What is the impact of the biggest change in history on the economic model of Ethereum and the value of ETH?

As July approaches, we are about to see a major change for Ethereum. According to previous news reports, in March this year, EIP-1559 was officially included in the Ethereum London hard fork upgrade, and the proposal is tentatively scheduled to be deployed to the Ethereum mainnet on July 14.

Ethereum has always been a leader in innovative encryption technology. ETH2.0, EIP1559 upgrades and Layer 2 expansion solutions are highly anticipated. These changes have significantly improved the scalability of Ethereum, thereby alleviating network congestion and reducing high-value transactions. The gas cost.

We know that the price of Bitcoin has always been at the head of encrypted assets, and one of the reasons is that its number is capped at 21 million. Rare things are more expensive, and over time, when market demand exceeds supply, its scarcity will be magnified.

After the successful upgrade of EIP-1559 and ETH2.0, the basic structure of Ethereum will change, so how will its token economy change accordingly? Will the increase rate of ETH be affected by it? How will the change in issuance rate affect the price of ETH?

Most of the articles I have read only analyze the unilateral changes in Ethereum. This article integrates ETH2. A detailed analysis of the supply and demand aspects of the currency economy. This article is excerpted from Hacker Noon by Gideon Tay Yee Chuen, an analyst based in Singapore. Rhythm BlockBeats translated this article:

Ethereum will usher in major changes in the near future. The scale of this change will exceed most of the upgrades after Ethereum went online in July 2015, including ETH2.0, EIP-1559, and the increasing adoption of Layer 2 in the protocol. expansion.

The main purpose of these changes is to increase the scalability of Ethereum, alleviate network congestion, reduce high gas fees, and improve network efficiency. These much-anticipated changes come against the backdrop of a surge in demand for Ethereum applications, especially DeFi and NFT applications, which have exceeded Ethereum’s current limits. High demand has led to skyrocketing Ethereum fees and the growing success of competitors such as Solana and BSC.

While we look forward to this Ethereum upgrade, it will be interesting to see how the changes to its infrastructure will affect the token economy (and price) after the upgrade. Here, we outline these infrastructure changes, their timeline, and their potential impact on the ETH token economic model (and price) in the short and long term. This article hopes to:

Consolidate information and incorporate all Ethereum changes. Most of the articles cover only one aspect, some do not deal with the token economy, and do not analyze how changes in the infrastructure will affect the token economy; explore the impact of Layer 2 on token prices, which is not often discussed; except for the usual discussion On the supply side of the project, possible changes in demand are also explored.

Considering the length of the article, you can skip the parts you are familiar with.

ETH2.0

Overview: ETH2.0 can be divided into two major upgrades: PoS and sharding

1. PoS consensus mechanism

The setting of Beacon Chain is the first step in the upgrade of ETH2.0. It runs in parallel with the main network of Ethereum. It introduces the PoS consensus mechanism into the Ethereum network and lays the foundation for breaking away from the current PoW consensus mechanism.

Under PoW, blockchain transactions need to be verified by miners who solve cryptographic problems, and these miners need to have high computing power. The first miner to solve the problem creates a block and is rewarded with newly minted ETH. At the same time, in PoS, users lock 32 ETH as pledge rights to become a verification node, and create and verify blocks like miners under the PoW mechanism. However, instead of competing for problem solving, they are randomly selected to create blocks and receive rewards. Therefore, participants will be rewarded according to the amount of ETH invested.

This reduces the energy consumption of the network, guarantees decentralization by reducing the need for expensive hardware and encourages the creation of more nodes, and makes the network more secure since a large amount of ETH is required to launch an attack. This solves both the security and decentralization aspects of the blockchain trilemma. At the same time, the sharding technology of ETH2.0 solves the problem of scalability.

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Graph visualization of slices, from Quantstamp

Sharding divides a large database into smaller parts, called shards. This increases scalability because validators do not need to store data for the entire network, only for their assigned shards. Currently, ETH2.0 plans to have 64 shards, and the interaction between shards is coordinated through the Beacon Chain. There is still debate over whether shards should just serve up additional data, or whether they should also have code execution.

Timeline: Beacon Chain will go live in late 2020. The roadmap will include sharding in 2021 and join the Beacon Chain until it is finally merged with the Ethereum mainnet in 2022. At that stage, the existing old Ethereum chain will become one of many shards in the network.

