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As the Ethereum network gears up for its next big ‘Electra’ upgrade, community members debate whether to include a proposal to reduce ETH’s token inflation and staking yield mechanism.
As we dig into these nuanced and complex ideas, the overall aims do seek to address Ethereum’s philosophical goals — painting different ideas about the future and intent of the world’s second-largest decentralized blockchain.
In this article, we discuss the Issuance Curve Adjustment proposal and the rationale behind the suggestions.
New Ideas for Ethereum’s Next Upgrade, Electra
On February 22, 2024, Ethereum Foundation (EF) researchers Ansgar Dietrichs and Caspar Schwarz-Schilling proposed the addition of an ETH issuance policy change in the upcoming Ethereum network upgrade, Electra.
The policy aims to optimize Ethereum to stop issuing ETH tokens more than what is necessary for security.
According to EF researchers, the proposed policy change will ensure that the dilution for ETH holders is capped at 0.4%, compared to the currency dilution limit of 1.5%.
Dilution refers to the negative yield for ETH holders due to the issuance of new ETH to stakers.
‘Ethereum Staking Economics’: A More Aggressive Approach
Additionally, Dietrichs and Schwarz-Schilling also urged the Ethereum community to consider a second option called Endgame staking economics.
This proposal looks to introduce an ETH issuance curve that is designed to go towards negative infinity beyond a certain staking level. The rationale behind this proposal is to discourage high staking participation by making it unprofitable.
“We argue that endgame staking economics should include an issuance policy that targets a range of staking ratios instead, e.g. around 1/4 of all ETH. The intention is to be secure enough but avoid overpaying for security and thereby enabling said negative externalities,” read the proposal.
Let’s put this into clearer language: Let’s assume the optimal staking ratio is decided to be 0.25 (i.e. 30 million ETH staked, out of a circulating supply of 120 million ETH).
At a low staking ratio, the staking yield will be high (say 8% APY) to incentivize staking participation. When the optimal staking ratio of 0.25 is achieved, the staking yield will be 0%.
If the staking ratio increases beyond 0.25, the staking yield will turn negative, meaning that ETH staker will have to pay to stake their tokens.
Reasons for the ETH Issuance Proposals
Here are the main reasons to adjust ETH’s issuance curve:
1. Prevent High Staking Ratio
The current issuance policy is designed to decrease staking yield as staking participation increases. However, there is no mechanism to prevent the staking ratio from exceeding a threshold. According to Ansgar Dietrichs and Caspar Schwarz-Schilling, even if all of ETH’s circulating supply is staked, the protocol will pay a staking yield of 2% APY, thereby favouring stakers over non-stakers.
2. Lower Protocol Exposure to Liquid Staking Token (LST) Risk
As mentioned above, the current issuance policy is designed in such a manner that makes it plausible for most ETH tokens to be staked. At the time of writing, liquid staking platforms are the most popular avenues for individuals to stake their ETH due to the ease of use and low fees.
Most importantly, the issuance of a LST has been a game changer in solving the illiquidity problem of the ETH staking process.
However, the LSTs that take the place of locked ETH come with added risks such as operator risk, governance risk, legal risk and smart contract risk.
3. Growing Influence of Liquid Staking Platforms
The risk of a growing or dominant influence of Lido, the most popular liquid staking platform on Ethereum, is well-documented. As of April 10, 2024, over 29% of total ETH staked was deposited on Lido.
Critics fear that Lido’s dominant position is a centralization risk for Ethereum. Even Ethereum co-founder Vitalik Buterin voiced his concern in a blog post, saying:
“Liquid staking has some natural centralizing mechanics at play: people naturally go into the biggest version of staked ETH because it’s most familiar and most liquid (and most well-supported by applications, who in turn support it because it’s more familiar and because it’s the one the most users will have heard of).”
Dietrichs and Schwarz-Schilling fear the creation of a “too-big-to-fail” staking service provider due to which security measures such as slashing may not put the entire protocol at risk.
4. LSTs Replacing ETH
The issuance curve adjustment proposal highlighted the risk of ETH being replaced by LST as the de facto money for most use cases in a high staking ratio environment. We are already seeing new ways in which LSTs are being used, be it for providing crypto-economic security on EigenLayer or for stablecoin collateralization on Ethena.
“Ultimately, Ethereum users will end up holding LSTs, economically quasi-forced to expose themselves to those added risks (operator/governance/legal/smart contract/etc. risk).
“Is this desirable for Ethereum users? Further, such intermediated ETH is worse collateral. For true economic scalability, the money of Ethereum needs to be maximally trustless: ETH,” wrote Dietrichs and Schwarz-Schilling.
5. ETH Dilution
The ease of liquid staking has given ETH holders the privilege to view staking as a yield-generation tool, when in technicality, staking yield is the cost a protocol pays to validators to keep its network operational and secure.
A key objective of the proposed ETH issuance policy is to prevent Ethereum from overpaying for its security cost. Therefore, the new policy will target an optimal staking ratio range and ensure that ETH holders are not diluted “beyond what is necessary for security.”
According to Dietrichs and Schwarz-Schilling, the proposed issuance policy will cap ETH dilution at 0.4%, compared to the current dilution limit of 1.5%.
The Ethereum Community’s Reaction to the Proposals
The reaction from the Ethereum community regarding the proposed ETH issuance curve adjustment has been mixed.
David Hoffman of a popular crypto podcast Bankless lauded the proposed issuance curve adjustment, calling it a “slam dunk.”
“I think that option 2 (Endgame staking economics) is the most credible path to choosing a monetary policy that we will never ever have to touch again,” said Hoffman.
Meanwhile, Hoffman’s co-host Ryan Sean Adams took a cautious approach and said that it may be too soon to implement a new ETH issuance policy.
“The full range of economic agents that we will see in the future have not yet entered Ethereum in force.
“We are just at the early outset of figuring what restaking is going to look like, and that could be a massive economic force inside of Ethereum’s monetary considerations.
“We don’t have an ETH ETF yet. We have no idea how much ETH the institutions are gonna slurp up and what it looks like when a BlackRock with X% of ETH starts to flex its muscles and say we are now staking.
“What kind of ripple effects will that have?” said Adams
Elsewhere on the Ethereum community forum, several members urge the community to conduct a thorough analysis of the proposals.
“I think it makes most sense to not add this into Electra fork, and wait for more analysis and clarity on these issues. We should push for more external research on issuance change impact on stake distribution,” wrote artofkot.
The Bottom Line
On April 3, 2024, Dietrichs said that at the time of writing, the proposal did not have enough required support to be accepted.
He also added that a final decision on its inclusion in the Electra upgrade will be made in four months.
So far, only four Ethereum improvement proposals have been approved to be included in the Electra upgrade.
Will these proposals make the cut? Whichever direction the Ethereum community takes, the proposals here each paint different ideas about the future of Ethereum — should it be decentralization at all costs? Is staking meant to be a way of safeguarding Ethereum or a money-making tool? Should liquid staking be an added bonus, or allowed to be a dominant focus and purpose for ETH?
These are very interesting and important questions for the community to consider.
