The Economics of Eth2

An investor at an endowment recently said to me “I believe in BTC as digital gold, but I don’t understand what gives ETH long term value? Unlike a business, there’s no underlying cash flow. Throughout history when an asset is worth billions of dollars in total market cap with no fundamentals underlying it, it eventually crashes. This must be the likely outcome for ETH.”

Many traditional investors share that sentiment. They now believe the investment case for BTC but they don’t understand the ETH investment case. Unlike BTC, which has a simple monetary policy that will not change and a clear store of value narrative (digital gold), ETH has a confusing monetary policy that will change and an ambiguous store of value narrative.

With the upcoming launch of eth2, that could change. The technology upgrades that come with eth2 (see Danny Ryan’s recent post) are exciting and tend to get most of the attention, but the economic upgrades may be more impactful.

Economic upgrade #1: Solidify the monetary policy

A novel feature of cryptocurrencies is that there is no central bank that can change the monetary policy on a whim. Many central banks globally have increased the money supply to the detriment of citizens (see Lebanon most recently). The BTC community has a culture of keeping the protocol the same, which has allowed it to build trust in its monetary policy, designed first and foremost to maintain digital scarcity.

Ethereum differentiated from Bitcoin early on with its culture of innovation, led by a known founder (Vitalik) with influence in the community. Some early protocol changes have led some to believe that the monetary policy could be easily changed based on the whims of a few people. The DAO hard fork was the most widely publicized protocol change, but there have been two other hard forks that adjusted the block rewards since the Ethereum genesis block on July 30th, 2015.

The reality is that Ethereum governance today is much closer to Bitcoin than most recognize. The plan is to change the monetary policy once more upon the launch of eth2 (details below). Once eth2 goes to mainnet, the likelihood of the monetary policy changing again is similar to the likelihood of the BTC monetary policy changing. It’s possible for both, but unlikely and dependent on a consensus approval from developers, miners and users.

Economic upgrade #2: Reduce the issuance rate

At the time of the genesis block, 72M ETH was distributed to initial contributors. Since genesis, 39.2M ETH has been distributed to ETH miners via a proof-of-work (PoW) consensus mechanism similar to that of Bitcoin. ETH inflation with PoW has been roughly 11.20% per year since July 2015, roughly double BTC’s inflation of 5.58% per year over the same time period.

With Eth2, the consensus will change from PoW to proof-of-stake (PoS) and the issuance will be significantly reduced. The theoretical maximum issuance that will be triggered upon launch of phase 0 is 2M ETH/year. This means that ETH inflation will drop from 4.5% over the past year to a maximum of 1.80% in the first full year of eth2. With conservative assumptions about the number of validators, total ETH staked and transaction fees, it’s likely that inflation will be well below that (details below).

It’s widely known within the crypto community that Bitcoin’s current inflation rate of ~1.8% compares favorably to the inflation rate of a basket of global fiat currencies of ~2.99%. What’s less well known is that when eth2 launches, the inflation rate of ETH will compare favorably to the inflation rate of BTC.

Economic upgrade #3: Burn transaction fees, which could cause the inflation rate to approach 0 much sooner than 2140

Currently, ETH miners capture all of the fees associated with Ethereum network transactions. This transaction activity is growing rapidly and in the past year, miners earned ~259,823 ETH ($59.7M) in fees.

With EIP 1559, the bulk of transaction fees will be burnt rather than being paid directly to miners. This means that net inflation could be negative if transaction fees burnt exceed new issuance. See here for a detailed economic model on what net inflation in eth2 will look like given assumptions about PoS participation and transaction activity.

The Bitcoin inflation rate will famously reach 0% in 120 years from now, in the year 2140 when total supply reaches 21M. Having a monetary policy baked into the code is what gives BTC holders such conviction about the digital scarcity of BTC. No such policy is set in stone for ETH, which has led to less belief in the digital scarcity of ETH. But when people look closely at the new policy once it is set in stone, they may recognize that ETH is much more scarce than widely understood.

ETH’s Evolving Investment Narrative

It’s commonly believed that BTC best exhibits the 7 properties (scarcity, durability, divisibility, portability, fungibility, recognizability and programmability) needed for a cryptocurrency to be a good asset for storing and transferring value. ETH currently has 6 of the 7 and is shining especially bright in terms of programmability, the property that sets cryptocurrencies apart from fiat currencies and gold.

The one property ETH has lacked to date is the perception of scarcity, which has muddled the investment narrative. This is reflected by the fact that despite leading the industry in terms of innovation and having the most transaction activity, ETH has a total market value that is ~15% of the BTC total market value. The upgrades described above are not set in stone and until the code is committed by developers and approved by miners and users it’s just hearsay. But if the changes are soon made as described, the ETH investment narrative may begin to resonate more with traditional investors.

Disclosure: 1confirmation owns ETH .This is for informational purposes only and is in no way promoting ETH as an investment. In fact, you should not buy ETH unless you’re able to spend significant time understanding the complexity of the Ethereum Network and contributing to the ETH ecosystem.

The Economics of Eth2 was originally published in The Control on Medium, where people are continuing the conversation by highlighting and responding to this story.

—Source link—

What do you think?

A Superior Financial System Placeholder

Governance Polls: Monthly MIPs, Add KNC & ZRX as Collateral Types, Appoint Oracles, and more