EIP-1559 & Ethereum 2.0 have been circulating as ideas in the Ethereum community for years. However, we are now at an inflection point at which Ethereum 2.0 very soon will become a reality and EIP-1559 will be implemented in a foreseeable future, most likely in 2021.
Both factors will lead towards a reduction in the issuance of Ethereum and will impact how Ethereum is valued. In the following, we are going to examine the impact on the supply and inflation dynamics of Ethereum.
EIP-1559
EIP-1559 was first proposed by Vitalik Buterin in 2018. The proposal has two major goals:
- To increase predictability in Ethereum transaction fees
- To reduce network congestion in periods of peak demand
Background
Ethereum miners receive regular revenues from mining transactions which are referred to as block rewards. On top they receive the transaction fees which are paid by Ethereum users.
During the boom of Decentralized Finance transaction fee revenues for miners were approaching significant levels in relation to block rewards revenues.
EIP-1559 is intended to stabilize transaction fees. Behind the scenes the Ethereum Improvement Proposal regulates the base fee that is paid on Ethereum transactions based on the network usage.
Impact on Inflation
Besides the features described, EIP-1559 triggers a deflationary mechanism to the supply of ETH. This is because the base fee of an Ethereum transaction which will be dynamically adjusted by an algorithm gets burned. The burn of the base fee essentially reduces the supply of Ethereum in circulation.
Theoretically it is possible that more Ethereum is burned than ETH is generated through mining rewards which would result in making Ethereum deflationary.
At the current point nobody can tell exactly what the inflation of Ethereum will look like after the implementation of EIP-1559. However, it is sure that the inflation rate will be lower than it was previously which would benefit Ethereum investors.
State of the proposal
During a recent implementer’s call the implementation of a testnet for EIP-1559 was discussed. It is planned to include the proposal in the upcoming Berlin hard fork. The Berlin hard fork is not yet scheduled and will likely occur during 2021.
The proposal has far reaching implications on the Ethereum ecosystem. It will require decentralized applications to adapt towards the new network dynamics.
Furthermore it impacts the miner community and leaves them worse off since currently they are receiving all the transaction fees paid on the Ethereum network. Therefore the EIP is mostly opposed by the miner community.
ETH 2.0 & Staking
ETH 2.0 was initially designed in three phases. Phase 0 of ETH 2.0 which is known as the beacon chain is projected to go live in 2020.
Despite the fact that the beacon chain won’t be fully operational in comparison to the current Ethereum chain it will mark the beginning of the Proof of Stake consensus mechanism on Ethereum. Etherum holders will be able to run a node and stake their Ethereum.
Migrating from Ethereum 1.0 to Ethereum 2.0 will be a one way transaction. Ethereum that was moved to the beacon chain can not be transferred back to the current Ethereum 1.0 chain. After some time most likely there will be trading pairs between ETH 1.0 and ETH 2.0 coins.
We at Frontier Protocols expect the price of ETH 1.0 to be slightly higher than the price of ETH 2.0 coins. This is because of the fact that ETH 1.0 can be used on the current Ethereum chain and additionally can be transferred to ETH 2.0 at any point in time.
However, ETH 2.0 will be more valuable for many investors due to the fact that it can be staked and used in order to earn an interest rate. Therefore several investors will make the transition to ETH 2.0 early on.
The staking use case will enter into competition with Ethereum’s DeFi use cases, where it can be used as collateral and to generate interest as well. Rational investors will use their Ethereum where they can expect to obtain the best risk adjusted return.
Assessing the risks associated with staking in ETH 2.0 and participating in DeFi protocols are subjective conclusions and therefore both use cases will most likely flourish independently from each other.
Inevitably staking under ETH 2.0 will decrease the supply of Ethereum since ETH will need to be locked for a certain amount of time. The ETH that is staked will no longer be available in the market just as it is the case with ETH that is used as collateral in DeFi.
ETH 2.0 has another positive side effect: It comes eventually with a lower issuance rate and can lower the inflation of Ethereum by up to 50%. However, this effect will enter into force only when ETH 1.0 and ETH 2.0 will finally merge. Temporarily the supply of Ethereum will increase since both systems will run in parallel.
Can We Quantify Both Effects?
As we have pointed out in our analysis Ethereum’s inflation reduction will only occur in the course of the next years.
Many variables are still unknown such as the amount of Ethereum that will get burned as a consequence of EIP-1559 and the percentage of Ethereum that will get staked under ETH 2.0 which will ultimately determine the issuance of Ethereum.
As pointed out by Vitalik Buterin the more Ethereum is staked under ETH 2.0 the lower will be the inflation rate. For these reasons it is far too early to make credible predictions what the inflation rate of Ethereum will be after the implementation of EIP-1559 and ETH 2.0.
With regard to Bitcoin, the impact of the halving on its price is typically only measurable months after the actual halving took place. However, some people discount the stock to flow valuation model of BTC and argue that demand is much more important than supply.
If you follow this line of thought then the reduction in inflation is not what is most relevant for the price of Ethereum. In this view the demand for an asset is the by far the most important driver of value.
Before You Go…
We at Frontier Protocols believe that the inflation dynamics of a cryptocurrency matter in the long term for the valuation of an asset. Therefore in the medium term EIP-1559 and ETH 2.0 point towards a higher fair valuation of Ethereum after they will be implemented successfully.
