The economic engine of Ethereum
Bitcoin is extreme at optimizing very specific parts of its crypto-economic system. BTC the asset is prioritized above all other components. Bitcoin is designed to preserve the 21 Million hard cap supply of BTC, and everything else is a means to produce this end. From the perspective of a holistic, integrated system design of both an economic engine and monetary fuel, Bitcoin has sacrificed the efficiency of its engine to produce scarcity in the asset.
But crypto-economic systems are composed systems, and as with all technological innovations, there have been 12 years of crypto-economic research and development to leverage. Leveraging these advances in crypto-economics means that we can elaborate and explore narratives beyong a ‘Gold 2.0’ and move into mind-bending sci-fi economics using optimizations in both cryptography and digital economies.
The big deal that is Proof of Stake
Proof of Stake is an alternative to Proof of Work that leverages the value of the native asset of a crypto-economic system to provide security to the economy. Bitcoin Proof-of-Work secures itself via a competition in resource consumption, and forces potential attackers to match and surpass the rate of economic consumption to attack the network. Ethereum Proof-of-Stake secures the system by erecting a ‘wall-of-value’ that a potential attacker must overcome in order to attack the system.
Currently, there is 3,618,200 ETH ($6.7B) staked to the Ethereum beacon chain (the early foundation for Ethereum 2.0). An attacker must stake an equivalent amount of value to attack Ethereum, denominated in ETH. If an interested party wants to attack Ethereum, they will need to source 3,618,200 ETH in order to do so. $6.7B of buying pressure on ETH the asset is likely to significantly increase the price of ETH, so the US-Dollar value of Ethereum security is actually likely much higher.
What’s more important, however, is that Proof of Stake systems do not consume economic resources. All that is needed to secure Ethereum under PoS is a Raspberry Pi, an internet connection, and 32 ETH. Stakers are not required to sell their ETH rewards to pay for the economic costs of providing security. The ‘economic costs’ of Ethereum are the opportunity costs of holding ETH. Proof of Stake operates on the assumption that there is a sufficient supply of interested parties who will hold ETH in order to access ETH-denominated rewards.
Naturally, the disposition of people who are particularly suited to do this are those who are bullish ETH. People who are bullish ETH always want more and more ETH. These people will both purchase ETH off the secondary market in order to stake it, and keep the ETH dividends that they receive. Those who are fundamentally the most bullish on ETH the asset are also those that are willing to accept the least amount of ETH rewards as compensation for locking up their capital in ETH to stake to Ethereum.
Proof of Stake rewards increase or decrease as a function of the supply of ETH being staked to Ethereum. If there is less ETH staked, ETH rewards are higher and vice versa. As more and more validators stake ETH to Ethereum, the ETH-denominated rewards are reduced. This process will wash out the lesser-ETH bulls who are less interested in reduced rewards, leaving those who are willing to receive the least amount of ETH possible. Through this mechanism, Ethereum organically discovers the optimal balance between Ethereum security and ETH issuance.
This mechanism leverages control-theory to optimize for sufficient Ethereum security, while maximally retaining ETH scarcity. Additionally, this mechanism tilts the axis of power towards those who are the most bullish on the economic asset that powers the Ethereum economy: ETH. ETH holders are the individuals who are most interested in Ethereum’s health and success, and Ethereum perpetually rewards these individuals with the asset they love the most: ETH.
This is how Proof of Stake erects the highest walls around its economy, while specifically compensating the party of people who are the most inclined to uphold the network, for the cheapest cost. As a result of this mechanism, Ethereum needs to issue the least amount of new currency to provide adequate security for Ethereum. Once Proof of Stake is adopted and the Proof of Work system is forked away, yearly ETH issuance drops from ~4.75M ETH to a projected 0.6-1M issuance with staked ETH projected between 10M and 30M.
Burn baby burn 🔥
Ethereum has mechanisms for capturing the economic excesses of the Ethereum economy, and funneling these excesses back into the value of ETH. EIP1559 formally links the economic power behind the Ethereum economy with the value of the ETH currency.
BASEFEE is paid by economic actors on Ethereum to get a transaction included on the Ethereum ledger. The size of BASEFEE is determined by the demand to get a transaction included. If there is significant demand to transact on Ethereum, BASEFEE moves upwards. BASEFEE operates as a governor over Ethereum’s economy. If the economy gets hot, BASEFEE increases; if Ethereum’s economy cools down, BASEFEE decreases. -> BASEFEE is burnt.
Unlike Bitcoin and other non-EIP1559 crypto-economic systems, Ethereum’s transaction fees aren’t paid to those that provided security. They are simply removed from supply, effectively returning the value of the burned units back into the remainder of the circulating supply. This is the exact opposite of issuance, where the minting of new coin is borrowing monetary power from the circulating supply. EIP1559 makes the flow of power go in reverse: value flows from the excesses of the economic engine into the economic unit. All systems generate heat loss, but EIP1559 is a heat-recycling mechanism that recaptures Ethereum’s economic excesses.
