Understanding Ethereum’s dividend model. Deciphering protocol’s reward mechanisms.

The aim of this article is to provide readers with a clear framework for understanding the various reward mechanisms used by blockchain protocols to incentivize token holders, ranging from ‘dividends’ to token issuance and burns. Using Ethereum as a practical example, we’ll explore how these mechanisms operate to reward holders and stakers.

What is Ethereum?

After Bitcoin’s deployment, whose network main functionality is to transact Bitcoin, Ethereum emerged as the first fully Turing-complete blockchain. This advancement introduced a platform not just for cryptocurrency transactions but for deploying smart contracts and decentralized applications, significantly broadening the scope of blockchain technology.

Based on David Hoffman’s definition of Ethereum:

• Ethereum is a new application layer for the internet: The Value Layer.
• The Internet-native global settlement layer for digital assets.
• A landscape for building permissionless financial applications, which together support a permissionless economy.

What kind of asset is Ethereum’s Ether?

Ethereum’s native token (ETH) defies simple categorization within Robert Greer’s original asset classifications.

Initially, its ability to generate yield through staking suggests it fits the profile of a Capital Asset. Yet, its role as a medium of payment within the Ethereum network, necessary for transaction fees (gas), aligns it with Transformable/Consumable Assets. Furthermore, the Proof of Stake (PoS) model which has led to approximately 25% of ETH’s supply being staked, not only incentivizes network participation and security but also affects ETH’s liquid supply and scarcity, enhancing its characteristics as a Store of Value Asset.

This multifaceted nature underscores ETH’s unique position in the digital asset landscape.

Additionally, the surge of liquid staking tokens (LSTs) such as Lido’s stETH and Eigen Layer’s restaking solutions significantly enriches Ethereum’s staking landscape.

These innovations enable ETH holders to participate in staking while retaining liquidity, allowing their staked ETH to serve as cryptoeconomic security across various protocols, not limited to Ethereum, in return for additional fees and rewards. This innovation broadens the utility and incentives for ETH holders, integrating deeper into the DeFi ecosystem.

Understanding Ethereum’s dividend model

This segment aims to clarify the concept of how cryptoassets, like ETH, generate value and offer rewards to their holders. By drawing comparisons with well-known financial concepts, this approach intends to provide readers with a foundational understanding of multiple token reward mechanisms, making the complex and often abstract world of crypto rewards more comprehensible.

First, we need to differentiate between ETH holders and stakers. ETH holders simply own the token without engaging in the network’s staking process, missing out on staking rewards. Ethereum’s reward system primarily revolves around two sources: transaction fees, which include both base fees and miner tips, and block rewards, which consist of new ETH issued with each added block to the blockchain.

Transaction fees in the Ethereum network are primarily influenced by network usage, fluctuating based on the demand for transaction processing. Conversely, block rewards are determined by the amount of ETH staked in the network. As the number of validators increases, more ETH is issued, albeit at a reduced rate per validator, leading to a practical effect of a lower annual percentage yield (APY) for each individual validator.

Finally, I’d like to mention the MEV (Maximum Extractable Value) as an ‘unofficial’ mechanism to increase the maximum amount of value a validator can receive by including, excluding, or changing the order of transactions during the block production process.

Transaction Fees

Base fee

Since the EIP-1955 upgrade, a burn mechanism was introduced. This mechanism comes in the form of a dynamic fee structure that adapts to network congestion, increasing the cost of transactions during peak times and decreasing them when demand falls.

This reward mechanism has a similar effect to stock buybacks, reducing ETH’s circulating supply . Consequently, this benefits both ETH holders and stakers by increasing scarcity and potential value. , which is ETH burnt with every transaction.

From my point of view, this burn mechanism is a perfect example on how to align tokenomics with the long run success of a protocol: the more Ethereum is used, the more ETH is burnt, the more value accrued by ETH holders.

