Ethereum is Proof-of-Stake, Now What?
Here are the Things You Need to Know One Month After Ethereum’s Transition to PoS
At a Glance
- The merge on September 15th was successful and trouble-free
- Electricity consumption for Ethereum is down 99.5%
- By design, gas fees remain unchanged
- Ethereum Community awaits the “Shanghai” update to unlock staked ETH
- “The Splurge” is the next step on the roadmap of the Ethereum Foundation
- The supply of $ETH is periodically deflationary and has significant inflation resistance
- Ethereum encountered no regulatory hurdles as a result of the merge, but there is a discussion around whether ETH Staking yields resemble bonds (more here)
- With the removal of mining, ETH has become a yield-bearing asset, with the staking yield at the time of writing around 8,3% APR
- Ethereum is more economically secure against a 51% attack under Proof-of-Stake (PoS)
History Made on September 15th
Following September 15th’s long-awaited merge, the Ethereum blockchain transitioned to Proof-of-Stake consensus without a hitch. It is hard to overstate how much of a gargantuan achievement this represents: a blockchain securing thousands of applications and billions in capital flows daily changed how it operates on the most basic level- without anything breaking in the process.
A proof-of-stake consensus algorithm now secures the Ethereum Blockchain by requiring validators to stake 32 ETH to operate validator nodes that process transactions and add blocks to the blockchain. Presently, there is over 14,000,000 ETH locked in the staking contract - valued at over $19,000,000,000, with 440,000+ validators in operation. It is possible to earn 6% — 12 % annual returns depending on whether a staker runs their own node at home, keeps their ETH in their own custody, or if they use custodial services and staking derivatives that compound their staking rewards, resulting in a higher annual return. In terms of energy consumption, Ethereum is now in a class by itself when it comes to Layer 1 blockchains, using 99.5% less power for continuous year-round operation.
Ethereum Supply Dynamics Are Vastly Different Now
The issuance rate, otherwise known as the inflation rate, is the amount of new supply divided by the amount of existing supply. Prior to the transition to Proof-of-Stake, Ethereum had a ~3.5% annual inflation rate. In relative terms, bitcoin currently has a ~1.76% inflation rate. The Ethereum network now issues ~1,600 ETH per day (-0.1% annual issuance rate at the time of writing), issued to validators (ETH stakers) for securing the network. If gas prices average 16 gwei, then 1,600 ETH is burned every day, effectively bringing net ETH inflation to zero- or less when more is burned as a result of increased activity and thus gas spending.
In the last few weeks, ETH’s net issuance has ranged between -1% to 0.6%, depending on the amount of daily activity that affects how much ETH is burned as a result of fee spending. It is worth noting that when new ETH is issued, it is issued to validators, who do not incur operating costs, unlike miners in proof-of-work systems. This reduces the daily overhead of sell pressure on Ethereum to a significant degree. In practice, this means that since the merge about a month ago, around 416k ETH (540m$) that would have been issued under PoW weren’t.
5.6b$ of annual structural selling of ETH (issuance to miners) was effectively eliminated overnight.
The current total supply of ETH is approximately 120,500,000 ETH. With significantly more clarity on the supply and issuance of Ethereum, there is a surge of interest in secure staking solutions, both centralized and decentralized.
The yield stakers generate depends on three variables:
- The amount of ETH staked
- Net transaction fees (or, to put it simply, usage of the chain
- Maximal Extractable Value (MEV)
In our pre-merge staking report, we estimated: Currently, the staking yield on Ethereum’s Beacon Chain ranges between 4.3–5.4% APR based on the ETH issued to reward stakers for fulfilling validation duties. We expect the total yield to rise to upwards of 8–11% APR after the merge, once we consider net transaction fees and “Maximal Extractable Value”.
This estimate proved largely correct, with the current yield hovering around 8.3%.
Contrary to most other “staking” mechanisms that some PoS-based blockchains employ, the yield on ETH is what we call “real yield” as it is not negated by dilution through expansion of supply. On the contrary, since on-chain activity has historically been cyclical, it is not unreasonable to assume mean reversion to higher levels.
Impact on Gas Fees
There is a common misconception that the gas fees for everyday transactions have been reduced. Ethereum’s solution for scaling to mass adoption continues to depend on Layer-2 blockchains, which enable near-zero gas fees for transactions while providing security and finality through the Ethereum mainnet (Layer-1).
Ethereum gas costs remain relatively low due to lower activity overall, which has resulted in less demand for block space in general. The Proof-of-Stake consensus does not prevent Ethereum transaction fees from exceeding $100 per transaction if activity on Ethereum grows exponentially, as in prior times of high activity. Now, however, gas spikes will lead to a reduction in total supply.
Originally a community-run analytics dashboard, Ultrasound Money has quickly become the go-to dashboard for everything Ethereum. The dashboard offers interesting metrics, such as the net issuance of Ethereum after accounting for EIP-1559’s burning of ETH. Ultrasound Money can be used to see which smart contracts are contributing the most amount of ETH supply reduction in real time. At times, the net issuance of Ethereum is deflationary due to increased demand for block space when gas fees rise in excess of 16 gwei for prolonged periods of time.
[The area above 15.3 Gwei is referred to as the “Ultra Sound Money Barrier”]
Nevertheless, a few welcome benefits that will go mostly unnoticed are in effect. Block production now occurs every 12 seconds versus 13.3 seconds during proof-of-work
Source: Ychart — Ethereum Blocks per Day
Source: YChart — Ethereum Average Block Time
The Ethereum blockchain is now well-positioned to cope with the many attack vectors that all blockchains face. With regards to reducing centralization risk, new validator nodes can be activated to secure the network, and barriers to entry are being lowered through affordable and easy-to-use staking services. It is significantly more expensive and difficult to carry out a 51% attack on the Ethereum network than a 51% attack on the Bitcoin network, even though the two attacks would use different methodologies. If a bad actor did attempt to take over the Ethereum blockchain, a social recovery “soft-fork” is a simple counterattack the community of stakers can utilize.
Going Forward with Ethereum
While overall market dynamics have overshadowed the engineering marvel that was demonstrated on September 15th, it is hard to understate how much of a game changer it has (been and will be) for ETH and the DeFi ecosystem at large in the long run.
With ETH supply being neutral to negative at the low end of historically cyclical levels of activity, one can imagine the supply dynamics that take place as activity increases.
Notably, developer activity shows no signs of slowing down. 2022 already set a new high for new smart contract deployments on Ethereum.
Source: Alchemy Q3 Developer Report
From a macro investment perspective, ETH represents a diversified index for DeFi, 90% of which occurs on the Ethereum blockchain. Overall, It’s an exciting time in the fintech sector as web3 financial primitives are being built, early products are maturing, and regulations are becoming more clear.