Understanding the charm of token economics design: taking Bitcoin and Ethereum as examples

Cryptocurrency is a huge experiment, and token economics is an important part of the experiment.

The term “Tokenomics” is a mixture of tokens and economics, and its meaning is quite similar to economics. Token economics studies how people interact with tokens. Especially the issuance, distribution and destruction of cryptocurrency tokens. Economics is usually divided into microeconomics and macroeconomics. In this article, I want to view the internal operations from a micro perspective: Bitcoin and Ethereum .

Just as the central bank applies monetary policy to control its currency, tokenomics applies policy to cryptocurrencies. These policies are the core of a currency. If these rules are not considered carefully, currencies are likely to fail. The rules of token economics are implemented through code and are difficult to change because they require the consent of many network participants. Due to these decentralized protocols, cryptocurrencies are generally more predictable than similar currencies issued by central banks. For example, the issuance rate and schedule are pre-set, and the burn rate (removed from circulation) is predictable to a certain extent. Compared with traditional fiat currencies, these characteristics make investing and owning cryptocurrencies more transparent.

The design aspects of token economics are: how to create tokens, how to get tokens into circulation, and how to remove them from circulation. Incentive mechanisms also play an important role in this process. How do you get network participants to do what you want them to do? If you want the transaction to be added to the blockchain, you will need to pay a fee to the miner to include it. If you want people to stake their tokens and verify the network, you have to pay them. The design aims to guide people how to interact in the network.

Why is it a good idea to study the economics of tokens?

Unless you are designing a new cryptocurrency, you may wonder why you should study token economics. If you are thinking about exchanging your hard-earned and tax-paid fiat currency for some kind of digital token, it would be good to understand some basic dynamics. There are many different cryptocurrencies to choose from, and understanding the economics of tokens will help you make a decision. The key points that need to be studied are:

  • What is the number of existing tokens and how much will it increase?
  • Is the supply inflation (increase) or deflation (decrease)?
  • Do tokens have utility, that is, can they be used for other purposes besides exchange?
  • What are the real world use cases?
  • Who owns most of the tokens? Is it scattered or concentrated in a few accounts?

For me, these issues are important issues to study before investing. Understanding the supply and demand of tokens will help you form an investment argument. In this article, I want to start with the simplest, arguably the most beautiful design, and then gradually move up to more complex models. In future articles, I would like to explore some other less popular coins, study algorithmic stable coins in depth, and possibly conduct more macro studies by studying cross-chain exchanges. But first let’s start with Bitcoin.

Bitcoin

Understanding the charm of token economics design: taking Bitcoin and Ethereum as examples

The simplicity of Bitcoin’s design is its charm. Let’s take a look at the chart above:

  • The total supply of 21 million is pre-programmed. Approximately every 10 minutes, a block is mined, and miners are rewarded with 6.25 BTC (at the beginning of Bitcoin, the reward for each block is 50 BTC, then 25, 12.5, 6.25, etc.). Every 210,000 blocks, the reward is halved-calculated at 10 minutes per block, it is equivalent to halving every 4 years. Without changing the agreement, the final Bitcoin will be mined around 2140 (supply curve).
  • Bitcoin’s inflation rate is halved every 4 years. So far, we can see that due to the expected decrease in supply, this has caused a spike in prices. During the first and second halvings, the value of Bitcoin climbed by about 9000% and about 3000%, respectively.
  • The current circulation indicates that we are close to nearly 90% of the total supply. The annual circulation can be calculated as follows: the total number of minutes per year/10*6.25. First divide the total number of minutes in the year by 10, because a block is mined every 10 minutes. Then multiply this number by 6.25, because each mined block will issue 6.25 new BTC. Currently, the annual supply of new bitcoins is approximately 328,000 BTC.
  • Transaction fees are used to pay miners to add your transaction to the next block. The basic fee is related to the size of the transaction, in bytes, you can add a tip above to give priority to purchase and speed up the processing (details of fee calculation).
  • As shown in the figure, miners obtain new bitcoins through mining rewards and put them into circulation when they are sold on the market.

All in all, Bitcoin is simple and elegant because its mechanism is predictable. This does not really help predict price fluctuations, but if it is easy to understand and explain, it can help eliminate surprises in your investment argument.

Ethereum 1.0 + EIP 1559

Understanding the charm of token economics design: taking Bitcoin and Ethereum as examples

Ethereum was very similar to Bitcoin when it started. In its current version, it also relies on the “Proof of Work” consensus mechanism. Smart contracts have given Ethereum more practicality, and a huge decentralized application (Dapps) ecosystem has been developed and has generated very high transaction volumes. Some issues related to this have been resolved in the recent update (EIP-1559), which has also led to interesting new token economics dynamics. Let’s take a look at the chart.

