Peering Into The Ether

Research May 31, 2022

Key Takeaways

  • Ethereum is poised to make a radical change to its consensus protocol later this year, switching from Proof-of-Work (PoW) to Proof-of-Stake (PoS) – a massive technically challenging undertaking that has been years in the making.
  • Ethereum monetary policy will be greatly impacted. Some ETH fans are anticipating a sharp fall in the circulating supply  over the next decade, which is the basis for the Bitcoin taunting ETH as “Ultra Sound Money” meme.
  • A successful Merge would be price-supportive because it would open ETH up a much broader universe of investors, especially increasingly ESG-conscious institutional investors.
  • Conversely, if the Merge doesn’t go smoothly it will be a disaster and not just for Ethereum. Following the recent Terra/Luna debacle it would undermine confidence more broadly in crypto.
  • The stakes are high (no pun intended).

In a recent article looking into the environmental impact of cryptocurrencies[1] I mentioned that Ethereum, the second largest cryptocurrency by market cap, is slated to make a major operational transition (aka “The Merge”) later this year, when it shifts its consensus protocol from Proof-of-Work (PoW) to Proof-of-Stake (PoS). This switch, which has been pushed back from June to “a few months after” according to Tim Beiko, the Ethereum Merge lead developer, will – assuming it gets made[2] - have substantial implications for ETH and for crypto more broadly.

Six Long Years

There may only be one word difference between the two consensus protocols, but making the change has been a long and complex process. Based on an 2013 article for Bitcoin Magazine, it is clear Ethereum’s creator Vitalik Buterin has been a fan of PoS for many years[3]. However, as Buterin acknowledged in a recent blog post[4], developing a PoS system with robust features is…

“...hard. It took years of research, years of failed experiments, and generally took a huge amount of effort. And the final output was pretty complex.”

Moreover, he argues, validly in my view, that using PoS from the beginning would have been a mistake because PoW was ...

“...helpful in expanding the initial issuance distribution and making Ethereum accessible, as well as encouraging a hobbyist community.”

The Gas Is Always Greener

For many people, even those with only a passing interest in cryptocurrencies, the most obvious impact of the change in Ethereum’s consensus protocol will be the reduction in its energy usage. According to a blog post from the Ethereum Foundation[5], it’s PoS protocol is over 2,000 times more energy efficient than PoW, which in percentage terms equates to an energy saving of 99.95% (worth about 100 TWh of power per year[6]).

Given the increasingly popularity of ESG[7], which together with passive[8] (as opposed to active) and crypto are three investment trends that have been accelerating over the past decade[9], Ethereum’s protocol shift should open it up a much broader universe of investors, especially institutional investors.

It will certainly put it on the radar of some sizeable asset management firms. For example, Black Rock Chairman and CEO Larry Fink in his 2022 shareholder letter[10] stated they were studying digital currencies and their underlying technologies on the back of increasing interest from their clients. Fink is well-known for being a fan of ESG investing, so purchasing cryptocurrencies that use much less energy-intensive protocols than PoW provides Black Rock with a way to respond to their clients’ rising interest in crypto without jeopardising their commitment to ESG. Moreover, because Ethereum is already a large player in the space – accounting for roughly 20% of the overall market cap of cryptocurrencies – it has more attractive liquidity characteristics for the bigger asset management firms like Black Rock than other, smaller, PoS-based cryptocurrencies[11].

Monetary Policy Impacts

While environmental impact of Ethereum’s PoS switch is the most visible, it is not the only one. Ethereum’s monetary policy will also be affected.

When one hears the words “monetary policy” the tendency is to think of central banks, like the Fed, tweaking interest rates to achieve their stated inflation objective (or not as is presently the case). However, in the crypto world monetary policy refers to the supply issuance of the coin in question. It is more akin to money supply targeting frameworks that central banks used before inflation targeting frameworks replaced them from the mid-nineties onwards.

