Ethereum Merge is Complete — But So What?
An Overview of Monetary Policy Changes in the Post-Merge Ethereum
Brief Intro to the Merge — Context
The Merge, the biggest update in crypto history, was successfully completed on September 15, 2022 — after years of development. This event marks the network shift from Proof-of-Work (PoW) to Proof-of-Stake (PoS) with the transition to the Beacon Chain, which has been running since December 2020. In this article, I will focus on the Economics of such change, analyzing Ethereum protocol’s past and future monetary policy.
There are many other updates lined up for the coming months that will introduce new rules to the ecosystem such as Shard Chains, but I will limit the analysis with current data.
How PoW Economics Worked —The Past
In the pre-Merge PoW network, miners must perform hard computational puzzles in order to be assigned to validate the next block — a process that requires massive energy consumption. Consequently, mining is an economically intensive process, requiring high financial incentives through ETH issuance for the maths to make sense.
So, let’s dive deeper into the actual numbers:
- Execution Layer Issuance: In every block, or every 13.5 seconds, a block is validated with ~2.08 ETH in rewards for the miner; this translates into 4.93 million ETH issued per year. Considering the current circulating supply of 120.5 million, we observe an annual inflation rate of 4.09%.
- Consensus Layer Issuance: On top of block rewards, around 1,600 ETH are issued per day — or 584,000 ETH per year — and distributed to stakers on the consensus layer. Assuming the same 120.5 million in circulating supply, there is an additional inflation rate of 0.48%.
- Aggregated Inflation Rate (or Annual Issuance Rate): 4.09% + 0.48% = 4.57%.
Clearly, this monetary policy structure results in constant deterioration of holdings, benefiting miners above every other economic agent in the ecosystem. The consensus for the next best alternative is Proof-of-Stake (PoS).
What Changes with The Merge — The Catalyst
In the PoW model we discussed above, the penalty of unsuccessful attempts for malicious activities from miners can be simplified into just the energy cost incurred. With the completion of The Merge and transition to PoS, users must stake 32 ETH in order to run a validator node, which is locked and also serves as collateral. For undesired behaviours such as inactivity, malicious attacks, and misleading validations, there are direct penalties incurred to the staked amount, called Slashing Penalty.
With the switch, there are no miners in the network anymore, and also no block rewards — we will look at this difference in the next section.
Before we move on to PoS inflation calculations, it is important to highlight the whopping +99% reduction in energy consumption due to the almost negligible computational use required for running nodes. In the chart above, it is clear that concerns regarding ESG guidelines are solved, which will open many doors for institutional players to invest and to further develop the Ethereum ecosystem.
How PoS Monetary Policy Works — The Future
With all being said, the key information we want to analyze is the new ETH issuance rate, and compare it to the pre-merge rate.
- Execution Layer Issuance: Zero. In Proof-of-Stake, there are no block rewards like pre-merge Ethereum or Bitcoin; Inflation Rate of 0%.
- Consensus Layer Issuance: There are no changes here, maintaining the same ~1,600 ETH daily issuance distributed to stakers on the consensus layer. Assuming 120.5 million in circulating supply, we have an inflation rate of 0.48%.
- Aggregated Inflation Rate (or Annual Issuance Rate): 0% + 0.48% = 0.48%.
This is a 89% reduction in inflation rate, which directly improves economic incentives and upside potential. But that still makes ETH inflationary, right? Well, it depends. If gas price is on average 16 gwei or over, at least 1,600 ETH will be burnt per day, making it a deflationary asset. Thus, assuming adoption will keep trending up, we will most likely have a deflationary scenario.
Final Thoughts
When comparing PoW and PoS, there are many arguments to support both sides. For Ethereum, however, the thesis is to become the base layer for all DApps, which would imply large scale adoption. Scalability, energy concerns, and transaction costs are all key for achieving mass adoption, and the Ethereum team is guiding the protocol in this exact direction. Next up are multiple updates, leading up to the also awaited Sharding — when we should finally see lower gas prices.
Ethereum now has better monetary policy when looking for value accrual, and it will depend solely on increased adoption and further tech development to succeed in the long-term.
Sources:
https://ethereum.org/en/energy-consumption/
https://ethereum.org/en/upgrades/merge/issuance/
