22.05.2024
In this article, we will examine ethereum's inflationary and deflationary mechanics, the impact of the Dencun upgrade, and the arguments supporting the case for controlled positive inflation in the Ethereum ecosystem.
Ethereum is a blockchain network that has revolutionized our conception of decentralized applications and digital assets. Its influence has transcended the crypto ecosystem and now challenges the traditional finance environment. Its transition from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism marked a significant milestone, promising enhanced scalability, energy efficiency, and security.
Nevertheless, this transition and the recent Dencun upgrade have also ignited discussions about Ethereum's monetary policy and its implications for the protocol's inflation.
In the crypto ecosystem, inflation refers to the increase in the supply of a digital asset over time; deflation tends to burn tokens out of the supply. While often viewed as a way to control fluctuation, inflation and deflation play a crucial role in the liquidity and sustainability of a blockchain network.
I. Understanding the Dencun upgrade.
The Dencun upgrade, properly a hard fork, combines the Cancun and Deneb enhancements and represents a major leap forward for Ethereum.
Ethereum has utilized Layer 2 (L2) solutions to ease the financial burden of transactions for users. However, L2, while effective in reducing transaction fees, does not address the fundamental issues of the Ethereum blockchain itself. L2s employ a data management mechanism that is not practical for Ethereum. Specifically, L2s utilize calldata, which stores a limited amount of transaction data on-chain. This approach strains the validators due to the requirement for permanently retaining the data. The Dencun upgrade aims to improve ethereum’s scalability and drive widespread adoption. In order to drive the network to more scalable solutions, the upgrade introduces proto-danksharding (EIP-4844), an innovative scaling technique that temporarily stores large data amounts ("blobs") outside the main blockchain, significantly increasing network throughput without compromising security. This upgraded rollup transaction storage method reduces the data load on ethereum nodes, mitigating network congestion, enhancing network efficiency, and lowering gas prices.
Source: Glassnode
The Dencun upgrade reduced transaction fees and increased throughput on the ethereum network. Nevertheless, this reduction has impacted ethereum’s deflationary status as well. As the figure above shows, gas prices have fallen since the upgrade, and, as we will see in the next section, lower gas fees mean less ethereum is burned.
II. Ethereum's inflationary dynamics.
Ethereum's monetary policy is a complex and evolving system, especially when compared to bitcoin. Traditionally, ethereum followed a PoW model, where miners were rewarded with newly minted ETH for validating transactions and securing the network. Since then, the transition to Proof of Stake (the Merge) has introduced a new issuance mechanism. Sincethe Merge, Ethereum's issuance has been undergoing a “triple halving” that results from the combination of the shift from mining rewards to staking fees, a reduced ETH issuance rate, and gas fee burning. As a result, the estimated annual issuance rate under PoS could drop as low as 0.5%, potentially making Ethereum deflationary after considering fee burns.
EIP-1559, a major upgrade implemented in August 2021, introduced a base fee-burning mechanism that destroys a portion of the transaction fees paid by users (it destroys 100% of the base-fee, while retaining the variable “tip” that is paid by users for faster validation). This deflationary mechanism has the potential to exceed the inflationary effects of validator rewards, particularly during periods of high network activity, leading to deflation in the network.
Source: Glassnode
Recently, ethereum has experienced a slight inflationary trend despite its potential for deflation due to decreased (yet still relatively high) network activity and lower transaction fees brought on by Dencun.
III. Evaluating the inflationary case for ethereum.
Despite concerns over ethereum's recent return to an inflationary trend, several arguments support the case for an equilibrium of slight inflation in the network. The current issuance model encourages validators to stake their ETH and contribute to the network's consensus, ensuring its security and decentralization. A healthy level of inflation attracts validators and promotes decentralization, enhancing network security and resilience. Ethereum's monetary policy, considering potential deflationary pressures via EIP-1559 and adaptability to changing network conditions, seems to position the network for long-term sustainability.
Asset management firm Fidelity has decided to remove staking plans from its Ethereum ETF, and this development suggests that ETH stakers will continue to primarily consist of crypto natives deeply invested in the ethereum ecosystem. Thus, the ethereum tokens acquired to support the ETF issuance will remain unstaked, potentially increasing the share of ethereum yield for active stakers in proportion to all ethereum holders.
Both increases in price and relative yield for ethereum stakers would incentivize more users to stake their tokens, thereby strengthening the network. This would lead to a more stable and secure network. While the Dencun upgrade may have inadvertently contributed to a slight increase in inflation, the broader picture suggests that ethereum's monetary policy is designed for long-term sustainability.
As ethereum continues to evolve and adapt, the debate about its optimal monetary policy will undoubtedly continue. Nevertheless, the current evidence suggests that the inflationary case for ethereum and the ETF interest is potentially beneficial for the network's long-term success.