Bankless joint creation: Ethereum will start an industrial revolution on the Internet
Original author:image description
Compilation of the original text: The Way of DeFi
Image Credit: Generated by Maze AI
Image Credit: Generated by Maze AI
A cryptoeconomic system must find a balance.
In order for encrypted systems to stand the test of time, they must be flexible to adapt to the changing circumstances around them. Rigidity is fragile. Rigid systems will eventually require human intervention to prevent breakdowns.
The cryptoeconomic structure must automatically discover a state of natural equilibrium, otherwise the following diagram will be our inevitable future:
"You're a stupid animal"; "You're waiting for the Fed to tell you how much value your anti-establishment digital currency will lose"
Humans have always used homeostatic mechanisms to control chaos and complexity.
The development of the early steam engine was a series of explosions and uncontrollable chaos. To function, a steam engine needed to produce a steady and predictable power output, but controlling the speed of that output was an unsolved problem.
By applying a clever little mechanism known as a centrifugal governor, a negative feedback loop is created between energy input and output. As the system's power output increases, the governor will begin to reduce the magnitude of its input.along withcontrol theory
With the simple application of steam, the infinite potential of steam was transformed into an industrial revolution.
Control theory: The area of mathematics that studies the control of dynamical systems in engineering processes and machines. Its purpose is to develop a model or algorithm to control the application of system inputs to drive the system to a desired state while minimizing any delays, overshoots, or steady-state errors and ensuring the stability of the control; usually to a degree Optimization.
Also, the effect is greatest when one wing is parallel to the ground. And when the plane is banked, there is less lift force on the wing because the wing is no longer fully "up".
Dihedral wing angles are automatically balanced to maintain aircraft stability. When this type of aircraft rolls over to one side, the upward force on the wing is naturally transferred to push against it. It's a negative feedback loop that helps maintain stability.
A reverse-slope wing does the opposite. When a reverse sloped plane rolls to one side, the pressure on the wing changes, causing a greater rollover! This is a positive feedback loop.
So why do we design airplanes with reversed sloped wings? Because their instability is easily controlled by external intervention (aka steering), pilots benefit from the other advantages of reverse-slope wing designs. However, it still only works because of external influences on the system!
Can we apply these same principles of automatic homeostasis to cryptoeconomic systems? How do we structure the ethereum economy to balance it, even in an age when stupid humans are doing crazy things to it?
Similar to the centrifugal governor of a steam engine, or the design of a self-correcting airplane, cryptography allows us to generate self-governing economic systems.
Ethereum is an attempt to create and optimize the properties of self-government as an economic engine. With a key upgrade to the Ethereum crypto-economy, we can now efficiently harness the power output of the Ethereum economy and turn it into productive economic output.
I believe all the signs are there. Let's explore together!
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Ethereum, a self-balancing economic system
In May 2021, Ethereum's engine was at its hottest on record.
Gas fees of 200+gwei last for several months, and sometimes even reach 600+gwei for 24 hours. A Uniswap transaction costs $175. An Aave position costs $400. Curve LPing is $1000 per transaction.
Token speculation, yield farming, minting, and overall economic activity are so lucrative that high gas fees are an afterthought; there is so much money to be made! Ethereum was a smash hit.
In addition, Ethereum PoW miners are also making a lot of money. But due to the economics of PoW, miners are forced to sell their ETH to pay for electricity and GPUs; these are external things to Ethereum.
Ethereum at that time was leaking its economic power.
Ethereum's source of income, the gas fee for block space, eventually leads to:
The growth of the mining business
Increase in energy production (and corresponding consumption).
Growth in chip production
Ethereum's economic engine generates a lot of output, but this energy is not captured by Ethereum's actual economy. The revenue earned by the Ethereum-focused PoW industry represents the total amount of economic leakage that Ethereum has failed to contain.
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Ethereum's new circulatory system
EIP 1559
EIP 1559 Two mechanisms added to Ethereum greatly increase its power output and also translate this power into effective economic productivity.
Converting block space requirements into ETH value, the fuel that powers the Ethereum engine. With a higher value of ETH, Ethereum's fuel has more power and the engine is more productive.
EIP 1559 is a mechanism to capture heat from the Ethereum economy and use this energy to refine ETH into a more powerful economic fuel.
proof of stake
Proof of Stake translates block space requirements into ETH staking earnings.