BASEFEE is the crypto-economic analogue to Central Bank interest rates; it goes up when the economy heats up, and it falls when the economy cools down. It adds value back to the balance sheet of the holistic economic system. This is restoring power back to the economic unit. BASEFEE is a persistent buyer of ETH. It is a ‘stock buy-back’ of company equity. It is the central bank charging interest rates, to add strength to the currency. Every single transaction on the Ethereum economy is adding power into its monetary asset, ETH. This mechanism benefits all ETH holders equally, as all ETH holders have a higher percentage of remaining ETH supply. As a monetary unit, EIP1559 makes ETH a more compelling money to hold. EIP1559 is a mechanism that associates economic output to economic unit scarcity. ETH gets more scarce as Ethereum’s economy produces economic output. As we discussed above, sound money is money that tracks the economic output of an economy.
Growth in the economic output of an economy charges the monetary unit with economic power. If the GDP of an economy doubles, and the supply of money stays the same, the power-output of money should have also doubled. With EIP1559 and the burning of BASEFEE, the supply of ETH reduces as a function of the growth of the Ethereum economy. This is the new paradigm specifically enabled by crypto-economics. This is the difference between trying to recreate ‘stone-age’ economics (gold 2.0), and the creation of something brand new, using new tools.
Sound money is money that grows in scarcity as a function of the growth in the size of the economy that uses it. But what is money that receives outsized tailwinds from economic growth? Importantly, the more power lies behind ETH the asset, the less ETH is needed to be issued to fund economic security, as one economic unit of ETH goes further as a reward for providing security.
The rate at which BASEFEE will burn ETH won’t truly be known until it is implemented; test-nets and economic models only go so far. But the Ethereum researchers estimate that BASEFEE will burn 50-70% of Ethereum’s current fees (50-70% estimation from a conversation with Ethereum core devs). There are reasons as to why EIP1559 doesn’t burn 100%.
According to CoinMetrics, the 200-day moving average for ETH fees paid to Ethereum is ~10k ETH per day (March 2021). If EIP1559 were to be implemented right now, the yearly ETH burn rate would be projected to be about 2.2M ETH (60% burn rate, 10k ETH paid in daily fees).
The ETH burn rate is strongly correlated to the total economic activity that is hosted on Ethereum. Ethereum fees have never found any sort of equilibrium; there is no ‘normal’ fee level. Future fee magnitude is highly unpredictable.
Critics of Ethereum will point towards Ethereum’s current state of highly speculative, yield-chasing, gambling-esque behavior and claim that Ethereum fees are only sustained by a greater-fools game.
Those bullish on Ethereum will rattle off a seemingly endless list of possible economic activities that Ethereum is uniquely suited for, as mechanisms for long-term sustainable fee demand.
Ultra Sound Money 🔊🦇
Ultra Sound Money refers to the compounding synergies created from EIP1559 and Proof of Stake.
EIP1559 puts perpetual buy-pressure on ETH from the fee revenue it generates from its native economy. In contrast to the federal reserve being the ‘lender of last resort’ for the USD, Ethereum is the ‘primary buyer’ of its own native currency, and it uses all of its excess revenues to buy-and-burn ETH from the circulating supply. Simultaneously, Proof of Stake inherently rewards the smallest viable cohort of ETH bulls who are willing to accept the least amount of ETH rewards possible while providing adequate Ethereum security.
The power of these components are multiplicative. They are a function of each other; a recursive relationship between the power behind one function feeding into the others. With Proof of Stake, yearly ETH issuance is under 1% (~25% ETH staked). ETH issuance drops from 4.75M ETH per year (4.5% monetary base inflation) to between 0.5M ETH and 1.2M ETH per year (~0.5-1% monetary base inflation). With EIP1559, yearly ETH burn is at 1.9%, an estimated ~1M ETH will be burnt in fees (at current fee markets, assuming 60% fee burn). All of these factors feed into each other and make each other stronger, creating a positive feedback loop into the value of ETH.
This positive feedback loop is furthered by the fact that ETH is the most trustless asset on Ethereum. As the native asset on Ethereum, ETH has favorable risk parameters as collateral on DeFi. There is no matching ETH’s level of trustlessness, as all other assets on Ethereum were issued by humans (who are folly) or code (which can be buggy).
We can see this in applications like MakerDAO, Aave, or Compound, who give favorable interest rates and collateralization ratios to ETH collateral, enabling ETH capital to be more efficient than alternative assets. We also see this in applications like Uniswap or Sushiswap, where ETH is the dominant trading asset. Total Uniswap liquidity is $5B as of March 2021, and ETH represents $2.1B of this total supply of liquidity. The second most liquid asset on Uniswap is USDC, sitting at $350M. We also see this in applications like RAI, which attempts to make a self-referential, governance-eliminated, non-USD stable collateral, which logically can only use ETH to back it, due to the design-goal of eliminating human governance.
ETH’s privileged position as pristine collateral in DeFi applications will add to the scarcity tailwinds to the supply of ETH; an additional source of power that feeds into the monetary energy behind ETH. The 12 years of crypto-economic advances made since the introduction of Bitcoin in 2009 are coming to a head with Ethereum and Ether. With the integration of EIP1559 and Proof of Stake, along with a native economic layer on the internet, Ether is will be the most economically optimized asset that humanity has ever come up with.
A new era of economic efficiency and monetary soundness will be unlocked, and will assist humans everywhere to more effectively achieve their economic goals and aspirations.
With the Ultra Sound Money putting power into our engine, a new age of human coordination and flourishing is upon us!