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

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As July approaches, we are bracing for major changes to Ethereum

As July approaches, we are bracing for major changes to Ethereum. According to previous reports, in March this year, EIP-1559 was officially included in the Ethereum London hard fork upgrade, and is tentatively scheduled to be deployed to the ethereum mainnet on July 14th.

Ethereum has been a leader in innovative crypto technology, and the anticipated upgrades to ETH2.0 and EIP1559, along with the Layer2 expansion solution, have significantly improved scalability, alleviating network congestion and reducing high gas costs.

We know that one of the reasons bitcoin has been at the top of the crypto asset list is that it has a ceiling of 21 million coins. Rarity is valuable, and over time, scarcity will be magnified when demand outstrips supply.

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

While most of the articles I've read have analyzed the changes in Ethereum only on one side, this article links the dots between ETH2.0, EIP-1559, and Layer2 scaling, and provides a detailed analysis of how these infrastructure changes will affect the supply and demand side of the ETH coin economy. This is an excerpt from Hacker Noon by Singapore-based analyst Gideon Tay Yee Chuen. This article is translated by Rhythm Blockbeats:

Major changes are coming to Ethereum in the near future, and the scale of these changes will exceed most of the upgrades since Ethereum went live in July 2015, including ETH2.0, EIP-1559, and the increasing use of Layer2 scaling in protocols.

The main purpose of these changes is to increase Ethereum's scalability, ease network congestion, reduce high gas bills, and improve network efficiency. These much anticipated changes come against a backdrop of surging demand for Ethereum applications, particularly DEFI and NFT applications, which have exceeded Ethereum's current limits. High demand has led to soaring fees for Ethereum and the growing success of competitors such as Solana and BSC.

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

Integrate the information and bring all the changes to Ethereum together. Most articles cover only one aspect, some do not cover the token economy, and do not analyze how the infrastructure changes will affect the token economy; Explore the effect of Layer2 on the price of tokens, which is not often discussed. In addition to the usual discussion of the supply side, we will also explore possible changes on the demand side.

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

ETH2.0

Summary:ETH2.0 can be divided into two major upgrades: POS and sharding

1. POS consensus mechanism

The Beacon Chain setup is the first step in the ETH2.0 upgrade, which runs parallel to the Ethereum main network. It introduces the POS consensus mechanism into the Ethereum network and lays the foundation for moving away from the current POW consensus mechanism.

Under PoW, blockchain transactions need to be verified by cryptographic problem-solving miners with high computing power. The first miner to solve the problem creates a block and is rewarded with a newly minted ETH. At the same time, in POS, the user locks 32 ETH as a pledge to become a verification node and creates and validates blocks like a miner in a PoW mechanism. However, instead of competing to solve problems, they are randomly selected to create blocks and be rewarded. Therefore, participants will be rewarded according to the amount of ETH invested.

This reduces the energy consumption of the network, ensures 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 needed to launch an attack. This solves both the security and decentralization aspects of the blockchain triad. At the same time, ETH2.0's sharding technology addresses scalability issues.

2. Sharding

Shard Graphic Visualization, from Quantstamp

Sharding splits a large database into smaller parts, called sharding. This increases scalability because verifiers do not need to store data for the entire network, only for the shards they are assigned. Currently, the ETH2.0 program has 64 shards, coordinating the interactions between them through the Beacon Chain. There is still debate as to whether shards should simply provide additional data or whether they should also have code execution capabilities.

Time line:Beacon Chain went online in late 2020. The roadmap will include sharding in 2021 and joining 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.

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 tert block (created when multiple blocks are mined at the same time, as only one block can be verified and added to the ledger). Please note that the rewards are higher until February 2019. At the current difficulty level, the average block production time is about 13.15 seconds and the annual growth rate is about 4.5%.

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

1. Number of ETH pledged/number of verifiers:More verifiers usually result in more ETH being pledged in the network. However, as the rate of return on which verifiers pledge decreases, so does their willingness to pledge as more verifiers appear, limiting the amount of ETH that can be pledged.

2. Evil behavior of the verifier:If verifiers go offline or intentionally verify erroneous transactions, they are penalized with forfeited ETH.

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

Overall, the pilot phase of ETH2.0 before it is merged with the mainnet will result in a short-term increase in the supply rate, as both PoW and POS systems issue ETH. However, the combined ETH2.0 will result in significantly lower supply rates.

EIP-1559

Summary:EIP-1559 changes the fee structure of Ethereum by introducing the destruction of base fees

1. According to EIP-1559, the transaction fee currently consists of two parts: the basic fee (to be destroyed) and an optional tip for miners. The tips incentivize miners to prioritize transactions when volumes are high.

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

These changes reduce the need for users to guess the price of gas for their transactions, resulting in a more efficient collection system and less payment than the previous "first bid model".

Time line:It will be included with other EIPs at the London Hard Fork in July 2021.

Impact of EIP-1559 on Token Economy (Supply side)

The base cost of destruction would reduce the supply of ETH proportionate to the amount of Ethereum activity, as the base cost would increase to meet the 50% block utilization target when the network is congested. It is difficult to estimate the extent of the impact, as it depends heavily on the amount of network activity. It's also inaccurate to use current transaction fees as a measure because we're not sure what the ratio of the base fee to the tip is. It has been argued that the implementation of EIP-1559 will significantly reduce the net growth of ETH and thus push ETH into deflation.