Through PoS, the transaction tips received by stakers (fees exceeding the EIP 1559 base, mainly paid by MEV robots) have reached 20% of the total transaction volume. By using transaction tips as rewards for ETH staking, there is a channel between the popularity of the Ethereum economy and staking returns.
Through this channel, a negative feedback loop is established between the heat of the Ethereum economy and the motivation to pledge ETH. Increasing the APY of staking has a depressing effect on the economy, as increased ETH yields encourage capital to flow out of DeFi and into staking.
Since we've all just gone through this "crash course" in 2022 on the economic impact of raising interest rates, this should be intuitive. The Fed raises interest rates to fight inflation and curb an overheating economy. Ethereum has also done the same mechanism, increasing the rate of pledge when DeFi becomes hot, and reducing the rate of return when DeFi becomes cold. But it does so without measuring the economy subjectively and without the influence of surrounding political interests.
More on this later on.
recapture and control
The EIP 1559+PoS combination changed the economics of Ethereum from loss-making to regenerative.
The value that was previously one-way output to PoW is instead transferred to the internal value of the Ethereum economy, and the signal generated between transaction volume and ETH earnings allows Ethereum to self-regulate between excessive speculation and economic depression.
The only input required is human intelligence at the application layer to induce economic demand for block space. And Ethereum does the rest by itself.
economics in search of balance
Two key parameters enable the flexibility this environment requires: issuance of ETH and recapture of ETH.
The issuance rate of ETH is controlled by the PoS algorithm and changes slowly. While PoS needs to be flexible to remove brittle rigidities, it should only change slowly, as it is the security foundation of all Ethereum. It should be stable, not fluctuating.
EIP 1559 governs the capture rate of ETH. Compared to PoS algorithms, EIP 1559 quickly adapts to changes in economic conditions at the application layer. By default, the blocks on Ethereum are 50% full, and EIP 1559 will automatically increase or decrease the block size and Gas fee according to demand.
As gas fees drop, blocks get smaller. As the block space requirement increases, so does the block size, but so does the gas fee! While the block size target remains constant throughout (15 m gas), instantaneous block sizes are allowed to be adjusted upwards or downwards, depending on the needs of economic actors.
This mechanism is like a cog in the Ethereum economy. When the Ethereum economy is hot, the engine shifts into high gear. Block sizes rise to meet demand, fees rise, and ETH is burned. When the demand decreases, Ethereum downgrades, reducing the supply of block space, and the burning of ETH will also weaken.
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Ethereum Economics
The flexibility of Ethereum’s cryptoeconomics allows it to achieve a natural state of equilibrium, even if stupid humans are playing stupid Ponzi games on it.
Ethereum's economics adapt to its surroundings.
For example, the issuance rate of ETH - as more ETH is pledged to Ethereum, the issuance algorithm will issue more ETH. However, it proportionally reduces the ETH issuance per validator as issuance is distributed among more validators.
When the total amount of ETH pledged to Ethereum is low, the rate of return for individuals is high, but the total amount of ETH issued is low.
ETH issuance curve:
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Green line--network circulation %; purple line--ETH/day circulation
ETH staking yield curve:
As more ETH is pledged to Ethereum, yields decrease and issuance increases, softening the disruption to economic activity by encouraging ETH to flow out of staking and into the Ethereum economy.
MEV
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MEV is an important part of the Ethereum economy. MEV is the conduit connecting DeFi activity and ETH yield. It is a transfer of value from arbitrageurs to stakers.
When anyone does almost anything on Ethereum, there is a small trail of arbitrage in their wake. Buying ETH on Uniswap dislocated the price and created a micro-opportunity for arbitrageurs to rebalance their pool.
Economic actors throw the market out of balance and arbitrageurs automatically reposition the system.
The net effect is the correlation between staking yield and Ethereum’s economic heat.
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find balance
All these various inputs into ETH issuance and ETH burn rate have resulted in an organically balanced system that makes Ethereum an unaffected cryptoeconomic system, resulting in the 'sci-fi economy' that I'm so excited about!
When the Ethereum economy is hot, the Gas price is high, resulting in a high ETH burning rate. MEV is also high in this environment, increasing the yield on ETH staking.