The current annual supply of Ethereum is about 4.5%. The reward for miners is 2 ETH per block, and 1.75 ETH per uncle block. This reward has been reduced through previous requests for software changes. In general, the overall calculation is not as simple as Bitcoin, but the daily block reward is about 13,500 ETH, which is equivalent to about 4.9 million ETH issued every year.

One big difference from Bitcoin is that not all ETH is mined. In fact, most of it is issued as part of the pre-mining of the genesis block. Adding up the mined and pre-mined ETH, the current circulation is about 116 million.

EIP-1559 will stabilize transaction fees so that they are not too high during busy periods. Before EIP-1559, transactions were auctioned. This means that users can pay high prices and allow their transactions to be processed quickly. Miners are incentivized to choose the highest fee and extract the greatest return for them. Users with lower bids are forced to wait or raise their bids.

Since the implementation of EIP-1559 on August 4, 2021, the fees have been divided into fixed basic fees and small priority fees. The basic fee will be dynamically adjusted, but the total fee must not change more than 12.5% ​​from the previous block, effectively controlling volatility. The priority fee still allows users to buy priority by tipping miners, but it is limited due to the total gas limit of the block.

EIP-1559 not only introduced the basic cost, but also destroyed the same basic cost and removed it from circulation. Paying the basic fee to the miner instead of burning it will not improve the situation, because the off-chain protocol can allow for auction-like tips, as we knew from EIP-1559 before (this article proves this in detail).

Let us assume that approximately 70% of the transaction fees are burned (simulation here and here), which may result in the consumption of approximately 2.6 million ETH per year. Approximately 4.9 million ETH is added every year, which will cut the supply in half. With more adoption, we may even see Ethereum turn into deflation.

Ethereum 2.0

Understanding the charm of token economics design: taking Bitcoin and Ethereum as examples

The large-scale application ecosystem built on Ethereum is developing rapidly, faster than the network itself can adopt. Due to the scalability issues of the underlying network, transaction costs are high and processing time is slow. The Ethereum team has been working hard to introduce a new and more scalable stack. The Ethereum 2.0 beacon chain has been launched and plans to merge with Ethereum 1.0 ~2021/2022. Let’s see what will change in 2.0.

Ethereum 2.0 has shifted from a proof-of-work consensus to a proof-of-stake consensus mechanism . Mining has become obsolete, replaced by verifiers who will ensure the security of the network. Mined and pre-mined supplies remain in circulation after the merger, so users are not affected.

Anyone who is willing to pledge 32 ETH can become a validator, or can act as multiple validators when the mortgage is also multiplied. Verifiers will receive an annual return (APR) reward. This expenditure is the only source of new network issuance in Ethereum 2.0. The more ETH pledged, the lower the annual rate of return of the pledger, and the more new ETH is issued. There are currently about 6 million ETH pledges. If Ethereum 2.0 goes live today, the potential issuance will be between 300,000 and 600,000. The APR rate of return is 6.3% (see the table for details).

Understanding the charm of token economics design: taking Bitcoin and Ethereum as examples

Since the beacon chain of Ethereum 2.0 has been launched, staking can be carried out today. However, these funds will be locked until the official merger of versions 1 and 2. More than 6 million ETH has been pledged and therefore has been released from current circulation, which is a potential supply shock.

Staking comes with responsibilities: storing data, processing transactions, and adding new blocks. If you fail to verify, go offline, or operate maliciously, you may be punished and your profits may be eaten away.

The cost burning introduced by EIP-1559 will continue and may lead to slight inflation or even deflation, depending on the transaction volume.

Concluding remarks

Tokenomics is the core of every cryptocurrency project (blockchain or Dapp). Poor token economics design can lead to low adoption rates, false incentives, or ultimately the failure of the entire project. Therefore, it is important to understand how tokens flow in a protocol or blockchain, and should be part of any project evaluation or research.

Bitcoin and Ethereum have existed for quite a long time, and this can be attributed to the incentive structure that encourages users to join the network and miners to verify transactions. Those who know Bitcoin will see its great value because it is so simple, elegant and has a limited total supply. Bitcoin’s token economics creates digital scarcity enforced by the network (incentivized by tokens).

On the other hand, Ethereum has introduced smart contracts that allow the execution of decentralized code. The cost of execution is gas and is paid to miners/validators in ETH, making the token ETH practical. People who own ETH can use it to pay for the execution of a piece of code in applications such as Uniswap , AAVE or Maker.

Cryptocurrency is a huge experiment, and token economics is an important part of the experiment. Protocols and blockchains use tokenomics for experimentation. This rapid experiment through trial and error is a good way to develop the system and its tokenomics model, and ultimately create a better system.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/understanding-the-charm-of-token-economics-design-taking-bitcoin-and-ethereum-as-examples/
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