If you’re new to crypto and wondering what gives a token value, it’s incredibly helpful to understand its “tokenomics” or “cryptoeconomics,” which is the system of incentives that gets unaffiliated entities to offer the goods and services needed in that decentralized crypto network.
I explained earlier the cryptoeconomics of Bitcoin, and now I’ll explain the same for Ethereum, the second-biggest crypto network.
Like Bitcoin, one of the purposes of Ethereum’s tokenomics was to secure the network. For that reason, it had a similar setup: miners would mine for newly minted ether, which would incentivize computers to mine ether, thus adding more security to Ethereum.
However, Ethereum’s cofounders did not face the same conundrum Bitcoin’s creator did: by the time Ethereum came out, many people wanted a piece of the pie. Even though many people were still skeptical of cryptocurrencies, by that point, there was a large enough number of people interested, that Ethereum actually had a different problem: people wanting an unfair size of the pie. (You can read more about this in my book, The Cryptopians.)
Ethereum did not need a supply cap to motivate people to participate in Ethereum, the way Satoshi did. And in fact, there has never been a maximum cap on the eventual total number of ethers. However, due to its current monetary policy, the supply could very well peak at a certain number and then actually decrease from there. Here’s why.
The Most Recent Change to Ethereum’s Monetary Policy: EIP-1559
Ethereum has always had uncapped issuance, and the amount issued with the block reward has been changed a few times through Ethereum’s rough-consensus governance process, which takes place via Ethereum Improvement Proposals (EIPs). Once, in 2017, the reward was cut from its original 5 ETH to 3, and then in 2019, from 3 ETH to 2.
In August 2021, Ethereum adopted EIP-1559 to improve the user experience of sending transactions. However, in order to make EIP-1559 cryptoeconomically secure against attackers, it is required for a portion of a user’s transaction cost to be burnt. This burn mechanism more closely couples the usage of Ethereum to the value of ether. As more people use the Ethereum network, more ETH is burned, which makes the remaining ether more scarce and more valuable.
Originally, when you transacted on Ethereum, you had to pay a transaction fee in what was essentially an auction. The problem was that people had to guess at the amount to pay, although most wallets would estimate for you what amount would be necessary to get a transaction executed by the miners. People would sometimes pay higher amounts to be sure their transaction would be executed first, but it wasn’t clear exactly how much more was necessary (though again, wallets would estimate for you), so sometimes people wildly overpaid, while others didn’t pay enough extra and so didn’t have their transactions executed as quickly as they would have liked.
Now, everyone pays the same base fee per block, no matter whether you want your transaction to go in the next block or you’d be cool with it executing sometime that day. (However, from block to block, the cost of the base fee is variable, and the system will adjust it up or down, aiming to keep blocks half full, making it possible for Ethereum to briefly produce extra-large blocks to increase network capacity in periods of high network usage.)
Now, here’s what could have a big effect on the price of ETH: that base fee is no longer sent directly to the miners. Instead it’s burned, meaning it’s sent to an address from which it cannot ever be retrieved. This takes all that ETH out of circulation permanently.
When you execute a transaction, on top of the base fee, you also pay what is called a ”priority fee,” which you can think of like a tip. This is what you can use if you’d like to incentivize the miners to include your transaction more quickly.
Instead of this money being burned, it goes to the miner, along with the block reward of newly issued ether.
Why Sometimes More ETH Is Burned Than Issued Per Block
At this moment, here are the factors that determine Ethereum’s new issuance: 1) the block reward, 2) the base fees, which are now burned and 3) usage on the network at any given moment. Each block results in new ETH being minted, plus in some amount of ETH being destroyed. How much gets burned is determined by how busy the network is. And since its adoption in August, EIP-1559 has resulted in not only specific blocks having a net negative issuance, but even full days and one week.
For instance, The Block reported that September 3, 2021, was the first day in which the number of ETH burned (13,840) surpassed the number of ETH minted (13,507), while at the end of October, Evan Van Ness, founder of Week in ETH News, captured a week of net negative issuance. The website ultrasound.money reports that more than one million ETH has so far been burned.
What has so far driven a lot of burning of ETH since EIP-1559 was implemented has been NFTs, which cause massive spikes of usage on the network, driving up the base fee, which in turn, boosts the number of ETH being burned per block. Indeed, the “burn leaderboard” on ultrasound.money shows that NFT platform OpenSea is responsible for the greatest amount of ETH burned, at 115,000 ETH vs. 103,000 for basic ETH transfers.
As you can see, at times, ETH is now deflationary, though at the moment, these tend to be for certain periods of time. Overall, net issuance has decreased by about two thirds since EIP-1559 went live.
Why the Merge Will Likely Make ETH Deflationary
An event on the horizon that could drive ETH further, and more permanently into a deflationary state is what is called the “merge” to Ethereum 2.0, or ETH2. Ethereum 2.0 is an upgrade of the network that will shift Ethereum from a proof-of-work blockchain to a proof-of-stake one, in which security from the network will not come from using electricity by performing mathematical calculations but by each validator (equivalent to a miner) locking up a certain amount of coins (32 ETH minimum) for a certain time period. At that point, the threat of a 51% attack via hardware and electricity will be eliminated entirely and attacks will instead use large amounts of staked ETH.
Ethereum already began the transition to Ethereum 2.0 a year ago when it launched just a proof-of-stake chain, called the beacon chain, with no economic activity on it. Already, more than 260,000 validators have staked more than 8.4 million ETH, according to Beaconcha.in.
However, in the first half of 2022, Ethereum will finalize the upgrade and swap out the proof-of-work consensus mechanism supporting all the economic activity on Ethereum to a proof-of-stake one. At that time, issuance will also drop. Although the exact rate of new issuance won’t be known until that time, community estimates expect issuance to be slashed by 90%, which is equivalent to three bitcoin halvings (which would normally occur over a period of 12 years).
Combine that with the current burnings of the base fee that are occurring, ETH will likely end up with net negative issuance.
A simulation on ultrasound.money projects that, if usage of Ethereum continues at the current rate, then 3.3 million ETH a year will be burned while only 500,000 new ETH will be issued, making ETH deflationary by 2.4% a year.
Justin Drake, an Ethereum researcher and one of the architects of this new system, projects that the supply of ETH will peak at around 120 million and then become deflationary from there.
While all this should help push up the price of ETH, as Viktor Bunin, protocol specialist at Coinbase, said on my podcast recently, that could have the negative effect of making people hesitant to spend ETH (in the way that people resist spending bitcoin on coffee, which might eventually, years on, be a $200 cup of coffee). So we’ll have to see how this new cryptoeconomics system for Ethereum plays out after the merge.
Thanks to Viktor Bunin for providing feedback on this article.