

ETH Price = $125

Network ETH at Stake = 1,000,000

Network Fees/Day = 500

Net Yield = 2.90%