Understanding Ethereum 2.0 Economics: If BTC is digital gold, what is the long-term value of ETH?

Written by: Nick Tomaino, founder of venture capital firm 1Confirmation

Compiled by: Perry Wang

Original title: "Understanding the Economics of Ethereum 2.0"

An endowment investor recently told me, “I believe BTC is digital gold, but I don’t know what the long-term value of ETH is? Unlike a business, it has no underlying cash flows. Throughout history, when an asset reaches a market cap of billions of dollars but has no fundamentals to support it, it eventually collapses. This is bound to be the likely outcome for ETH.”

Many traditional investors have similar views. They now believe in the investment rationality of BTC, but they do not understand the investment rationality of ETH. BTC's monetary policy is simple and will not change, and it has a clear narrative of value storage - digital gold. Unlike BTC, ETH's monetary policy is confusing and will change, and its narrative of value storage is also unclear.

With the upcoming launch of Eth 2.0, things are about to change. The technical upgrades to Ethereum that come with Eth2 are exciting and have attracted most of the attention, but the economic upgrades are likely to have a greater impact.

Economic upgrade 1: Strengthening monetary policy

One of the new features of cryptocurrency is that there is no central bank that can change its monetary policy at will. Many central banks around the world have recently increased the money supply, causing harm to citizens (see what happened in Lebanon as a recent example). The BTC community has a culture of keeping the protocol unchanged, allowing it to build trust around BTC's monetary policy, which is designed with the primary goal of maintaining digital scarcity.

Ethereum’s early culture of innovation was different from Bitcoin’s, led by its famous founder Vitalik Buterin, who had a significant influence on the community. Some of Ethereum’s early protocol changes led some to believe that its monetary policy was easily changed by the whims of a few people. The DAO hard fork was the most publicized protocol change, but there have been two other hard forks that adjusted block rewards since the Ethereum genesis block was created on July 30, 2015.

The reality is that Ethereum’s governance today is much closer to Bitcoin’s than most people realize. Ethereum’s plan is to change its monetary policy once again when Eth 2.0 launches (more on that below). Once Eth 2.0 is on mainnet, the likelihood of Ethereum’s monetary policy changing again will be about the same as the likelihood of BTC’s monetary policy changing. Both are possible, but the likelihood is slim and depends on consensus and approval by developers, miners, and users.

Economic Upgrade 2: Reduce the issuance rate

At the genesis block, Ethereum distributed 72 million ETH tokens to the initial contributors. Since the genesis block, 39.2 million ETH has been distributed to Ethereum miners through a proof-of-work (PoW) consensus mechanism similar to Bitcoin. Since July 2015, the inflation rate of PoW-based ETH has been approximately 11.20% per year, which is twice the 5.58% annual inflation rate of BTC during the same period.

With the launch of Eth 2.0, Ethereum's consensus mechanism will change from PoW to Proof of Stake (PoS), and the amount of coins issued will be greatly reduced. The theoretical maximum amount of coins issued when Phase 0 is launched is 2 million ETH per year. This means that the ETH inflation rate will decrease: it was 4.5% in the past year, and the inflation in the first full year of ETH 2.0 will not exceed 1.80%. Based on conservative assumptions about the number of validators, the total number of ETH staked, and transaction fees, the inflation rate may be much lower than this value (details are as follows).

It is well known in the crypto community that Bitcoin’s current inflation rate is around 1.8%, which is better than the inflation rate of a basket of global fiat currencies, which is around 2.99%. What is less well known is that when ETH 2.0 is launched, ETH’s inflation rate will be better than BTC’s inflation rate.

Economic Upgrade 3: Burning transaction fees may cause ETH inflation to approach 0 much earlier than 2140

Currently, ETH miners capture all fees associated with transactions on the Ethereum network. This activity has grown rapidly, with miners earning approximately 259,823 ETH ($59.7 million) in fees over the past year.

With the introduction of Ethereum Improvement Proposal EIP 1559, a large amount of transaction fees will be burned instead of being paid directly to miners. This means that if more transaction fees are burned than newly issued ETH, the net inflation rate may even be negative. This table on Google Doc explains its economic model in detail: what net inflation rate will Eth2 present based on various assumptions about PoS participation and transaction behavior.

Excerpted from: https://docs.google.com/spreadsheets/d/1zU1wzlDsw-BPWp5d4eJMJLHGuCbBUJ2rPLP7eanW9I/

As we all know, 120 years from now, in 2140, the total supply of BTC will reach 21 million and its inflation rate will drop to 0. Because this monetary policy is written into Bitcoin's code, BTC holders have full faith in BTC's digital scarcity. But ETH's policy has not yet been finalized, so people are less confident in ETH's digital scarcity. However, once Ethereum's new policy is finalized and people begin to examine it carefully, they may realize that ETH is much scarcer than generally believed.

ETH’s evolving investment narrative

For cryptocurrency to become a good asset for storing and transferring value, it needs seven properties: scarcity, durability, divisibility, portability, interchangeability, recognizability, and programmability. BTC is generally considered to be the best example of these seven characteristics. ETH currently has six of these properties and is particularly good at programmability, which also distinguishes cryptocurrency from legal tender and gold.

One attribute that ETH has lacked so far is a perception of scarcity, which makes its investment narrative confusing and ambiguous.

But note this fact, which is a good reflection of this: despite leading the industry in innovation and having the most on-chain transactions, ETH's total market capitalization is only about 15% of BTC's total market capitalization. The Ethereum upgrades mentioned above are not set in stone yet, and until developers submit code and miners and users approve them, the above statements are just rumors. However, once the changes mentioned above become a reality soon, ETH's investment narrative will likely win more resonance among traditional investors.