Opinion: The Economics of Ethereum Migration
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- Photo by Andre A. Xavier on Unsplash-
As a follower and supporter of Ethereum, I have always been a big supporter of constructive discussions around network development and upgrades. The purpose of this article is to discuss in depth the economic advantages of the current Ethereum 2.0 migration design (i.e. transfer of ether via a one-way bridge), and the challenges it faces.
The comparison of one-way bridging versus two-way bridging has been well expressed and demonstrated from a technical standpoint; however, the economic benefits and challenges of migrating design have not been adequately discussed. The deliberations on the economic side have not progressed.
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What views so far?
Additionally, there are proponents of a two-way bridging scheme, and preliminary discussions around potential native integration will take place in the future, but given current technical specifications, this article aims to discuss the economics of some of the key economic incentives.
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The so-called one-way bridge scheme, whereby existing Ethereum 1.0 Ether holders can burn their holdings in exchange for an equivalent amount of Ethereum 2.0 Ether (also known as Beacon Ether, or "bETH") ). It can be understood that bETH will be generated and locked in the margin contract of the proof-of-stake mainnet ("beacon chain"). This migration plan will start during Devcon V in October 2019, and the Ethereum 2.0 and Phase 0 mainnets will be officially released in January 2020.
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Below are some notable pros and cons of one-way and two-way bridges listed on EthHub. It is worth noting that the advantages of one-way bridges are mostly reflected in the technical aspects, while the disadvantages are mainly concentrated in the economic aspects. In other words, the choice between one-way bridges and two-way bridges is essentially a trade-off between technical and economic challenges.
- Figure 1 - Source -
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As of January 2019, the block reward of Ethereum 1.0 has dropped to the level of issuing 2 eth every 15 seconds, and its total amount maintains an annual growth rate of 4.8%. At some point in the future, the Ethereum 1.0 community will completely migrate to Ethereum 2.0, reducing its inflation to zero.
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- Figure 2 - Source -
Additionally, the diagram below is the proposed block reward design for Ethereum 2.0. It is worth noting that the issuance is set in stages and depends on the total amount of bETH used to prove the stake. For early validators, the incentive will be higher, and as the number of validators and bETH increases, the incentive will gradually decrease.
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- Figure 3 - Source -
Now, let's break down the three design decisions introduced above:
"Ethereum 1.0's Ether will be burned" - Different from Figure 2, I think: If a one-way bridge is implemented, it makes more sense to consider the money supply of Ethereum 1.0 and Ethereum 2.0 separately. The burn-then-mint model predicts an inverse relationship between the total supply of Ethereum 1.0 and 2.0 (ie, for every Ethereum 1.0 ETH burned, an equal amount of bETH is minted). This means that once more than 4,890,000 Ethereum 1.0 ETH are migrated and burned, their supply will be deflationary; that is, the projected inflation rate of Ethereum 1.0 (4.8%) will also decrease by the same amount as the migration ratio . Therefore, the remaining unburned Ethereum 1.0 ETH is likely to appreciate in value, other things being equal.
"bETH will be minted and locked" - bETH will be locked on the Beacon Chain for approximately 1.5 years. Therefore, only a portion of bETH is liquid and available for futures or OTC transactions negotiated directly between individual validators. Given the limited liquidity of bETH, I think Ethereum 1.0 ETH will have a liquidity premium compared to bETH. In other words, since bETH is expected to be locked for 1.5 years, the price of ETH 1.0 will be higher than that of bETH. For Ethereum 2.0 validators who choose to accept liquidity risk and execution risk, the return is provided in the form of bETH yield (see Figure 3). However, whether it is a cost-effective investment for early validators to burn Ethereum 1.0 ETH and hold bETH depends on the exchange rate between bETH and Ethereum 1.0 (the closer to one to one, the better) and the bETH obtained as a validator Interest. The price of bETH may be lower than ETH for a long time (if the development of ETH 2.0 is delayed or the two chains cannot be fully merged). In view of its liquidity constraints, some bETH may be wrapped back to the ETH1.0 chain (that is, wrapped-bETH, also known as wbETH) to obtain higher liquidity and utility.
"The bETH locked in the equity account will earn interest." - It is worth noting that the validator rewards of Ethereum 2.0 will be denominated in bETH. When rational cryptocurrency holders evaluate how to optimally allocate their assets, not all channels yield the same rate of interest. The following is the decision a holder faces: Option 1, configure DAI on Compound and earn 14.8% annualized floating interest rate provided by DAI (measured in DAI); Option 2, pledge bETH and earn 1.56% provided by bETH Up to 18.1% annualized floating rate. Due to different pricing methods and risks, the interest rates in Option 1 and Option 2 cannot be directly compared. For example, DAI faces smart contract risks, while bETH faces liquidity and execution risks. The key issue is that the interest brought by staking bETH may not be high enough to make early validators willing to bear the associated risks. After all, they can configure the ETH on the 1.0 chain to earn interest in a variety of ways.
Ultimately, we hope to create a healthy economic environment for Ethereum 1.0 and 2.0, so that both can achieve the right incentives, but in an economically isolated system, Ethereum 1.0 Ether holders and bETH holders Unexpected competition may arise between owners. Ideally, there should be some kind of economic incentive to coordinate the communities on both chains.
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Futures as a Price Stabilization Mechanism
Finally, I would like to mention one more point, which is also a conclusion I derived from game theory in view of the fact that Ethereum 1.0 has a certain probability of being fully migrated to 2.0 in the future (planned to be so).
I think this probability is neither 100% nor 0%, but a value between the two. Even with a 10% chance of a full migration being done at some point in the future, this would limit volatility between Ethereum 1.0 ether and bETH, but I'm not sure how this would be reflected in the market.
Example 1: Using the stock analogy, I think a proposed merger is a good example: If Company A bids $1 per share of outstanding stock in Company B, and the merger has a 99% probability of success, the market Company B's share price will be close to $1 (the market is pricing in this probability).
Example 2: Using the analogy of decentralized finance, I think an excellent example of the above-mentioned balanced relationship is that MakerDAO uses Global Settlement as a stabilization mechanism for DAI: for DAI holders, the price of DAI is stable at around $1 One of the reasons is that at some point in the future, DAI will be repurchased by global liquidation assets worth $1. If you buy (or sell) DAI for less than $1, you make a profit (or a loss) when the global liquidation happens. Likewise, if there is a reasonable possibility that Ethereum 1.0 will migrate to Ethereum 2.0, bETH should be traded at a price similar to Ethereum 1.0. Any changes only reflect the risk of Ethereum 2.0, or liquidity premium/illiquidity discount.
