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Ethereum is crypto’s second largest asset. With a market capitalization of a whopping $200 billion, Ethereum represents the most important cryptocurrency after Bitcoin. It holds dominion over both DeFi and the NFT market, while successfully attracting developers who seek to build all kinds of dApps.
Ethereum’s fundamentals are great. In fact, they’re better than great. But investors shouldn’t exclusively be interested in fundamentals. Factors such as tokenomics matter as well. And in this article, I’ll teach you everything you need to know about Ethereum tokenomics.
Tokenomics are a science that delve into the structure of a cryptocurrency, its supply, distribution, and yields. It gamifies cryptocurrencies by creating a model around which investors are gathered and are incentivized to use a protocol. This might mean rewarding users when performing certain actions or punishing them when they act maliciously.
Take Bitcoin and it’s 21 million supply for example. Would Bitcoin have worked as a store of value asset if there were 21 billion coins instead? Would it have the value it has today if even the supply was larger than it is? The answer is more than likely not.
You can’t just mint millions of tokens out of nowhere and expect that the tokenomics will work correctly with the protocol. A protocol and its subsequent smart contracts are important, but so are the tokens that allow users to utilize the protocol in the first place.
Tokenomics provide answers to the following questions:
Ethereum itself is a network that features smart contracts. These smart contracts allow developers and users alike to issue a type of transaction that execute tasks once certain conditions are met.
Let’s say I want to send 10 ETH to a buddy of mine in the case that he loses everything inside of his wallet gambling. I’ll create a smart contract that automatically sends 10 ETH from my wallet to my buddy’s address once his wallet is empty.
Smart contracts have various utilities. Their primary utility is to facilitate dApps (decentralized applications) which come in the form of lending protocols, yield farming platforms, decentralized exchanges, and so on.
But for these smart contracts and their transactions to take place miners have to mine and for users to pay fees. Factors such as token emissions, token burning, and token minting have a big impact on the project’s tokenomics and they’re about to change forever.
Ethereum currently faces massive transformation. The network is set to switch from a Proof of Work (PoW) consensus model to a Proof of Stake (PoS) one. These are monumental changes that leave a deep impact on Ethereum’s tokenomics and it’s utility.
To make things simple, I’ll start with the original Ethereum network first.
Ethereum is a Proof of Work network. Much like Bitcoin, it emits new tokens through mining. Miners act as validators who confirm transactions and log transaction blocks onto the blockchain. Miners earn their income from transactions fees.
Users that issue new transactions have to pay the fee. This fee comes in two forms: a base fee and an optional fee.
The base fee is what users pay for miners to embellish it into the blockchain. This fee is burned and disappears forever from the supply.
But if a user wants his transaction to pass faster, he can pay the optional fee. The miner (also called validator) will prioritize the transaction and confirm it faster. The miner takes the optional fee as a reward and keeps it.
Miners also compete to be the ones to mine a transaction block into existence. Each transaction block carries a reward of 2 ETH. Of course, the miner keeps this reward.
The base fee decreases the token supply through burning. The optional fee increases the supply. And lastly, the block reward increases the supply. Because transaction blocks spawn each 15 seconds and mint 2 ETH, the rate at which new tokens enter circulation is much higher than the one exiting it. This means that Ethereum’s token supply is inflationary.
Here is Ethereum’s supply as of the 13th of September 2022:
Ethereum currently emits five million new tokens per year. That’s roughly a 4% increase annually. But if you take into account the token burning (which is dynamic and changes its rate depending on market demand), Ethereum’s inflation reaches a final number of 2.7%.
Ethereum is an inflationary asset as of right now. And because of the laws of supply and demand, an inflationary asset is never good. A stable cryptocurrency used for payment may rightfully own the title of being inflationary, but a speculative asset that represents a stake in crypto’s largest ecosystem cannot.
Inflation is part of the reason why Ethereum is switching to Proof of Stake. And the impact that a PoS network brings is monumental.
The merge is set to occur on September 15h 2022. This is a highly anticipated and important event in which Ethereum will merge two of its networks and transition to the new PoS blockchain.
Proof of Stake is a consensus mechanism that swaps miners with validators. Validators stake a certain number of tokens – in this case 32 ETH – by locking it inside the network. Staking ensures that the network has a high enough amount of crypto locked so that malicious actors can’t perform a 51% attack.
Validators keep their 32 ETH staked and validate new transaction blocks for the network. In return, they receive rewards denominated in ETH proportionally to how much they have staked.
Staking not only tackles security but decentralization as well. It encourages more users to become validators and removes highly expensive mining hardware out of the picture. Staking also drastically reduces energy consumption.
Under Proof of Stake, the issuance rate of new ETH tokens ranges between 0.5% and 1%. The exact rate depends on how much validators they are. The more validators exist the lower the rewards are. And those who act maliciously will have their staked assets forcibly taken and burned.
Deflationary effects are also expected to come from the base fees being burned – a feature introduced via EIP-1559. However, the effects are influenced by demand. The higher the demand, the more tokens the network burns. Staking also influences tokenomics by temporarily removing tokens from the circulating supply.
The Merge brings a mutlitude of positive effects to Ethereum’s tokenomics. EIP-1559 makes it possible for users to burn tokens whenever they pay for gas fees. Staking will remove tokens from the ciruclating supply. And the amount of tokens issued will decrease dramatically as more and more users stake.
Proof of stake impacts both the demand and supply side. It reduces supply growth and transfers incentives to long-term holders who are willing to stake for years. The merge attracts institutional and retail interest by transforming Ethereum’s narrative to a yield-generating one. Lower fees will also attract users who want to use DeFi in their everyday lives.
Combine all the factors mentioned above and you have the perfect recipe for a deflationary asset with high demand. The exact rate at which Ethereum’s tokenomics improve depend on a few factors. But ultimately, the tokenomics will drastically improve.
If you want to learn more about Ethereum, I recommend reading the following articles:
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