Layer2 / non-Layer1 expansion solution

Summary: These solutions do not change the Ethereum infrastructure (Layer1). Instead, they reduce network congestion by processing transactions down the 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 side chains) are not technically Layer2, nor are they directly protected by Layer1. Below is a brief overview of some expansion solutions:

1. ZK Rollups:Only transaction data about the back and forth states (such as account balance) are recorded on the Ethereum mainchain, where transaction status and execution take place. The smart contract processes transactions in batches at Layer2, updates the final state at Layer1, and verifies that the final state recorded at Layer1 is accurate by using encryption proof (SNARK).

2. Optimistic Rollups:The principle of Optimistic Rollups is basically the same as that of ZK Rollups, but Optimistic Rollups does not need to use SNARK to prove the accuracy of the final state of each record in Layer1. Instead, it assumes that all records are updated accurately. The status update is verified only when someone challenges the error, the fraudster is punished, and the questioner is reimbursed for the fee.

3. State channel:Establish channels between parties to form an off-chain network where frequent transactions take place, and update their final transaction status on Ethereum.

4. Side chain:Transaction on a separate blockchain, with its own consensus mechanism. Assets and data are transmitted to Ethereum via smart contracts, which lock down assets on the main chain and recreate the same amount of assets and data in the side chain.

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

How Non-Layer1 Scaling Solutions Change the Token Economy (Supply Side)

The expansion solution will not have a real impact on ETH issuance until EIP-1559 is implemented in July 2021. However, since these solutions are closely linked to network activity and transaction fees, and EIP-1559 enhances the relationship between transaction fees and ETH supply, some interesting effects may occur:

1. Dampening effect:Decrease in unit transaction volume generated by on-chain activities and applications results in a reduction in the base cost of burning under EIP-1559, which curtail the deflationary effect of EIP-1559.

2. Counterbalance effect:The lower transaction costs offered by scaling solutions attract new, price-sensitive users and increase user engagement with the application. To some extent, the increase in participation can offset the decrease in base cost destruction caused by low activity on the main chain. Overall, the "real demand" for the Ethereum network is likely to remain the same.

3. New Activity EffectIt can be argued that the nature of some scaling solutions will enable new economic activity on Ethereum. For example, high frequency interaction between two parties through the state channel is not possible on the main network. If these new economic activities are introduced into Ethereum, and periodic off-chain and on-chain interactions can still result in the destruction of the base fee, the supply of ETH will be further reduced.

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

1. Adoption degree of capacity expansion solution;

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

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

How Non-Layer1 Scaling Solutions Change Token Economy (Demand Side)

These changes are likely to lead to an increase in demand for ETH and an increase in fiat currency inflows and attract investors by:

1. Increase the attractiveness of ETH as an asset:ETH2.0 converts ETH into productive assets that generate cash flow through pledges. The deflationary impact of EIP-1559 on ETH supply seems to have attracted many investors, based on media coverage prior to the implementation of EIP-1559 in July and the rise in ETH prices.

2. Improve cognition through use:Eth2.0's sharding and Layer2 scaling solutions improve Ethereum's scalability and reduce transaction costs per "unit" of network demand. This makes Ethereum more accessible to users with smaller transactions, driving users to further use and learn about applications in the ecosystem and ETH itself. This increases the pool of investors interested in buying and holding ETH.

Combine the above:

Graph of the impact of Ethereum infrastructure changes on ETH supply and demand. The arrows indicate expected changes over time, and the size of the box indicates uncertainty

The chart above explains the evolution and timing of "ETH2.0" and "Scale-up Solutions.

Here is a brief overview of the positioning of the three elements in the chart:

ETH2.0 & have spent

Short term:ETH2.0 will increase the rate of ETH issuance during the test period. Investors buy ETH in the hope that they can get a return by pledging it, thus leading to increased demand.

For a long time:After the merger of ETH2.0 and the Ethereum mainnet, the secondary issuance rate dropped significantly. As awareness of ETH2.0 increases, so will the demand for ETH.

EIP-1559

,When EIP-1559 is implemented in July, there will be a significant decrease in the ETH issuance rate as the base cost will be destroyed. On the demand side, this was the main factor behind ETH prices breaking all-time highs in April and May 2021.

,Although the impact of the implementation of EIP-1559 on the growth rate is expected to be significant, the exact extent of the impact is difficult to determine due to the uncertainty of future network activity and the ratio of base fees to miners' tips.

Capacity expansion solutions

Short term:Prior to the implementation of EIP-1559, the rate of ETH issuance was not affected. As some scaling solutions have been implemented, they have gradually attracted users with smaller transactions and increased their participation in Ethereum, which has had a positive impact on ETH demand.

For a long time:According to the three effects discussed above, we can know that the final effect of the additional issuance rate is impossible to predict accurately. Let's go out on a wild guess and say it's going to go to zero. Due to the "new activity effect", more new economic activity will be added to Ethereum over time through scaling solutions, which in the long run will result in a slightly lower rate of new offerings. This is expected to have a significant positive impact on the demand for ETH, as it will increase the engagement of potential Ethereum users, thereby increasing the number of potential investors interested in buying ETH.

conclusion

All of the above charts and our discussion point to the fact that changes in the Ethereum infrastructure will have an impact on both supply and demand, which creates a strong driver for ETH prices. However, as the price of ETH continues to break historical highs, many people are beginning to wonder how high the price of ETH can go, and whether these positive factors have been fully priced in.

My personal view is that even if ETH goes through a lot more, it will be worth a lot more in 10 to 15 years than it is now. Here's my three-step reasoning:

1. Innovation in cryptocurrency will disrupt many industries, especially the financial sector, and create and capture significant value in the process;

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

3. EIP-1559 links Ethereum's success to ETH.