Ethereum
Scaling Ethereum with L2s damaged its Tokenomics. Is it possible to repair it?
While Ethereum’s Layer 2s are at an all-time high in terms of active addresses and transactions, the mainnet may not be faring as well.
What is the impact of L2s on Ethereum’s deflationary goals?
Posted May 15, 2024 at 10:56 AM EST.
Ethereum, often celebrated as an “ultrasound currency” due to its deflationary bent, has become inflationary again over the past month, calling into question the fundamentals that its community believed determined its value. A recent report by CryptoQuant has declared the ultrasound money narrative dead, sparking debate and concern over the tokenomics of ETH.
Learn more: What is Tokenomics? A beginner’s guide
The heart of the problem lies in the balance between Ethereum’s main chain and its Layer 2 (L2) scaling solutions. Although L2s successfully improved Ethereum’s scalability by handling transactions off the main chain, they inadvertently reduced demand for Ethereum’s native token, ETH, on the main chain. This reduction in demand led to a drop in transaction fees, measured in gwei, and consequently a decrease in ETH consumption. Currently, gwei is around 8, which is significantly lower than in previous periods, indicating that at this level ETH is far from deflationary.
Learn more: Why Ethereum Gas Fees Dropped to Their Lowest Level Since 2020
Ethereum may shift from deflationary to inflationary due to changes in network activity and the balance of Ether burned versus issued. Below EIP-1559, when transaction volumes are low and the base fees burned are less than the Ether issued as block rewards, the total supply of Ether increases, making Ethereum inflationary. This dynamic demonstrates how the supply of Ethereum is not fixed but responds to network usage, which can impact its value and scarcity when shifts from a deflationary to an inflationary state occur. .
Meanwhile, Ethereum L2s are tearing apart, treatment 10 times more transactions than the main chain, while reaching a weekly all-time high active addresses.
Given these gas fee levels, the question arises: how much activity needs to occur in L2s for ETH to become deflationary again?
Learn more: Horizontal Scalability is the Solution to L2 Fragmentation
A complex system
Ansgar Dietrichs, a researcher at the Ethereum Foundation, told Unchained that ETH’s deflationary mechanism is directly linked to its market capitalization and the balance between income and expenses. At low prices, the combustion mechanism can exceed issuance, making ETH deflationary. However, as market cap increases and if revenues do not follow proportionately, ETH may become inflationary.
This bidirectional influence means that market cap not only affects the deflationary or inflationary nature of ETH, but also that this nature, in turn, affects market cap through investor perceptions and behaviors.
To reverse this trend and restore ETH’s deflationary status, a significant increase in L2 activity is necessary. This means that more transactions and fees need to be redirected to the Ethereum main chain to increase ETH consumption. However, according to Dietrichs, no research has been done to gauge exactly how much activity this would require. Neither the Ethereum Foundation nor researcher Justin Drake responded to multiple emails requesting additional information on the level of L2 activity needed to keep the ETH supply deflationary.
Furthermore, Dietrichs pointed out that for any given level of revenue and emissions, with constant investor preferences, there is essentially a specific equilibrium market capitalization that the market would tend toward. Any change in these factors (revenues, emissions or investor preferences) shifts this equilibrium point of market capitalization. This dynamic feedback loop suggests that meeting the deflationary challenge is not just about changing a few parameters, but about understanding and influencing a complex system of interdependent factors.
As Ethereum continues to evolve, the question remains: Can the fundamental promise of ultrasonic money be restored, or will Ethereum need to adapt to a new economic reality?
Learn more: Beginner’s Guide to Ethereum Layers: Data Availability, Consensus, and Execution