Bitcoin’s monetary policy is, for example, determined by two elements: the pace of blocks being mined and the number of newly minted Bitcoins issued as a reward for mining a block. The parameters defining the issuance schedule are embedded in the Bitcoin code overseen by Bitcoin core. Theoretically, these parameters could be changed. However, an overwhelming consensus in the Bitcoin community would be required to enact such a fundamental change[12]. For all-intents-and-purposes Bitcoin follows a rule-based monetary policy approach[13], wherein the supply of new Bitcoins halves roughly every four years until it asymptotically reaches a 21 million supply cap. At present, this schedule generates an annual supply growth rate for Bitcoin of 1.7% and it will remain at this rate until the next halving event due to take place in 2024.

Unlike Bitcoin, Ethereum does not have a fixed supply schedule rather it pays out a pre-determined reward to miners for mining blocks. At inception the block reward for Ethereum was set at 5 ETH but this was subsequently lowered to 3 ETh, then 2 ETH via two EIPs[14]. According to the EthHub, the block reward is chosen on the basis that it is the “minimum issuance to secure the network”[15] and at present this approximates to an annual supply growth rate of 4.5% (nearly three times greater than Bitcoin’s).

Burn, Baby Burn

Following the implementation of EIP-1559 last year, colloquially known as the London hard-fork, the procedure for reimbursing miners for producing blocks was substantively altered. The 2 ETH block reward was maintained, but the gas fee paid to process transactions over the Ethereum blockchain is no longer paid to miners in its entirety. Gas fees are now split into a base fee and a tip. Only the tip gets paid to the miners, the base fee is burnt, ie it is removed from the supply. Importantly, neither the tip nor the base fee are fixed.

Base fee is dynamically adjusted dependent upon the size of the preceding block relative to a target block size[16] multiplied by a constant factor (1.125)[17]. When blocks are above the target size the base fee is increased and the amount of ETH burned rises. Conversely, when blocks are being created below the target size the base fee is reduced and the amount of ETH burned is reduced. The basic idea behind making the base fee variable is that during times of high transaction demand, block sizes are more likely to be above target and over time the minimum fee for transactions (the base fee) increases to discourage demand and reduce network congestion. Similarly, when demand is low and block sizes are more likely to be below target the minimum fee for transactions is lowered to encourage demand[18].

Tips, in contrast, are simply market-driven rather like the system prior to the implementation of EIP-1559. Ethereum users who wish to have their transactions processed quickly are incentivized to offer a higher tip and those that are less time sensitive are incentivized to offer lower tips.

This change has, rather obviously, had a profound effect on the rate for ETH issuance – the annual rate of supply growth has fallen to 2.6%, with over ETH 2.3m in base fees having been burned since the launch of EIP-1559 (or $4.8bn at current prices)[19].

Annual Supply Growth – Total

Source: Etherscan.io and www.blockchain.com

PoS: Under The Hood

With the shift to PoS, the pace of ETH issuance – it’s monetary policy – will change again. As alluded to by Buterin in his aforementioned quote, the PoS system that Ethereum has coalesced on is certainly complex and understanding it’s impact on issuance is not straight forward[20].

To participate in PoS, Ethereum users must deposit 32 ETH into a deposit contract in order to become a validator[21]. These deposits are locked-up and unavailable for sale. Deposits above 32 ETH do not confer any additional benefits[22] and any less and the validator will not activate[23]. Unlike PoW, where block production is determined by mining difficulty, under PoS, block production times are fixed. The base time unit is called a slot, each lasting 12 seconds, and 32 slots form an epoch, which lasts just over six minutes.

Random selection is used in each slot to pick an active validator, who is responsible for proposing a block containing ETH transactions, and to pick a committee of 128 validators whose votes (attestations) are used to determine the validity of the block being proposed. Dependent upon which role the validator is given – proposer or attestor – they receive rewards once the slot is finalized, which if everything goes as planned occurs after two epochs. Under this set-up it is perfectly possible for Ethereum users with a minimum of 64 ETH to be both the proposer and an attestor within the same slot – something that opens up the prospect for a certain type of malicious attack[24].

