How Ethereum’s deflationary model works post-merge
Ethereum’s shift to PoS and transaction fee burning has turned net issuance negative, potentially impacting prices as transaction volume grows.
As Ethereum has moved from Proof of Work (PoW) to Proof of Stake (PoS), block rewards have been reduced. Together with an earlier protocol update which leads to the base fee of transactions being “burned”, i.e., tokens being removed from circulating supply, net issuance of ETH has turned negative.
Given Ethereum’s growing role in the crypto space, this leads to the following questions:
What will happen to the net issuance of Ethereum as Ethereum transaction volume increases?
How will this impact Ethereum’s price?
This article will explore the current trends in net issuance and elaborate on how the recent protocol updates might impact prices.
Key Insights
Ethereum supply has decreased by nearly 170,000 ETH since the Merge on Sept. 16, 2022 turning ETH deflationary at an annualized rate of approx. -0.22%
The current supply is 120M ETH, with approximately ~18.9M staked in ETH 2.0 deposit contract.
With ETH being deflationary and given continuing strong demand, prices might be trended upward in the long-term
Concept
The net issuance of Ethereum refers to the difference between new Ether generated as block rewards and Ether burned through transaction fees. With Ethereum 2.0's daily issuance depending on ETH staked and the token burn mechanism, transaction volume will have a more direct impact on Ethereum's net issuance. As Ethereum transaction volume increases, more gas fees will be consumed, and the base fee will be burned, which reduces the net issuance.
Assuming a 3.8% issuance rewards rate and 19.2M staked, this gives us an issuance of 1,999 ETH/Day or 729,600 ETH/year which is ~0.61% of the supply. Each block targets 15x10^6 gas/block (more on gas). Using this, we can solve for the average gas price (in units of gwei/gas) required to offset issuance, given a total daily ETH issuance of 2,061 ETH
7200 blocks/day * 15x10^6 gas/block * Y gwei/gas * 1 ETH/ 10^9 gwei = 2,061 ETH/day or Y = (2,061 (10^9))/(7200 * 15(10^6)) = (17x10^3)/(72 * 15) = 16 gwei (rounding to only two significant digits)
Another way to rearrange this last step would be to replace 2,061 with a variable X that represents the daily ETH issuance and to simplify the rest to:
Y = (X(10^3)/(7200 * 15)) = X/108
f(X) = X/108 where X is daily ETH issuance, and f(X) represents the gwei/gas price required to offset all of the newly issued ETH.
As the number of transactions increases over time issuance will continue to fall, with issuance falling below 0 and ETH inflation moving into negative territory as we are currently witnessing.
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If X (daily ETH issuance) rises to 3000 based on total ETH staked, f(X) (gwei required to offset all of the issuance) would then be 17 gwei (using 2 significant digits).
The long-term expectation is for Ether inflation to lie between 0.5% and -0.5% whilst retaining and improving security.
After the Ethereum 2.0 merge, which transitions the Ethereum network from Proof of Work (PoW) to Proof of Stake (PoS), the block issuance and burning mechanisms work as follows:
Block Issuance: With Ethereum 2.0 and PoS, new Ether (ETH) is no longer issued through mining, as it was under PoW. Instead, validators are selected to propose and confirm blocks. Validators are required to lock up a certain amount of ETH as a stake, and they receive block rewards and transaction fees for their work. The rewards are determined algorithmically, and they are generally lower than under PoW, which helps control Ether's inflation rate.
Burning Mechanism (EIP-1559): EIP-1559, implemented before the Ethereum 2.0 merge, introduces a "base fee" that changes dynamically according to network congestion. This base fee is burned, effectively removing that amount of Ether from circulation. This burning mechanism is designed to make Ether's supply more deflationary over time, as the base fee helps regulate its issuance.
Post September 2022 merge, the transaction fees on the Ethereum network are determined as follows:
Base Fee: As mentioned above, EIP-1559 introduces a dynamic base fee that adjusts according to network demand. When a block is less than 50% full, the base fee decreases, and when a block is more than 50% full, the base fee increases. This mechanism helps ensure that transaction fees are more predictable and transparent for users.
Priority Fee (or Tip): In addition to the base fee, users can include an optional priority fee (or tip) in their transaction. This is paid directly to the validator proposing the block and acts as an incentive for them to include the transaction in the block. The priority fee is not burned and does not affect the net issuance of Ether.
Maximum Fee: Users can set a maximum fee cap for their transactions. The maximum fee is the sum of the base fee and priority fee. If the base fee increases and the maximum fee is exceeded, the transaction will not be processed. However, if the base fee is lower than the maximum fee, the difference is refunded to the user.
Potential
This shows that Ethereum has a path forward to secure transactions without incurring large internal and external costs. Although it is not possible for the timeline to be specific, the incentives are designed to keep inflation within a target range and not to let Ethereum become too deflationary. Therefore, there may not be a high risk of Ethereum’s price appreciating too quickly due to Ether’s burning mechanism.
Risk
As discussed in earlier reports by Cointelegraph Research, there are several Ethereum competitors. While Ethereum may continue to be in the lead, any investment should consider protocol development proxied by developer activity.
Conclusion
In conclusion, an increase in Ethereum transaction volume might lead to a decrease in net issuance due to Ethereum’s burning mechanism. All else equal, this could have a positive impact on Ethereum's price given simple supply and demand dynamics.
In the Ethereum 2.0 Proof of Stake (PoS) system, the issuance of new Ether depends on the total amount of Ether staked in the network. The more Ether that is staked, the lower the annual issuance rate, and conversely, the less Ether that is staked, the higher the annual issuance rate. This mechanism is designed to encourage more people to stake their Ether and help secure the network.
The relationship between the total amount of Ether staked and the annual issuance is non-linear, and it's subject to diminishing returns. The annual issuance rate percentage decreases as the total staked Ether increases. This design incentivizes more validators to participate in the early stages of staking, with the rate of issuance slowing down as the total staked Ether grows.
The following is an example of how the issuance rate might be affected by the amount of Ether staked (these numbers are not definitive and are subject to change as Ethereum continues to evolve):
If 1 million ETH is staked, the annual issuance rate could be around 18.10%.
If 3 million ETH is staked, the annual issuance rate could be around 10.45%.
If 10 million ETH is staked, the annual issuance rate could be around 5.72%.
If 30 million ETH is staked, the annual issuance rate could be around 3.30%.
If 100 million ETH is staked, the annual issuance rate could be around 1.81%.
These percentages represent the rewards given to validators for participating in the PoS system. The rewards are distributed proportionally to the validators according to their staked Ether. It's important to note that validators also incur some risk, as they can lose a portion of their staked Ether if they behave maliciously or fail to perform their duties correctly.
In summary, ETH issuance in the Ethereum 2.0 PoS system depends on the total amount of staked ETH, with the annual issuance rate decreasing as the total staked Ether increases. This mechanism helps incentivize more validators to participate in securing the network while managing Ether's inflation rate.
This article is for information purposes only and represents neither investment advice nor an investment analysis or an invitation to buy or sell financial instruments. Specifically, the document does not serve as a substitute for individual investment or other advice.
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