“The Merge” Impact on Developing ETH Tokenomics

Understanding the tokenomics of cryptocurrency is an indisputable task in predicting the future of the token. ETH is obviously no exception to this rule, and the appearance of The Merge forces all players to reconsider their view of the ETH offers available on the market.

Since the official announcement of the Merge, there has been a noticeable impatience about the emergence of a model that would severely limit ETH inflation. So what is it really?

Separation between the level of execution and the level of consensus

Currently, according to the Coinmarketrate.com , the Ethereum blockchain is divided into two parallel networks with different purposes.

On the one hand, the execution level, called mining, is the level at which all the miners of the Ethereum network are grouped. As part of their work and Proof of Work, miners are allowed to interact only with the execution level. Their role? To solve various equations, they are given the opportunity to confirm blocks in the blockchain in order to contribute to its security.

On the other hand, the consensus layer, or beacon chain, was created only to facilitate the implementation of Proof of Stake. In this network, there are only validators who are involved in ensuring the security of the network. In fact, since its launch in 2020, this chain has not processed transactions on the Ethereum blockchain. However, validators are destined to replace miners after “the Merge”.

Two sides contributing to the evolution of ETH supply in the market

The offer of Ether (ETH) is due to two completely different, but undoubtedly complementary aspects:

  1. ETH Emission: the process of creating ETH that did not exist before
  2. Incineration of ETH: the process of destroying ETH to remove them from circulation

Please note that after the “London” update in 2021, the burning of Ether occurs with each new transaction on the blockchain. Indeed, in order for a transaction to be considered valid, the minimum transaction fee must be paid in ETH.

However, these minimum fees are then burned during the transaction, as a result of which ETH is withdrawn from circulation with each transaction on Ethereum. This update was supposed to cause the issue of ETH to become deflationary.

The Merge and Tokenomics

Rewards offered at various levels of the blockchain. Whether at the execution level or at the consensus level, contributors to the security of the network receive a monetary reward for their activities.

  • At the execution level

Before the “Merge”, the miner who first solves the next block in the blockchain receives the reward. So, starting with the Constantinople update in 2019, the block confirmation fee is set at 2 ETH.

In addition, miners are rewarded for confirming valid blocks, but not included in the canonical chain. In this case, the miner who publishes the ommer block receives an additional reward of 1.75 ETH.

  • The Consensus level

In the chain of beacons, everything happens differently, since validators must confirm the state of the chain and offer the inscription of new blocks. This work is naturally rewarded in ETH.

More specifically, the calculation of these rewards varies depending on the performance and the number of validators present in the network. However, one metric remains unchanged: the duration of the distribution of rewards. Thus, validators are rewarded every epoch, i.e. every 6.4 minutes.

In this system, rewards or penalties are usually less than those offered to miners. This is due to the fact that the complexity of participating in the verification of transactions on the PoS consensus is lower.

Comparison of ETH Emissions at Two Ethereum levels

Bearing in mind that two layers of Ethereum are involved in the creation of ETH, it’s time to make an approximate calculation of the consequences for the creation of ETH.

  • Before the Merge

The execution level produces an average of 2.08 ETH every 13.3 seconds, or 4,930,000 ETH issued per year. As a result, ETH inflation for the year is approximately 4.13%.

The consensus layer produces an average of 1,600 ETH per day, or 584,000 ETH issued per year, with an inflation rate of about 0.50%.

In fact, currently 80.4% of ETH emissions are intended for execution-level miners, while only 10.6% of these ETH are intended for beacon chain validators.

  • After the merge

The merge will change the consensus rules of the Ethereum blockchain. After it occurs, the PoW rules will no longer apply to the execution level. Therefore, the execution level will no longer issue ETH.

The consensus level will still have an issue similar to the current one – 1,600 ETH per day. However, the difference will be noticeable, since validators confirming and offering blocks will now be rewarded.

