Understanding the Charm of Token Economics Design: Taking Bitcoin and Ethereum as Examples

Author: Florian Strauf
Translator: Glendon Mao

The term "Tokenomics" is a blend of tokens and economics, and its meaning is quite similar to that of economics. Tokenomics studies how people interact with tokens, particularly the issuance, distribution, and destruction of cryptocurrency tokens. Economics is generally divided into microeconomics and macroeconomics. In this article, I want to start from the micro perspective of internal operations: Bitcoin and Ethereum.

Just as central banks apply monetary policy to control their currency, tokenomics applies policies to cryptocurrencies. These policies are at the core of a currency. If these rules are not carefully considered, the currency is likely to fail. The rules of tokenomics 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 often more predictable than their fiat counterparts issued by central banks. For example, the issuance rate and schedule are predetermined, and the burn rate (removal from circulation) is somewhat predictable. These features make investing in and owning cryptocurrencies more transparent compared to traditional fiat currencies.

The design aspects of tokenomics include: how to create tokens, how to bring 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 transactions to be added to the blockchain, you will need to pay miners a fee to include them. If you want people to stake their tokens and validate the network, you must pay them a fee. This design aims to guide people on how to interact within the network.

Why is it a good idea to study tokenomics?

Unless you are designing a new cryptocurrency, you might wonder why you should study tokenomics. If you are considering exchanging your hard-earned and taxed fiat currency for some digital tokens, it would be good to understand some basic dynamics. There are many different cryptocurrencies to choose from, and understanding tokenomics will help you make decisions. Key points to research include:

• How many tokens currently exist, and how many more will be created?
• Is the supply inflationary (increasing) or deflationary (decreasing)?
• Do the tokens have utility, i.e., can they be used for purposes other than exchange?
• What are the real-world use cases?
• Who owns the majority of the tokens? Is it decentralized or concentrated in a few accounts?

For me, these questions are important to research before investing. Understanding the supply and demand of tokens will help you form your investment thesis. In this article, I want to start with the simplest, and arguably the most elegant design, and then gradually move up to more complex models. In future articles, I want to explore some less popular coins, delve into algorithmic stablecoins, and potentially conduct more macro research by studying cross-chain exchanges. But first, let's start with Bitcoin.

Bitcoin

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, rewarding miners with 6.25 BTC (Bitcoin started with a reward of 50 BTC per block, then 25, 12.5, 6.25, etc.). Every 210,000 blocks, the reward is halved—at a rate of one block every 10 minutes, this means a halving approximately every 4 years. The final Bitcoin will be mined around 2140 (see supply curve).
• Bitcoin's inflation rate is halved every 4 years, and so far, we can see that the anticipated reduction in supply has already caused price surges. During the first and second halvings, Bitcoin's value increased by approximately 9000% and about 3000%, respectively.
• The current circulating supply indicates that we are close to nearly 90% of the total supply. The annual issuance can be calculated as: total minutes in a year / 10 * 6.25. First, divide the total minutes in a year by 10, as a block is mined every 10 minutes. Then multiply this number by 6.25, as each mined block issues 6.25 new BTC. Currently, the annual new Bitcoin supply is approximately 328,000 BTC.
• Transaction fees are the fees paid to miners to add your transaction to the next block. The base fee is related to the size of the transaction in bytes, and you can add a tip on top of that to prioritize and speed up processing (see details on fee calculation).
• As shown in the chart, miners receive new Bitcoins through mining rewards and put them into circulation when they sell them on the market.

In summary, Bitcoin is simple and elegant because its mechanisms are predictable. This does not truly help predict price fluctuations, but if it is easy to understand and explain, it helps eliminate surprises in your investment thesis.

Ethereum 1.0 + EIP 1559

Ethereum started off very similarly to Bitcoin. In its current version, it also relies on a "proof of work" consensus mechanism. Smart contracts give Ethereum more utility, and a large decentralized application (Dapps) ecosystem has developed, generating very high transaction volumes. Recent updates (EIP-1559) addressed some related issues, leading to interesting new dynamics in tokenomics. Let's take a look at the chart.