The impact of ETH2.0 on the token economy (supply side)

Under the current PoW system, the reward is 2 ETH per block and 1.75 ETH per uncle block (created when multiple blocks are mined at the same time, since only one block can be verified and added to the ledger). Note that rewards were higher prior to February 2019. At the current mining difficulty level, the average block mining time is about 13.15 seconds, and the annual increase rate is about 4.5%.

Under the PoS mechanism of ETH2.0, the increase rate is much lower. Based on some reasonable assumptions, the increase rate is expected to be between 0.5% and 1%. Since the issuance rate depends on several factors, it is difficult to give a precise rate:

1. Number of staked ETH/number of validators: More validators generally result in more ETH staked in the network. However, as validators’ rewards for staking decrease, their willingness to stake decreases as more validators come along, and ultimately the amount of ETH that can be staked is also limited.

2. Malicious behavior of validators: If validators are offline or deliberately verify wrong transactions, they will be punished by slashing ETH.

The above factors may lead to a decline in the issuance rate.

In general, the experimental phase of ETH2.0 before merging with the mainnet will result in a short-term increase in the supply rate, as both PoW and PoS systems will issue ETH. However, the merged ETH2.0 will result in a significant decrease in the supply rate.

EIP-1559

Overview: EIP-1559 changes Ethereum's fee structure, introducing base fee burn

1. According to EIP-1559, the transaction fee currently consists of two parts: a base fee (which is burned) and an optional tip for miners. Tips incentivize miners to prioritize transactions when transaction volume is high.

2. The gas limit for each block is 12.5M to 25M, but over time, the target for the average block size is 50% or 12.5M. This is achieved by increasing the base fee when the block capacity exceeds 50% (when the network is congested) and decreasing the base fee when the block capacity is below 50%.

These changes reduce the need for users to guess the gas price required for their transactions, resulting in a more efficient fee system and fewer fee payments compared to the previous "first bid model".

Timeline: To be included in London hard fork in July 2021 along with other EIPs.

Impact of EIP-1559 on Token Economics (Supply Side)

The base fee for burning reduces the supply of ETH proportionally to the amount of activity on Ethereum, as the base fee increases to meet the 50% block utilization target when the network is congested. It is difficult to estimate the magnitude of its impact as it is heavily dependent on the amount of activity on the Ethereum network. Taking current transaction fees as a metric is also inaccurate, as we are not sure of the ratio between the base fee and the tip. Some people believe that the implementation of EIP-1559 will greatly reduce the net issuance of ETH, thus causing ETH to enter deflation.

Layer2 / Non-Layer1 Expansion Solution

Overview: These solutions do not change the Ethereum infrastructure (Layer 1). Instead, they reduce network congestion by processing transactions off-chain. In addition to improving scalability, some solutions provide privacy in a blockchain world where all transactions are public.

We refer to them as Non-Layer1 scaling solutions, because some solutions (such as sidechains) are not technically Layer2, nor are they directly protected by Layer1. Here is a brief overview of some scaling solutions:

1. ZK Rollups: Only transaction data about previous and subsequent states (such as account balances) will be recorded on the Ethereum main chain, and transaction status and execution will be performed off-chain. The smart contract processes transactions in batches at Layer 2, updates the final state at Layer 1, and confirms that the final state recorded at Layer 1 is accurate by using cryptographic proof (SNARK).

2. Optimistic Rollups: The principle is basically the same as ZK Rollups, but Optimistic Rollups does not need to use SNARK to prove the accuracy of the final state of each record in Layer1, but assumes that all record updates are accurate. The status update will only be verified if someone disputes it is wrong, the fraudster will be penalized, and the doubter will be compensated for the fee.

3. State channel (State channel): A channel is established between all parties to form an off-chain network, where frequent transactions are performed on the off-chain network, and the final state of the transaction is updated on Ethereum.

4. Side chain (Side chain): Transactions are carried out in an independent blockchain and has its own consensus mechanism. Assets and data are transferred to Ethereum through smart contracts. Smart contracts will lock assets on the main chain and recreate assets and data of the same amount in the side chain.

5. Plasma chain: Similar to a side chain, it has its own consensus mechanism as an independent chain. The sub-chain will periodically submit the root hash to the main chain for consensus, which makes the system more secure, but limits its ability to perform complex business operations.