Both proposer and attestor rewards are calculated using a base reward which is dependent upon the balances of the validators – typically close to 32 ETH - divided by the square root of the total amount actively staked. Because the denominator is a square root, the base reward and hence the proposer and attestor rewards increase as more ETH is staked, but at a diminishing rate.

The table below, courtesy of Ethhub[25], shows how the annual increase of the supply in ETH will change dependent upon how much ETH is staked. Importantly, these figures represent the upper limit of issuance because PoS also has penalties and slashing in order to foster good behaviour from the validators and these will subtract from the overall amount of issuance.

Ether Issuance After The Merge

Source: Ethhub

Post-Merge Supply

Guestimating how much ETH will get staked after the Merge[26] will obviously depend on many elements including the prevailing level of interest rates available on fiat money, which is the opportunity cost of choosing not to hold fiat money in preference to ETH. The lower the rate of interest on fiat money, the more attractive it will be to stake.(NB: The maximum annual return from staking included in the above table is denominated in ETH. In order to make it directly comparable with the interest rate in fiat money requires an assumption on the ETH/USD exchange rate, specifically what will be it’s price appreciation or deprecation over the staking period.)

As I outlined in a previous piece[27], the macroeconomic backdrop is such that real long-term interest rates in fiat money will have to be negative over a prolonged period, likely implying that nominal, or inflation-adjusted, interest rates will also have to remain moderate. This will serve to boost the relative attractiveness of staking ETH. That said, staking is inherently risky due to lock-in periods and the risk of slashing etc and these serve to reduce the relative attractiveness of staking ETH. On balance, between 10-30 million in staked ETH at the time of the merge seems to be in the right ballpark[28]. This would imply an annual rate of issuance of roughly 0.7%, putting it below the rate of supply increase of Bitcoin (at least until the next halving event).

However, in order to determine how ETH supply overall will change after the Merge we also need to take into consideration the impact of EIP-1559, where the base fee gets burned and removed from the supply[29].

The impact of EIP-1559 depends upon two variables, the amount of transactions over the Ethereum blockchain and the split between tips and the base fee[30]. As can be seen in the chart below, which plots daily network transactions fees, there is a high degree of variability – the range is from 1,000 ETH to over 40,000 ETH. In addition, since the introduction of EIP-1559, the burn rate for transaction fees has averaged 82% (tips account for residual 18% of transaction fees).

Daily Ethereum Network Transaction Fees (ETH)

Source: glassnode.com

For sake of argument let’s assume that 20M ETH is staked (the mid-point of my predicted range) implying PoS annual issuance of 744,000 ETH, and a burn rate of 82%. Under these assumptions, the total supply of ETH would be unchanged around 120 million ETH when daily transaction fees average 2,500 ETH (including transaction tips the staking APR would come in at 7.4%). Based on the above chart, this seems quite plausible.

Ultra Sound Money

Some ETH fans – notably Justin Drake[31] an Ethereum researcher – have been pushing ETH as Ultra Sound Money, a taunt to Bitcoiner’s long standing claim that Bitcoin is sound money.  The basis for their meme is that as a result of EIP-1559, which burns ETH, and the switch to PoS, which lowers ETH issuance, the outstanding supply of ETH will not just be stable, but is likely to decline substantially over the coming years. Indeed, Justin’s “best guess” scenario predicts the outstanding supply will fall from 118.5M ETH currently to 100M ETH in roughly a decade[32].

Such a significant drop in supply has a lot of ETH supporters breathlessly predicting ETH’s price will surge[33], especially as this supply projection is based on 40 million ETH being locked-up in staking, meaning a circulating supply of only 80M ETH and falling.

As anyone who has studied economics will tell you, price is determined by the interaction of supply and demand. The Ultra Sound Money meme does not make much mention of this part of the equation – the implied assumption, common across much crypto analysis, is that deflationary monetary policy always results in higher coin prices. This only holds if there is sufficient and persistent demand. As the recent collapse in the Terra peg[34] only too vividly illustrates, this may not always be true. In the case of Ethereum, the shift to PoS and EIP-1559 both act as demand stimulators.

