Ethereum, the second largest blockchain after Bitcoin, recently transitioned to “Proof of Stake” (PoS).
Some claim that this move makes “ETH”, the crypto-token powering Ethereum, into “sound” and even “ultra-sound” money. As usual, in this space, some voices believe the opposite.
In this article, we’ll try to get closer to the truth by analysing the “Tokenomics” of Bitcoin, the old “Proof of work” Ethereum, and the new “Proof of stake” Ethereum, from a slightly different perspective.
We’ll assume that the meaning of “sound money” in this context is that the price of “ETH” expressed in fiat currency has a more “sound” support.
People in the crypto space generally assume that “scarcity” is the only friend and inflation is the main enemy of the token price.
This article will use a slightly more measurable framework by looking at the market mechanics, mainly that: the price between any two assets or currencies is established in exchanges, where buyers meet sellers.
Why do rational people exchange asset A for asset B?
1. They need asset B for its utility.
2. Asset B pays dividends.
3. Asset B is expected to appreciate compared to Asset A.
Note that these are massive simplifications. The world of finance is hugely complex, but eventually, the reason for a trade boils down to more or less a combination of the above.
If more people want asset A, then the price of A will go up relative to B. This goes on until the dynamic between them changes. For example, if B is now cheaper, then the dividends of B become more attractive, so that will increase buying pressure on it, and so on.
Bitcoin was created as a decentralised payment network. That was the utility envisaged by its creator. For various reasons, it hasn’t yet achieved traction for payments, but it became a successful “store of value”.
Looking up “store of value” in the above list, we notice that the main reason people exchange fiat currency for BTC is for the third reason. They expect BTC to increase in value relative to fiat.
There is another factor at play as well. People who buy or sell BTC need to pay network fees in BTC, so they need to buy it from somewhere. This creates more demand for BTC and falls into the first category of people buying the asset for its utility.
There is a catch here. The protocol pays all the collected fees to miners. Anyone can be a miner and invest as much as they like in mining equipment and electricity. Assuming they are rational actors, they will do this for profit, but the profit will be relatively small since anyone can do it.
The proof of work protocol is designed so that it makes economic sense to absorb all the fees (and the coinbase transaction) and transform them into electricity usage. High network usage and a high price of BTC lead to a more secure network, even if the network doesn’t need that much security.
This means that from a tokenomics point of view, there is no direct link between network usage and the price of BTC, and the price is based only on the sentiment of buyers and sellers.
Ethereum was created as a platform for building decentralised applications (dApps). ETH is the token powering the network.
In the original implementation, it inherited most of the PoW security protocol of Bitcoin.
Applying the same reasoning as we did for Bitcoin, we can conclude that transaction fees are transformed into electricity, thus security by the miners.
There are more factors at play when compared to Bitcoin which will change the dynamic.
Smart contract support enables the issuance of new assets on Ethereum that other people want to buy. These assets attract new users to the ecosystem who end up holding the native currency as a means to trade easily. This reason for buying ETH falls in the first category of buying the token for its utility.
The DeFi movement enabled by the ability of Ethereum to support Autonomous Agents added an interesting twist to the tokenomics. ETH can now be staked in various decentralised protocols and it is earning a yield. This adds both the first (utility) and the second (dividends) reason for buying the token.
What is important to notice is that the buying pressure from these two factors is not converted into electricity by the protocol. It is a net positive.
“Proof of stake” (PoS) is a highly complex protocol which aims to achieve the same goal as PoW, with the difference that there is no more mining, and thus burning of electricity.
We should notice now that this removes the protocol-level forced selling pressure. The tokens paid as fees no longer have to be sold to pay for electricity. This is an immediate win for the token price.
But it goes further than that. “PoS” is based on “Delegated staking”. Anyone can delegate “ETH” to the stake of a node and earn a dividend. The yield is paid from either transaction fees or inflation.
This means that all the collected transaction fees that used to be converted into electricity are now paid as interest to existing ETH holders. If you recall the three reasons for swapping assets, you will notice that this represents the second reason.
The transition to PoS has not only removed a weakness of the ETH tokenomics, but it has transformed it into a strength.
We can see that what started as a system based purely on the sentiment of market participants (which has worked very well for Bitcoin, by the way) has now become more complex by adding both utility and yield to the mix.
Utility and yield
Before concluding, it’s useful to look a bit into the mechanics of how the yield is created, as this will allow us to better understand the risks of this approach.
At the time of this writing, there are 120Million ETH out there, out of which around 15 Million are staked, paying a yield of ~4%. Basic math tells us that to support this yield, the network has to generate at least 600.000 ETH in fees per year.
Let’s consider the extremes.
Let’s say the network is utilised to the maximum. The blocks are full, and the fees are high. The protocol has two options to handle this fortunate scenario: either increase the yield or burn the collected fees. Both measures will lead to a price increase, not via some metaphysical mechanism, but because the yield will go up in both situations. In case ETH is removed from circulation, eventually, less will be staked and the yield will increase. A higher yield increases demand for the token.
On the other hand, if the network is not utilised, the protocol has to either mint new ETH to pay the yield or accept that less will be staked and thus negatively impact the protocol. If it constantly mints new ETH in significant quantities, it can lead to a snowball effect. All that new ETH can be staked, and the protocol has to mint exponentially more each time to maintain the yield to an attractive level. This can lead to hyperinflation, the worst nightmare of crypto.
This article focused purely on tokenomics and left out all technical details or judgements about the expectation of value increase.
Based purely on tokenomics, the new “PoS” Ethereum has an improved model if the goal is to increase the value of the ETH token and make it “sound”, or even “ultra-sound”.
This analysis also highlighted a risk. This new system can create the expectation of a yield, and, if the utility drops and the network cannot pay that yield, it could undermine confidence and decrease the belief in the token as a store of value. People who don’t believe in the utility of Ethereum thus have a good reason to doubt the sound money theory.
On the other hand, for believers in the utility of Ethereum and the wider Ethereum ecosystem composed of Layer 2s and Layer 3s, the transition to PoS should be very bullish news since there is now a strong link between the usage of the network and the price of ETH.
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