Miner tips

The miner tip is a transaction fee paid directly to validators who process new blocks. Therefore, this validator reward is similar to a dividend, as it could be understood as a gain that comes in the form of a share of the total protocol fees in exchange to contributing to the network’s security and good functioning.

The fee amount is variable and decided by the person initiating the transaction. This choice directly impacts how quickly a transaction gets included in a block, the more you’re willing to pay, the faster your transaction will be processed.

It’s crucial to recognize that this ‘dividend’ benefits only ETH stakers, not mere holders. Nonetheless, it doesn’t negatively impact holders since it involves the redistribution of existing ETH, avoiding the dilution of their stakes.

Block Rewards

When new blocks are added to the Ethereum blockchain, new ETH is issued and given to the validators. This situation benefits only the validators because regular ETH holders don’t get these rewards. This issuance can be seen akin to stock-based compensation for validators, enhancing their share without diluting it. However, for regular holders, it acts as inflation, diluting their share of the total supply.

Here’s a simplified example: If 25% of ETH (30M ETH) is staked and there’s a 10% inflation over a year, resulting in 12M new ETH issued to stakers, their share increases to 42M ETH. This means stakers now own a larger portion of the total supply (31% up from 25%), effectively diluting the share of non-stakers.

Beyond the rewards from staking or holding ETH, investors also face exposure to the token’s price fluctuations. In essence, ETH acts as a yield-generating asset with potential for capital gains or losses.

Expanding on this, I believe ETH has the potential to serve as the native risk-free rate within the crypto ecosystem, offering a foundational benchmark for evaluating investment returns against the inherent risks of the digital asset space.

Here comes the debate

Opening up the discussion, it’s important to acknowledge that my perspective on Ethereum’s mechanisms is personal and may not apply universally across all protocols.

For example, some protocols might have a continuous token issuance schedule that serve specific purposes, such as funding operational expenses.

Indeed, various protocols allocate a portion of their token issuance to cover essential services such as bug-fix programs, development, marketing, consulting, and legal services. These allocated tokens are essentially considered operational expenses, crucial for the protocol’s ongoing maintenance, security, and growth.

These strategies underscore the multifaceted use of token issuance beyond rewards, reflecting the diverse strategies protocols employ to balance growth, security, and user incentives.

Dencun upgrade effect

The Dencun upgrade is anticipated to significantly reduce transaction fees on Ethereum, potentially by up to 90%. This reduction is expected to impact both L1 and L2 fees, making transactions more cost-effective across the Ethereum network.

However, a substantial decrease in transaction fees could also affect Ethereum’s burn rate and its supply dynamics… A 90% reduction in fees would lead to a proportional decrease in the amount of ETH burned, potentially reducing the deflationary pressure brought by the EIP-1559.

While the Dencun upgrade could stimulate increased network usage by making transactions more affordable, the sharp decline in ETH burn might not compensate it. Unless there’s a corresponding decrease in new ETH issuance (very unlikely, as the trend suggest an increase of the ETH staked) or a significant uptick in demand for Ethereum transactions, the net effect could tilt towards Ethereum becoming inflationary.

The Dencun upgrade introduces significant changes within Ethereum’s tokenomics. Notably, in the short term, Ethereum will turn into an inflationary asset. The key question is whether the drop in transaction fees will sufficiently boost network activity to revert Ethereum to a deflationary state. This would require a tenfold increase in transactions to offset a 90% fee reduction, a challenging yet not impossible scenario in the long run.

It’s also worth considering the staking trend; if the current trajectory continues and more ETH is staked, the increase in block rewards issued could further contribute to inflationary pressure.

Moreover, the change in implied APY is profound when factoring in the effect of burned tokens, which represent a form of value accrual for token holdersakin to stock buybacks.

From a developmental standpoint, the Dencun upgrade marks a pivotal achievement in Ethereum’s roadmap. It represents a leap forward in the network’s technical evolution, even though it may temporarily dampen the attractiveness of Ethereum’s tokenomics.

Even so, I personally believe that ETH would still be a great asset that should be included in any crypto portfolio.