Higher ETH staking yield increases the enthusiasm for staking ETH! And this also encourages capital to flow out of DeFi and enter the pledge agreement, incurring an increase in the internal capital cost of DeFi.
High ETH yields increase the opportunity cost of capital in DeFi, naturally raising the bar for viable speculation.
Arbitrageurs will always ensure that the cost of borrowing ETH in DeFi is higher than the staking yield. If not, then there is an opportunity for free arbitrage, borrowing funds from DeFi at a lower interest rate, pledging them in an agreement, and freely pocketing the difference.
By increasing the ETH yield at the base layer, Ethereum increases the capital cost of DeFi.
As the Ethereum economy heats up, it will naturally add pressure to its own breaks! This also happens in reverse; as the economy cools, the pressure is released. A cooling economy would generate a high supply of ETH staking, but low staking yields, making external opportunities look more attractive.
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Economy 2.0
In TradFi, there is a tug of war between bond yields and stock valuations.
Bond yields are low, risk appetite increases, and capital flows from bonds to stocks. Asset inflation sets in and the supply of credit increases. The economy heats up and inflation kicks in. The Fed responded by raising interest rates, and yields followed suit. Stocks sold off as bond yields became attractive again.
The Fed has a tough job on its hands.
Humans are stupid, and the Fed is not external to the system it governs. The inputs that the Fed uses to make governance decisions respond to the Fed's decisions.
Chaotic systems come in two shapes:
Systems that do not respond to predictions about them. A weatherman's forecast doesn't change the weather.
Those systems that change as a result of its predictions. Enter game theory.
Of all the amazing technologies that make up ethereum, its greatest achievement may simply be removing the central manager of the economy from its focal point. Economic actors can no longer look to the Fed to make their financial decisions, because Ethereum puts the work of the Fed into EIP 1559 and Proof of Stake.
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An Internet Industrial RevolutionEthereum is Existingfirst profit
blockchain.
It is the first encrypted system to capture its own energy and channel it into productive output. By converting revenue from block space into the value of ETH, Ethereum naturally increases the total capital value of DeFi!
As ETH absorbs traffic from the Ethereum economy, DeFi grows with it.
Since ETH is the most dominant collateral in the DeFi economy, as the value of the collateral grows, so does the availability of credit!
The Ethereum economy is denominated in ETH, and when the value of ETH grows, so does everything downstream of ETH.
Many tokens trade directly with ETH via Uniswap or other DEXs. A token denominated in ETH means that an appreciation in ETH is also an appreciation in token value. Most of the tokens traded in stablecoins are still affected by the price of ETH, because when ETH can be used to borrow or mint stablecoins, there will be more and more appetite for stablecoins, and as ETH becomes more valuable , will also borrow more stable coins.
EIP 1559 brings an economic growth tailwind to the entire Ethereum economy. As the value of ETH grows, the availability of capital increases.
Wealth generation becomes easier. Investments in Ethereum will also grow.
The positive impact of EIP 1559 goes beyond simply increasing the value of ETH. ETH is closely related to DeFi, and the appreciation of ETH has a major positive downstream impact on the entire Ethereum economy!
We call it: "ETH Wealth Effect".
Ethereum will be able to finance its own future.
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Unlocking the Internet Industrial Revolution
We are watching the world of cryptoeconomics unlock a new productivity engine for the internet age.
An internet revolution is incomplete without cryptoeconomics. Before digitally native money and finance, we were stuck in the pre-teen stages of the Internet; the "pure data" version of the Internet.
Cryptoeconomics is the study of building an economic engine for the internet. With the invention of Bitcoin in 2009, a new category of engine was discovered, and a whole new industry was born around it.
Since then, Ethereum has been optimizing the science of cryptoeconomics. What used to be a productivity engine with losses and inefficiencies has now become a super engine for the digital age.
Ethereum is heralding an industrial revolution on the internet. Similar to how the steam engine was the input needed to start the Industrial Revolution, Ethereum's new cryptoeconomic engine is ushering in a new era of economic productivity and prosperity for the Internet.
We've seen the story and we know what's coming next.
The dots connected here are not that far apart.
Growth, entrepreneurship, invention, connection, wealth, prosperity, improved standard of living and quality of life.