As mentioned, to participate as a validator in PoS, one must deposit 32 ETH. Currently, this deposit could be generated by mining ETH on the Mainnet and then transferring the coins over to the beacon chain. However, once the merge occurs, anyone wishing to become a validator will have to purchase ETH off someone else as there will be no other means to get hold of ETH (new issuance only gets distributed to existing active validators[35]).

Regards EIP-1559, one consequence of burning the base fee is that transactions can only be paid for with ETH, unlike currently where it is (theoretically) possible to pay miners in non-ETH cryptocurrencies for including transactions in the block. In effect, it confirms ETH as the native currency of the Ethereum blockchain, which as David Hoffman of the Bankless podcast[36] astutely noted is ...

“...comparable to a nation-state demanding that only their native currency be legal tender.”

So, as long as people wish to use the Ethereum blockchain for financial transactions, creating ERC-20 tokens, minting NFTs or deploying dApps (including Defi dApps) then ongoing demand for ETH is assured by EIP-1559 and the Merge.

Sharding

A further impact from the Merge is on Ethereum’s ability to scale, something that has plagued Bitcoin. To understand why we need to consider the blockchain trilemma - see chart below.

The Blockchain Trilemma

Source: A Survey of Distributed Consensus Protocols for Blockchain

Networks working paper[37]

For those unfamiliar with this concept, it is the widely held belief that there is an unavoidable trade-off between centralization, security and scalability. While all three are desirable, according to the trilemma it is only possible to achieve two of these objectives at any given time. For example, because every node within the Bitcoin network has to process every transaction, Bitcoin is secure and decentralized but it doesn’t scale well – only seven transactions per second can be processed. Matching transaction volumes of Visa (thousands of transactions per second) is infeasible, hence all the work being done to establish the layer 2 Lightning Network, where payment channels are opened allowing off-chain transactions that are only occasionally settled on-chain.

At present Ethereum’s Mainnet can only handle around 13 transactions per second. Sharding will lead to the creation of 64 shard chains which will run in parallel with the main Beacon chain. Transactional bandwidth would increase 100X. The change to PoS is what makes sharding feasible.

Under PoW miners decide on which blockchain they wish to mine. Hence, splitting the blockchain into 64 parts, lowers the majority hash power threshold by 64X. Attacking the network may no longer be cost-prohibitive - as per the trilemma, security would be compromised.

In PoS, at least the version Ethereum is running, validators do not get to choose which shard they work on[38] because they are randomly selected. As long as there is sufficient decentralization in the set of validators, conducting a 51% attack (ETH holdings as opposed to hash power) becomes extremely difficult. PoS, therefore, weakens the blockchain trilemma by allowing increased scalability without sacrificing security.

So Far, So Good

Obviously, there are numerous benefits from the Merge, as discussed. However, there are of course downsides. One of the greatest weaknesses of the PoS protocol is that it is much more complex than PoW. Not only does this underline what a monumental challenge the Merge is from a technical perspective, but even if successfully completed, it leaves a much greater attack surface. Indeed, even Justin Drake of Ultra Sound Money meme fame, acknowledges as much[39]. To wit,

“There’s a variety of attacks that Ethereum could be subject to post-merge: proposer DDoS, fork choice attacks, randomness bias, 0-day exploits on clients. The scary thing is that MEV incentivises these attacks so we need to stay vigilant.”

Another major criticism of PoS, a general critique not restricted to Ethereum, is that it is a plutocratic system. Staking rewards are, over a long enough time interval to smooth out the impact from the random selection processes, the same for each validator. But, because those with large initial holdings of ETH are able to run multiple validators, those with the greatest number of validators will accrue the most rewards. This effect is compounded because, unlike PoW, which strongly incentivizes miners to sell their coins in order to pay for the costs of mining (rig depreciation and electricity), under PoS the marginal cost of producing blocks is near zero. There is, in other words, much less incentive to sell – this lack of selling pressure is what powers the Ultra Sound Money meme – hindering broader coin distribution[40].

