The Impact of EIP-1559 and Proof-of-Stake Consensus on Ethereum Monetary Policy
How a reduction in miner selling pressure could create conditions similar to a Bitcoin halving event
Intro
Ether (ETH) has seen significant price appreciation this year, surging to $4,300 as of May 12, compared with $189 only twelve months ago. While the performance so far has been impressive, there are two Ethereum network updates on the horizon that could catalyze an even larger run in the next 12–18 months: first, the execution of EIP-1559 in July 2021, followed by the merge to a Proof-of-Stake (PoS) consensus system in early 2022 (both dates subject to change) as part of the broader upgrade to Ethereum 2.0. These two updates will fundamentally change Ethereum’s monetary policy, and the effect on total supply, issuance and liquidity could impact the price of ETH in a way similar to how Bitcoin halving events have initiated major bull runs.
Halving Cycles and Selling Pressure
An interesting aspect of bitcoin (BTC)’s historical price pattern is its relation to halving cycles. Every 210,000 blocks (approximately 4 years), the amount of BTC awarded to miners (and thus added to total outstanding supply) for completing blocks is programmatically halved, effectively making BTC disinflationary over time as it asymptotically approaches a hard total supply cap of 21 million in the year 2140. In Bitcoin’s history, there have been three halving events (2012, 2016 and 2020), and each time the reduction in block rewards has initiated a major bull run over the subsequent months.
To understand why, note that Bitcoin uses a Proof-of-Work (PoW) consensus system where miners compete to add blocks to the blockchain by proving they have expended computational power (i.e. work) in order to secure the network. Mining is a painstaking process that requires expensive computing equipment and large amounts of electrical power. In order to cover these overhead costs as well as pay employees and income taxes, Bitcoin miners must sell a large amount of the BTC that they earn through block rewards and transaction fees. This effectively creates constant, price-insensitive daily selling pressure in the market, which would drive the cost of BTC down if not offset by an equal or greater amount of demand. When the block reward is reduced by 50% every four years, bitcoin miners have 50% less BTC available to sell, thus reducing the daily sell pressure. Over time, as the days accumulate with less supply being provided to meet stable or increasing demand, price increases, as we saw during the last three cycles.
How This Relates to Ethereum
If we establish that a reduction of selling pressure from miners contributes to an increase in BTC price during the period after halving events, we can apply this same logic to ETH knowing the upcoming changes being made to the network. The Ethereum network also uses a PoW consensus system like Bitcoin, but there is no hard cap to ETH supply, leading some Bitcoin proponents to criticize the lack of scarcity. However, this is about to change, as Ethereum is introducing two major network updates that will mark a sharp pivot in monetary policy.
In early 2022, as part of the Ethereum 2.0 upgrade, Ethereum is merging from PoW to a PoS consensus system where network participants can stake their ETH (essentially locking it up as collateral) and become transaction validators to secure the network. Instead of relying on energy-intensive mining like under PoW, PoS relies on economic incentives by rewarding honest validators with block rewards and transaction fees (paid in ETH) and penalizing dishonest validators by ‘slashing’ their ETH. Furthermore, PoS will allow ETH stakers to earn attractive yields simply by holding the asset in a special account. The more forthcoming change to the Ethereum network is an update known as EIP-1559 (Ethereum Improvement Protocol), expected to pass in July 2021. In addition to certain technical upgrades, EIP-1559 establishes that ~70% of ETH-denominated transaction fees on the Ethereum network will be burned (removed from circulation), while the remaining ~30% will be rewarded to stakers.
Modeling the Impact of EIP-1559 and Proof-of-Stake
Justin Drake, a researcher at the Ethereum Foundation, recently published several models forecasting the impact of PoS and EIP-1559 on the supply and issuance of ETH, and the results are highly favorable to ETH holders. Under the current PoW system, there are ~13.5k new ETH/day being issued to miners in the form of block rewards, plus an additional ~10.0k ETH/day in the form of transaction fees, resulting in a total of ~23.5k ETH/day in new issuance to miners being added to the total outstanding supply. As discussed earlier, the costs of hardware, electricity, employees and income taxes under a PoW consensus system are so substantial that miners need to sell most of their newly issued ETH. Of that ~23.5k ETH/day in new issuance, Drake estimates that miners currently sell ~95% to cover expenses, meaning there is currently a constant daily sell pressure in the market of 22.3k ETH/day.