Changes to the Token Economy by Non-Layer1 Scaling Solutions (Supply Side)

Before EIP-1559 is implemented in July 2021, the expansion solution will not really affect the ETH issuance rate. However, since these solutions are strongly tied to network activity and transaction fees, and EIP-1559 improves the relationship between transaction fees and ETH supply, some interesting effects will emerge:

1. Dampening effect: The reduction in unit transaction volume generated by activities and applications on the chain will lead to a reduction in the base fee burned under EIP-1559, which suppresses the deflationary effect brought about by EIP-1559.

2. Counterbalance effect: The lower transaction fees provided by the scaling solution attract new price-sensitive users and increase user engagement in the app. The increase in participation can offset to a certain extent the decrease in the amount of base fee burning caused by the low activity on the main chain. Overall, the "true demand" for the Ethereum network is likely to remain the same.

3. New activity effect: It can be argued that the nature of some scaling solutions will enable new types of economic activity on Ethereum. For example, it is impossible to achieve high-frequency interaction between the two parties through the state channel on the main network. If these new economic activities are introduced into Ethereum, the periodic interaction between off-chain and on-chain can still generate the destruction of basic fees, then the supply of ETH will be further reduced.

It is difficult to determine the final effects that may change over time. The final effect depends on:

1. Adoption of scaling solutions;

2. The amount of new economic activities that will enter the Ethereum ecosystem;

3. The net impact of the scaling solution on the "real demand" for transactions on the Ethereum chain.

Changes of Non-Layer1 Scaling Solutions to Token Economy (Demand Side)

These changes are likely to lead to increased demand for ETH and increased fiat inflows, and attract investors by:

1. Improve the attractiveness of ETH as an asset: ETH2.0 transforms ETH into a productive asset that can generate cash flow through pledge. Judging from media reports and ETH price increases ahead of EIP-1559’s implementation in July, it appears that EIP-1559’s deflationary impact on ETH supply has attracted many investors.

2. Increase awareness through usage: ETH2.0's sharding and Layer 2 scaling solutions increase Ethereum's scalability and reduce transaction fees per "unit" of network demand. This makes Ethereum more accessible to users with smaller transaction sizes, prompting users to further use and understand the applications in the ecosystem and ETH itself. This increases the pool of investors interested in buying and holding ETH.

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The above figure explains the development process and timing of "ETH2.0" and "Scaling Solution"

Here is a brief overview of the positioning of the 3 elements in the diagram:

ETH2.0 

· Short term: ETH2.0 will increase the issuance rate of ETH during the testing period. The purpose of investors buying ETH is to get returns through staking, thus leading to an increase in demand.

· Long-term: After the merger of ETH2.0 and the Ethereum mainnet, the issuance rate has dropped significantly. As people's awareness of ETH2.0 increases, the demand for ETH will also increase.

EIP-1559 

·When EIP-1559 is implemented in July, the base fee will be destroyed, which will lead to a sharp drop in the ETH issuance rate. On the demand side, this is the main factor behind ETH's continued breakout of all-time highs in April and May 2021.

Although the impact of the implementation of EIP-1559 on the issuance rate is expected to be significant, the exact extent of its impact is difficult to determine due to the uncertainty of the future network activity and the ratio between the basic fee and the miner's tip .

Expansion solution

· Short term: Before the implementation of EIP-1559, the increase rate of ETH was not affected. As some scaling solutions were implemented, users with smaller transaction sizes gradually attracted and increased their participation in Ethereum, which positively impacted the demand for ETH.

Summarize

Summarize

All of the above charts and our discussion point to the fact that changes in Ethereum’s infrastructure have an impact on both supply and demand, which creates a strong impetus for ETH price. However, as the price of ETH continues to break all-time highs, many people have begun to wonder how high the price of ETH can go, and whether these positive factors have been fully digested.

My personal opinion is that even if ETH will experience more bulls and bears, its value in 10 to 15 years will be much higher than it is now. Here's my three-step reasoning:

1. Innovation in the field of cryptocurrency will disrupt many industries, especially the financial industry, and will create and capture a lot of value in the process;

2. Ethereum has been the leader in innovative cryptographic technology to date, and infrastructure changes are improving its scalability and thus its ability to dominate the market;

3. EIP-1559 links the success of Ethereum to ETH.