Ethereum's current annual supply is approximately 4.5%. Miners receive a reward of 2 ETH per block and 1.75 ETH for each uncle block. This reward has been reduced through previous software change requests. Overall, the calculations are not as straightforward as Bitcoin, but the daily block rewards are about 13,500 ETH, equating to an annual issuance of approximately 4.9 million ETH.

A significant difference from Bitcoin is that not all ETH is mined; in fact, most was distributed as part of the pre-mined genesis block. The total mined and pre-mined ETH currently amounts to approximately 116 million.

EIP-1559 stabilizes transaction fees, preventing them from becoming too high during busy periods. Before EIP-1559, transactions were auctioned. This meant users could bid high to have their transactions processed quickly. Miners were incentivized to choose the highest fees for maximum returns. Users with lower bids were forced to wait or raise their bids.

Since the implementation of EIP-1559 on August 4, 2021, fees have been divided into a fixed base fee and a small priority fee. The base fee will adjust dynamically, but the total fee cannot change by 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 base fee but also burned the same base fee, removing it from circulation. Paying the base fee to miners instead of burning it does not improve the situation, as off-chain protocols could allow for similar auction-like tipping, as we knew before EIP-1559 (see this paper for detailed proof).

Let’s assume that about 70% of transaction fees are burned (simulations can be found here and here), which could lead to the consumption of about 2.6 million ETH per year. With an annual issuance of about 4.9 million ETH, this would effectively halve the supply. With more adoption, we might even see Ethereum become deflationary.

Ethereum 2.0

The large application ecosystem built on Ethereum is growing rapidly, faster than the network itself can adopt. Due to scalability issues with the underlying network, transaction fees are high and processing times are slow. The Ethereum team has been working to introduce a new, more scalable stack. The Ethereum 2.0 beacon chain is now live and plans to merge with Ethereum 1.0 ~2021/2022. Let’s see what changes will occur in 2.0.

Ethereum 2.0 shifts from a proof of work consensus to a proof of stake consensus mechanism. Mining becomes obsolete, replaced by validators who will ensure the security of the network. The supply of mined and pre-mined tokens remains in circulation after the merge, so users are not affected.

Anyone willing to stake 32 ETH can become a validator, or can take on multiple validator roles when staking increases. Validators will receive rewards in the form of annual percentage rate (APR). This expenditure is the only source of new issuance in Ethereum 2.0. The more ETH staked increases the lower the annual return rate for stakers, and the more new ETH is issued. Currently, about 6 million ETH are staked, and if Ethereum 2.0 were to launch today, the potential issuance would be between 300,000 and 600,000. The APR yield rate is 6.3% (see table).

With the launch of the Ethereum 2.0 beacon chain, staking can occur today. However, these funds will be locked until the official merge of versions 1 and 2. Over 6 million ETH have already been staked, thus removed from current circulation, which poses a potential supply shock.

Staking comes with responsibilities: storing data, processing transactions, and adding new blocks. If you fail to validate, go offline, or act maliciously, you may face penalties, which could eat into your profits.

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

Conclusion

Tokenomics is at the core of every cryptocurrency project (blockchain or Dapp). Poorly designed tokenomics can lead to low adoption rates, misaligned incentives, or ultimately the failure of the entire project. Therefore, it is important to understand how tokens flow within a protocol or blockchain, and this should be part of any project evaluation or research.

Bitcoin and Ethereum have been around for quite some time, thanks to their incentive structures that encourage users to join the network and miners to validate transactions. Those who understand Bitcoin will see its immense value, as it is so simple, elegant, and has a limited total supply. The tokenomics of Bitcoin creates digital scarcity enforced by the network (through token incentives).

On the other hand, Ethereum has introduced smart contracts, allowing for the execution of decentralized code. The cost of execution is gas, paid in ETH to miners/validators, giving the token ETH utility. Those who hold ETH can use it to pay for executing a piece of code in applications like Uniswap, AAVE, or Maker.

Cryptocurrency is a massive experiment, and tokenomics is an important part of that experiment. Protocols and blockchains use tokenomics to experiment, and this rapid experimentation through trial and error is a good way to develop systems and their tokenomics models, ultimately creating better systems.