After EIP-1559 is activated in July, ~70% of all transaction fees will be burned, meaning that stakers will receive only ~3.0k ETH/day in fees after the merge. PoS also greatly reduces the new issuance of ETH under block rewards from ~13.5k ETH/day to ~2.1k ETH/day. Combined, Drake estimates that after the merge, stakers will receive ~5.1k ETH/day, of which they will sell only ~50% to cover expenses (staking has a higher profit margin than mining because it does not require the same magnitude of computing equipment and electricity). The end result carries important implications: after the Ethereum network moves to a PoS consensus system in early 2022, daily net selling pressure coming from miners will be reduced by ~90% or 19.8k ETH/day (7.2 million ETH/year), which is equivalent to saying “an increase of 19.8k ETH/day (7.2 million ETH/year) in net buying pressure.”
This upcoming reduction to ETH selling pressure via EIP-1559 and PoS is analogous to a Bitcoin halving event. Whereas BTC daily sell pressure is reduced by 50% in a halving event every four years, ETH daily sell pressure is about to experience a 90% reduction. After the merge to PoS, there will be ~20k less ETH supplied as liquidity to meet demand every day (about 1% of daily volume), making the market less liquid and more volatile over time. There will be two additional sources of illiquidity: (1) the ability to stake ETH and earn yield under PoS, which incentivizes long-term holding, and (2) the growing volume of ETH being ‘locked’ in DeFi protocols to be used as collateral for loans or to provide liquidity in pools. If these three factors combine to make ETH less liquid, any large demand inflows post-PoS could theoretically drive massive ETH price increases.
What could drive an increase in demand inflows to the ETH market? For one, the aforementioned changes to Ethereum monetary policy will create a compelling narrative for ETH as it becomes an institutional-grade store of value that competes with Bitcoin. Consider the combined effect of EIP-1559 and PoS on ETH daily issuance: in periods of high network usage, the amount of ETH burned from transaction fees will outpace the amount of new ETH issued as block rewards, making ETH net deflationary (conversely, ETH will be net inflationary during periods of low network usage). Justin Drake has expressed high confidence that ETH will, in fact, deflate after the merge, given recent activity trends.
While Bitcoin has attracted interest from investors as a store of value due to its hard supply cap of 21 million BTC, Ethereum takes this a step further by actually reducing its total supply over time. There are currently ~115 million ETH in existence, and that number will grow as high as ~120 million by the merge to PoS in early 2022. After this point, the ETH being burned from transactions fees will likely exceed the ETH being issued to stakers, causing total ETH supply to decrease by 1–2% per year or more if transaction volumes remain robust. Institutional investors who were attracted to Bitcoin’s non-inflatable supply will undoubtedly be compelled by Ethereum’s new deflationary properties. Additionally, after the merge to PoS, investors will be able to earn ETH-denominated staking yields, making ETH a productive, cash-flow-generating asset. This is significant because the inability to earn yield on cryptocurrencies has been a major criticism from traditional investors who are accustomed to dividend-producing equities and coupon-paying fixed income assets. The ability to earn attractive yields on Ethereum will drive interest from more investors, especially when juxtaposed against Bitcoin, which has no such built-in mechanism.
Conclusion
Bringing this all together, if we establish that Bitcoin’s halving cycle is a catalyst for price increases due to the reduction in price-insensitive selling pressure from miners, there is reason to believe that Ethereum will experience a similar phenomenon due to the impact of EIP-1559 and PoS. If Justin Drake’s forecasts are accurate, ETH will see a ~90% reduction to its daily sell pressure after the merge to PoS in early 2022, which is far greater than the ~50% reduction to BTC sell pressure that has catalyzed three major BTC bull runs to date. With institutional awareness growing and a compelling adoption narrative being formed, it is possible that the new era of Ethereum monetary policy after EIP-1559 and PoS could facilitate a parabolic ETH price increase sometime in the next 12–18 months.
Risks
It is important to recognize several risks that could jeopardize this thesis from playing out. Despite concrete plans and commitment from developers, there is still the potential that EIP-1559 and/or the merge to PoS either fail or are delayed, due to protests from miners or technological issues. Additionally, transaction fees could decrease to levels that prevent the amount of burned ETH from making a substantial impact on total supply. Lastly, Ethereum is not immune to broader macroeconomic conditions, and could crash along with other risk assets if the economic environment deteriorated, as it did in March 2020 due to concerns over COVID-19.
Sources
The data use within this report was sourced from models produced by Justin Drake from The Ethereum Foundation. For more information on ETH supply and issuance, refer to the links below.
