Another important consideration of tokenomics are the incentives users have to play some role in a cryptocurrency’s function. The most explicit reward is that provided for processing new blocks of transactions, which differs depending on the consensus method used; the two main methods having already been introduced.
Mining (PoW) – Being rewarded for processing transactions by running mining algorithms for Proof of Work blockchains, like Bitcoin
Validating/Staking (PoS) – Being rewarded for validating transactions by staking funds in Proof of Stake blockchains.
Blockchains are self-organising. They don’t recruit or contract Miners or Validators, they simply join the network because of the economic incentive for providing a service. The byproduct of more Nodes is an increase in the resilience and independence of the network.
Being directly involved as a Miner or Validator requires technical knowledge, and up-front costs, such as specialist equipment, which in the case of Bitcoin means industrial scale operations beyond the budget of solo miners, and in the case of Ethereum, a minimum stake of 32 ETH.
But as the crypto ecosystem has become more sophisticated opportunities to passively generate income, by indirectly staking and mining, have grown dramatically.
Users can simply stake funds for PoS chains with a few clicks within a supported wallet and generate a passive income, or add their Bitcoin to a Mining Pool to generate a share of the aggregate mining rewards.
Ethereum will experience a significant change in its tokenomics in 2022, changing from a Proof of Work consensus mechanism to Proof of Stake. ETH holders have been able to stake since December 2020, when Ethereum 2.0 launched.
Total Value Locked (TVL) provides a measure of how much Ethereum has been staked, while figures are also available for how much ETH is now being burned, and the impact on overall supply.
Both these metrics are being interpreted positively by supporters of Ethereum, but its detractors simply say that the ability to make wholesale changes to its governing principles illustrates weakness, not strength.
How successful chains are at attracting this financial backing has a significant impact on price, especially where funds are locked for a given period as part of the commitment, as this provides price stability.
The impact of fees
Whatever consensus method a cryptocurrency uses, it can only grow if there is demand for transactions from users, which will be influenced by:
- the cost of making a transaction, how it is calculated & who earns it
- how fast a transaction is processed
Fees and Miner/Validator revenue are two sides of the same coin, providing a barometer of blockchain usage and health. Low fees can incentivise usage; while an active and growing user base attracts more Miners/Validators, keen to earn fees. This creates network effects, generating value for all participants in a win-win situation.
Fees are especially important where they pay for computational power, rather than just the processing of transactions. This type of blockchain emerged in the years following Bitcoin’s launch, starting with Ethereum, known as the world’s computer. It provides processes the majority of transactions related to the growth areas of DEFI and NFTs, but has become a victim of its own success with its fees – measured in something called GAS – pricing out all but the wealthiest users.
Addressing that challenge is one of the key objectives of the changes in the Ethereum Roadmap. EIP 1559 – aka the London Upgrade – which happened in August 2021.
Not only did the fee estimation process completely change, with the aim of making fees cheaper, the changes to Ethereum’s fee structure are also having a significant impact on its tokenomics. Instead of all transaction fees going to Ethereum Miners, a mechanism was introduced to burn a portion of fees turning it from inflationary (no maximum supply cap) to disinflationary.
Consensus methods and fee structures can therefore, provide important incentives for participation in a blockchain ecosystem, and even directly impact supply, so should be considered as part of tokenomics. There are also a number of other incentives and influences that complete the tokenomics picture.
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