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Gas and other use cases
In the most straightforward way, Ether is digital money on the Ethereum network. It is required when a user interacts with the network to pay network fees in the form of “gas.”
Gas is the allocative internal pricing mechanism in Ethereum used in transactions and can reach exceptionally high price levels during periods of network congestion. Gas is a derivative of Ether designed to mitigate spam attacks on the network and efficiently allocate computational resources. Transactions on the network must have some cost, otherwise, malicious actors could send millions of transactions a day for free, congesting the network.
Users pay different amounts of gas depending on the type of transactions they are looking to execute. The more complex the transaction, the more gas is required. Sending 1 ETH to a friend (an ETH transfer) is far simpler (computationally-speaking) than minting an NFT. Thus, minting an NFT requires more gas and is more expensive. Below is a monthly chart of ETH gas fees.
ETh gas market. Source
ETH gas usage by sector, May 2023. Source: Galaxy Digital Research
Fees, in addition to newly minted ETH each block, are rewards for Ethereum validators. As block rewards decrease over time, fees must grow to continually financially incentivize validators on Ethereum (figure below). Etherscan provides useful metrics on Gas and other components of the Ethereum network.
Source
Users of Ethereum are willing to pay nearly 20x more for its blockspace. Source: Token Terminal
In the early stages of Ethereum (pre-2019), Ethereum was unique in its economics for many reasons but none more so than its status as the platform of choice for launching ICOs. ICOs raised $5.6 billion in 2017 and $7.8 billion in 2018 but have become less prominent over the years due to U.S. regulatory concerns.
Monetary Policy and EIP-1559
In contrast to Bitcoin’s hard-cap approach, the Ethereum community supports a non-hard-cap supply in support of the smallest amount of inflation necessary to secure the chain in the future. The tokens emitted via inflation accrue proportionally to ETH stakers participating in the PoS consensus. Post-Merge, the daily issuance of ETH has decreased from approximately 15,000 ETH to less than 2000 ETH. Due to a drop in issuance and a reasonably stable burn rate, the net supply change of Ethereum has been negative since the Merge, decreasing overall. At this pace, Ethereum's annualized inflation rate is ~0.12%. Before the Merge, the annualized rate of inflation fluctuated between 4 and 5 percent.
ETH inflation, while not algorithmically programmed, has steadily decreased over time.
Image credit: Galaxy Digital
Integral to Ethereum’s long-term plan to act as sound digital money was the implementation of EIP-1559 in August 2021 during the London hard fork. The goal is to create a more efficient and simple gas payment process. EIP-1559 aims to improve user experience by reducing transaction wait times, mitigating fee-market uncertainty/volatility, and improving upon ETH’s imprecise gas usage for a typical transaction; this is in addition to introducing a burn mechanism.
EIP-1559 uses a mechanism similar to Bitcoin’s PoW difficulty adjustment to automatically find a dynamic equilibrium for gas prices. EIP-1559 changed Ethereum to have 2x the current block space but only target blocks to be 50% full (as opposed to nearly 100% currently). Therefore, over time, Ethereum’s blocks and block size will, on average, remain about the same, but the extra block space allows for flexibility with regard to transaction inclusion. If blocks get >50% full, gas costs increase. If blocks are <50% full, gas costs will decrease.
Prior to EIP-1559, Ethereum used a fee auction market structure to organize transactions similar to Bitcoin, where users place bids to compete for space on the next Ethereum block. Miners in PoW generally selected the transactions with the highest bids since they stood to collect all the fees. There was a gas ceiling of 12.5 million per block, meaning some transactions would get priced out until future blocks with a lower accepted fee.
The implementation of EIP-1559 and its fee-burning mechanism transformed ETH into a productive asset. Furthermore, the shift from Proof of Work (PoW) to Proof of Stake (PoS) reduced the rate of newly issued ETH. Since 'the Merge' in September 2022, Ethereum has ceased to distribute block rewards to miners, which has led to a ~90% drop in new ETH issuance, replacing ~14k ETH/day block rewards with ~1.7k ETH/day staking rewards. During periods of high network activity, this change has made the ETH supply deflationary.
EIP-1559 is a mechanism that enables Ethereum to reduce the net issuance of ETH as a function of the demand to transact on the network. This is the piece that makes ETH a consumable commodity. The combination of the base fee burn coupled with lower validator rewards in PoS plus ETH locked up in staking will result in a net negative issuance and shrinking circulating supply. Researchers estimate the supply equilibrium will eventually be between ~27-50 million ETH.
Image credit: Galaxy Digital
It also ensures that ETH is the only economic unit on Ethereum and removes the possibility of economic abstraction – the ability to pay fees in an asset besides Ether. Burning ETH also adds a deflationary mechanism to the ETH supply.
In addition to introducing variable block sizes to Ethereum, the London Upgrade and EIP-1559 increased the gas limit per block to 30 million; EIP-1559 also updated the structure of transaction fees. There will still be a base fee and a tip (or priority fee). The base fee is set by the protocol and adjusts every block based on network activity. The base fee no longer goes to miners but is instead burned. The tip is set by the market (can be zero in times of little congestion) and will go to the miners.
Source: TheBlock.crypto
How EIP-1559 Changes Value Capture on Ethereum
The economic model of Ethereum encompasses three critical components: total transaction fees, the portion of transaction fees that are burned, and staking rewards. Transaction fees are based on the supply and demand for the network's block space. Staking rewards are inflationary and add to the total ETH supply, while transaction fee burns introduce deflationary pressure on the native token. Over time, the reduction in supply can contribute to increasing the token's value.
The TL;DR of a hypothetical Ethereum transaction goes accordingly:
- Users initiate a block by paying 1 ETH as transaction fees, which includes Miner Extractable Value (MEV).
- Of the transaction fees, 0.8 ETH undergoes 'burning,' a process akin to a share buyback benefiting all ETH holders equally.
- The validator then garners 0.2 ETH from the transaction fees and an additional 1 ETH from block rewards. These rewards consist of newly minted ETH.
- If the validator received half of its stake from delegators, the validator is obligated to share 50% of its revenue with those ETH holders.
This process results in 0.8 ETH being burned, the validator receiving 0.6 ETH, and the ETH holders who participated in staking via delegation receiving 0.6 ETH.
Source: TokenTerminal
In the Ethereum ecosystem, approximately 85% of total transaction fees paid are burned, effectively serving as a 'share buyback' equally benefiting all ETH holders. The validator earns the remaining fees and an additional staking reward. Over the past 30 days, Ethereum has averaged around $15 million in daily fees.
Ethereum, as of 2023, has a market cap of roughly $200 billion and a circulating supply of about 119,000,000 ETH. Ethereum remains the second-largest cryptocurrency by market cap behind Bitcoin but leads all crypto projects in several meaningful economic categories.
