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How Ethereum’s monetary policy will change after The Merge

How Ethereum’s monetary policy will change after The Merge

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Ethereum is on the brink of The Merge, which will transform the network from proof of work to proof of stake. This major change is made primarily to reduce the grid’s energy consumption and increase environmental friendliness.

After moving to Proof of Stake, Ethereum no longer uses miners and their powerful, energy-consuming hardware. Instead, they are replaced by validators who collect large amounts of ETH and tie it to their reputation – if they act maliciously, they lose some of their tokens.

But there’s another, highly anticipated change that’s also happening: a major shift in Ethereum’s tokenomics.

This results in a significant decrease in Ethereum’s inflation rate as fewer tokens are issued each year. Simply put, the network rewards validators with fewer tokens than it currently awards miners.

Also, since the amount of Ether (ETH) is burned every year in the transaction payment process, it is possible that the network could even become deflationary – meaning the total supply of ETH decreases every year.

Here’s a look at how Ethereum’s Tokenomics is changing and the implications.

What is the current issue rate?

According to Ethereum’s proof of work system, the network pays 2 ETH for each block created by a miner and 1.75 ETH for each uncle block. An uncle block is when a block is created but narrowly loses to another block created at the same time – so it doesn’t end up in the chain, but still gets a smaller reward.

On average, this results in about 13,000 ETH each day and is given to miners as a reward.

This translates to 4.1% inflation (although there’s also already something from proof of stake, so this is technically a bit higher).

What is the percentage of issue after merger?

As Ethereum moves to proof-of-stake, validators will replace miners. These validators collect large amounts of ETH as collateral and are allowed to produce blocks on the network. If they act maliciously, they can lose their security deposit.

Since the network no longer has to cover the costs of miners (who pay huge electricity bills for the power of their 24-hour operation), it can be more efficient in distributing rewards for block production.

The new system has a dynamic payment model. This new model is much lower than the current system and varies depending on a few factors including the amount of ETH staked.

Based on the current amount of ETH staked, the network is issuing about 1,600 ETH per day, which represents an inflation rate of 0.5%. This means that when the merge happens, the daily issuance of new ETH will decrease by 90%.

As more ETH is staked, this issuance can go up to 5,000 ETH. Even if this increases, the effective return of each validator will decrease if this happens.

What if you include transaction fee burning?

So far we have kept this discussion fairly simple and limited ourselves to issuing new ETH as a mining or staking reward.

But there is one other big factor that affects Ethereum’s effective inflation, and that is token burning.

Introduced as part of the London update in August 2021, EIP-1559 brought the burning process as part of transaction fee collection online. When a person makes a transaction on Ethereum, they have to burn a part of their transaction fee and the rest goes to the miner (or soon the validator). This removes some of the total supply of ETH.

This transaction fee burning has had a big impact. Since its introduction, over 2.6 million ETH have been destroyed as a result of this alone. This roughly halved Ethereum inflation.

As Ethereum moves to Proof of Stake and rewards are cut significantly, it will be much easier for the amount to be burned to be greater than the amount to be awarded. If this happens, the network will become deflated – meaning that the supply will decrease over time

In order for the network to have an equal amount of issuance and burning after The Merge, transaction fees should average 16 gwein (the unit of measure used to pay fees). Anything higher than that online is deflation and vice versa.

Although transaction fees were very high for most of last year, they have come down significantly. As a result, less ETH is now burned due to transaction fees.

As a result, the net emission after the merger is expected to be around 0.1%.

© 2022 The Block Crypto, Inc. All rights reserved. This article is for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial or other advice.


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