(Listen to our latest podcast here. It is with Sandeep Nailwal of Matic Network, which is a layer 2 protocol working on ETH’s Plasma. Matic Network recently finished a successful launch on Binance Launchpad and is also the first Indian crypto startup to receive funding from Coinbase Ventures).
Ethereum is currently on track to shift to a new Proof-of-stake based consensus system from the existing Proof-of-work consensus protocol in 2020. One of the biggest features in the transition to PoS is going to be the changes in the underlying validator economics. Block rewards should be considered as the cost required to maintain the integrity of the blockchain by incentivizing block producers/miners/validators not to act in a malicious way and attack the blockchain. The downside to that is that block rewards invariably dilute the ownership of existing token holders.
Designing appropriate incentive structures for miners/validators involves striking a fine balance between security and dilution (maintaining adequate security whilst not overly diluting the ownership through block rewards). In the current scenario, under the current block reward of 2 ETH per block, roughly 4.8 million ETH is being created on an annual basis to secure the network. However, after moving to PoS, the reward mechanism is going to be a function of total ETH staked in the network. As the ETH staked in the network increases, the network becomes more secure, and the new issuance of ETH decreases. For example, at 30 million ETH staked, the annual issuance drops to as low as 100k ETH per year in contrast to the 4.8 million ETH in block rewards right now.
The first iteration of the proposed rewards structure for validators came under scrutiny as it was not deemed to be profitable for small scale validators based on current ETH price and existing fees market. Under the model, validator profitability is driven predominantly by the growth in fees, and the fee market is actually expected to shrink once sharding comes into effect. You can see the profitability matrix for the rewards structure in Figure 1. The matrix shows the net yield of a validator node as a function of network fees per day, ETH staked in the network and ETH price. At the current fee market rate of 500 ETH per day, staking more than 2 million ETH in the network is going to put validator profit in the red, assuming an ETH price of $148.
Figure 2 is a sensitivity analysis of Net yield with daily network fees and ETH price. Expectedly, keeping the volume of network ETH at Stake constant at 32 million ETH, the higher the ETH price, the higher the yield.