This is not the only criticism that flows from the fact that under PoS ETH issuance only gets distributed to existing active validators. Once the Merge is complete, the only way those without ETH will be able to get ETH is by buying it from existing holders willing to sell. This makes it, in some sense, a permissioned blockchain because ETH holders have the ability, in theory, to block a person, nation-state or other entity from purchasing ETH and therefore gaining accessing to the validator pool.

The final criticism relates to the subjectivity inherent in PoS blockchains. In PoW consensus protocols users can objectively determine the canonical chain because it is the longest one with the most cumulative work – energy that has been consumed and paid for by miners. Creating a branch whose length is at least as long of that of the main chain would be prohibitively expensive and not worth the effort - the hash power would be more effectively deployed mining new blocks in return for block rewards.

PoS does not have this objectivity because selecting the correct chain from multiple forks is done by counting historical votes. In order to stop long-range attacks, where nodes maintain an alternative (undisclosed) fork that gets published later to their advantage, Ethereum introduces checkpoints, which are fixed every two epochs. Blocks created prior to a checkpoint cannot be altered.

For nodes that are always online, there is no difficulty in identifying the canonical chain because it rejects blocks that conflict with the checkpoints that it has been observing. The problem arises when a node has been offline for an extended period of time: where does this rejoining node retrieve historic checkpoints? It has to sync them from a trusted source. Bitcoin was created to remove, or minimize, trust but under PoS it gets reintroduced. Ethereum proponents argue that the risk is minimal because checkpoints can be requested from multiple nodes reducing the likelihood of collusion amongst online nodes. They may well be right, but no one will know for sure until after the Merge takes place.

Make Or Break

The Merge[41] is a massive, technically challenging, undertaking that has been years in development. All the testing so far carried out points to it succeeding, but as it has never been attempted on such a grand scale before it is not certain all will go smoothly. It is quite conceivable that nefarious actors attempt to attack Ethereum at this critical juncture either for financial gain (rewards coming from short ETH contracts) or simply for the Lulz.

Crypto is, as I discussed in the recent article looking at the implications of increasing regulation[42], on the threshold of jumping the chasm and going “mainstream”. A botched Merge would greatly jeopardise this transition - it’s the last thing the crypto community needs after all the recent negative press surrounding the Terra/Luna debacle.

Conversely, a successful Merge is likely constitute another catalyzing force towards wider crypto adoption. Certainly, it will help to remove one of the stigmas that have plagued cryptocurrencies – their environmental impact. And, because Ethereum is such a large player in the crypto space, it would be a rather obvious first-choice for institutional investors seeking to offer their clients a way to gain exposure simultaneously to two of the most prominent investment themes over recent years: crypto and ESG[43].

The stakes are high (no pun intended).

Until next time.

Ryan Shea, Crypto Economist


[1]           See: https://blog.trakx.io/crypto-power-plays/

[2]           The switch to PoS has been a few months ago for years. The latest estimate on the Ethereum website is Q3/Q4 2022 – see: https://ethereum.org/en/upgrades/merge/

[3]           See: https://bitcoinmagazine.com/culture/what-proof-of-stake-is-and-why-it-matters-1377531463

[4]           See: https://vitalik.ca/general/2022/03/29/road.html

[5]           See: https://blog.ethereum.org/2021/05/18/country-power-no-more/

[6]           For reasons outlined in the aforementioned article I am not a major fan of Digiconomist’s energy consumption stats for Bitcoin but in the absence of alternatives for Ethereum I used his estimates – see: https://digiconomist.net/ethereum-energy-consumption/

[7]           For anyone recently returned to earth from outer space, ESG stands for environmental, social and governance.

[8]           Think ETFs.

[9]           Forgive me a little plug, but Trakx already operates at the nexus of crypto and passive and with the soon-to-be introduced ESG crypto index we will be able to offer clients an investible way to get exposure to all three trends in a single product – watch this space.

[10]         See: https://www.blackrock.com/corporate/investor-relations/larry-fink-chairmans-letter

[11]         After the merge, Ethereum will be by far the largest PoS coin with a market cap over 10X its nearest rivals Cardano  and Solana and over 100X the other leading PoS coins – see: https://coinmarketcap.com/view/pos/

[12]         Code changes that do not have near unanimous support simply leads to the creation of a new coin hard-forked from the Bitcoin blockchain.