Ultimately, the Merge is expected to reduce the annual issue of ETH by 89.4%.

Determining the remuneration of validators after the merge

In the blockchain, PoS validators are paid for following the established rules and ensuring the security of the network. Therefore, a golden mean must inevitably be found in order to properly encourage validators to act on the network.

Too little incentive to become a validator will weaken the security of the blockchain due to a lack of validators, and too much incentive can disrupt the economic stability of the blockchain.

Number of validators in the network

Prior to the Merge, in order for the chain of beacons to begin its journey, only 16,384 validators were required.

After The Merge, Ethereum developers have established a minimum number of validators in order to ensure reliable protection of the blockchain. Thus, 128 validators will be required for each committee, which means 262,144 validators and 8,388,608 ETH at stake.

A committee is a random subset of active validators selected to perform functions in a specific slot on a selected shard of the blockchain. Thus, the meaning of having so many validators on each shard is to reliably transmit information about the state of the blockchain at any given time between different shards.

Validation rewards

Validators are rewarded for successfully completing the tasks assigned to them. Thus, every 6 minutes (in each epoch), a task is assigned to a validator, and the latter receives a reward if he completes it on time. Remuneration (in ETH) for validators varies depending on the total share of ETH in the network:

  • Lower total ETH rate: the percentage of return to the validator increases;
  • Lower total share of ETH: the profit margin per validator increases;
  • The total share of ETH in the network is increasing: the annual issue of ETH is increasing to finance validators.

The profit margin is simply the annual rate at which validators are rewarded for their participation in ensuring network security.

Penalties for offline validators

The rewards offered to validators contribute to the additional issue of ETH in circulation. Conversely, penalties that may affect validators contribute to the disappearance of ETH from the market.

How do these penalties work and what impact do they have on the issue of ETH?

Technically, the penalty leads to a decrease in the amount of ETH on the validator’s balance. Although this is not actually burning, the inability to redistribute these ETH to another account is akin to withdrawing fined ETH from circulation.

Moreover, offline validators have an impact on the entire network, since every 1% of offline validators reduces the total number of issued ETH by about 3%.

On the other hand, if more than 33% of validators are offline at the same time, the goal cannot be achieved. Thus, if the situation persists for more than 4 epochs (i.e. about 25 minutes), all autonomous validators will be punished. In practice, developers expect that such a situation will occur very rarely. 

Validators will not have direct access to the fruits of their labor

Thus, the transition to proof of stake will mark the launch of rewards and punishments for Ethereum validators. However, validators will not be able to access the ETH accumulated as a result of their work until a future update.

Next after the Merge, the Shanghai Update will be in the spotlight. After the Merge, the validators’ rewards will accumulate on the balance sheet at the consensus level. In fact, the accounts in question will be different from the accounts currently available on the network.

As a result, rewards for validators will be released in the Shanghai update scheduled for 6-12 months after the “Merger”. Thus, until this update is completed, the ETH earned as rewards cannot be withdrawn or transferred by validators.

As a result, most of the ETH issued after the Merge will not be immediately available on the market.

Therefore, the circulation of these ETH is delayed for several months. However, there are many concerns about the consequences of the release of these ETH after the Shanghai update.

Firstly, validators eligible for these rewards are advised not to collect all ETH received as rewards immediately after their release.

Secondly, if a significant part of the validators do not comply with this aspect, the number of validators simultaneously leaving their role is limited to 6 validators per epoch. Moreover, this number can be reduced to 4 in order to avoid a large number of ETH entering the market at the same time.

Summing up 

The merger will lead to a profound transformation of the ETH tokenomics. Reducing ETH emissions by almost 90%, as well as the process of burning the minimum fees required to complete the transaction, should significantly reduce ETH inflation.

The ultimate goal of the Ethereum community is to make ETH deflationary in the long run. Only time will give an answer to this challenge, but the Merge is an indispensable condition for its solution.