[13]         In contrast to the discretionary policy rules followed by inflation-targetting central banks, which is the almost universally accepted modus operandi in the fiat system.

[14]         Known as the Byzantium and Constantinople hard forks – see: https://ethereum.org/en/history/#byzantium and https://ethereum.org/en/history/#constantinople

[15]         EIP stands for Ethereum Improvement Protocols, analogous to BIP in Bitcoin – see: https://docs.ethhub.io/ethereum-basics/monetary-policy/

[16]         The target block size is 15M gas and the max block size is set at 30M gas (refer to footnote below for more details).

[17]         For more details – see: https://timroughgarden.org/papers/eip1559.pdf

[18]         Because the base fee is burned this variability mechanism may be problematic, something I will cover later on in the article.

[19]         For real-time data see - https://watchtheburn.com/

[20]         I recommend taking a deep breath at this point because even though I have done my best to simplify things it still takes some working through.

[21]         For those with insufficient funds to reach the 32 ETH threshold pooling options are available. The most popular is Lido which offers users “Liquid” Ethereum staking - see: https://lido.fi/

[22]         Holders of more than 32ETH are able, and indeed incentivized, to run multiple validators.

[23]         Validators do not become active immediately after depositing 32ETH. Delays are added to ensure finality of the deposit transaction and then they must wait for a slot to become available as there are limits as to how many validators are activated every finalized epoch on the Beacon chain – see: https://docs.prylabs.network/docs/how-prysm-works/validator-lifecycle/

[24]         See: https://arxiv.org/abs/2110.10086

[25]         See footnote 12 above.

[26]         According to ethhub, for phase one, when shard chains are deployed, over 262,000 validators will be required, which given the 32ETH per validator deposit requirement implies the total amount of ETH staked must be around 8.4 million ETH- see: https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/eth-2.0-economics/

[27]         See: https://blog.trakx.io/fed-fears/

[28]         Since the beacon chain was first launched in December 2020 the amount of staking has been steadily rising and currently stands at 12.3M ETH from 384,077 validators – see:  https://ethereum.org/en/staking/

[29]         Please do not get confused between base fee, which is part of the transaction fee and base reward, which is part of the staking return.

[30]         See footnote 15 above for the most recent burn/tip data.

[31]         See: https://twitter.com/drakefjustin?ref_src=twsrc%5Egoogle%7Ctwcamp%5Eserp%7Ctwgr%5Eauthor

[32]         This drop in ETH issuance is also known as the triple-halving event. Justin has published a spreadsheet detailing his assumptions and the resulting impact on issuance - see: https://docs.google.com/spreadsheets/d/1vrK5sY5ooq-F8dcyRhmmAJ5YtgkvWKWP3OfGCZIYxSA/edit#gid=0

[33]         “Number Go Up” psychology.

[34]         I covered the Terra peg collapse in my previous article - see: https://blog.trakx.io/crypto-carnage/

[35]         This change in the way ETH will get distributed post-merge is often mentioned by the critics – see below.

[36]         See: https://podcast.banklesshq.com/

[37]         See: https://arxiv.org/abs/1904.04098

[38]         Randomness also ensures that validators do not know what shard they will be selected for and hence cannot collude with other validators ahead of time.

[39]         See: https://cryptostaker.com/interview-justin-drake-ethereum/

[40]         Not so good for the S element of ESG, but it is likely to be dwarfed in the minds of investors by the huge improvement in E.

[41]         Assuming all goes well, the rolling out of sharding will be the next major event and it is known as the Surge. This will be followed by the Verge (Verkle trees rolled out), the Purge (removing historical data and technical debt) and the the Splurge (residual stuff!). Lovely linguistics that any marketing company would be proud of!

[42]         See: https://blog.trakx.io/roadmap-to-utopia/

[43]         Trakx will soon be releasing a green ESG crypto index. Please contact us for more details.

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io