While Ethereum layer 2s are at an all-time high in terms of active addresses and transactions, the mainnet may not be doing as well.
What’s the impact of L2s on Ethereum’s deflationary goals?
Posted May 15, 2024 at 10:56 am EST.
Ethereum, often celebrated for being “ultrasound money” owing to its deflationary bent, has turned inflationary again over the past month, challenging the foundational principles that its community thought drove its value. A recent report from CryptoQuant has declared the ultrasound money narrative dead, sparking debates and concerns about the tokenomics of ETH.
Learn more: What Is Tokenomics? A Beginner’s Guide
The core of the issue lies in the balance between Ethereum’s main chain and its Layer 2 scaling solutions (L2s). While L2s have successfully improved Ethereum’s scalability by handling transactions off the main chain, they have inadvertently reduced the demand for Ethereum’s native token, ETH, on the main chain. This reduction in demand has led to lower transaction fees, measured in gwei, and subsequently, less burning of ETH. Currently, gwei sits at around 8, significantly lower than in previous times, indicating that at this level, ETH is far from being deflationary.
Read more: Why Ethereum Gas Fees Have Fallen to Their Lowest Level Since 2020
Ethereum can shift from deflationary to inflationary due to changes in network activity and the balance of Ether burned versus issued. Under EIP-1559, when transaction volumes are low and the burned base fees are less than the Ether issued in block rewards, the total supply of Ether increases, making Ethereum inflationary. This dynamic demonstrates how Ethereum’s supply is not fixed but responsive to network usage, potentially impacting its value and scarcity when shifts from a deflationary to an inflationary state occur.
Meanwhile, Ethereum L2s are ripping, processing 10 times more transactions than the main chain, while reaching an all-time high in weekly active addresses.
Given these levels of gas fees, the question arises: how much activity needs to happen in the L2s for ETH to become deflationary again?
Read more: Horizontal Scalability Is the Solution to L2 Fragmentation
A Complex System
Ansgar Dietrichs, a researcher from the Ethereum Foundation, told Unchained that the deflationary mechanism of ETH is directly tied to its market cap and the balance between revenue and expenses. At low prices, the burning mechanism can exceed the issuance, making ETH deflationary. However, as the market cap grows and if revenues don’t keep up proportionally, ETH can become inflationary.
This bidirectional influence means that the market cap not only affects the deflationary or inflationary nature of ETH, but also that this nature, in turn, affects the market cap through investor perceptions and behaviors.
To reverse this trend and restore the deflationary status of ETH, a significant increase in activity on L2s is required. This means that more transactions and fees need to be funneled back to the Ethereum main chain to increase the burning of ETH. However, research has not been done to assess exactly how much activity it would take. The Ethereum Foundation did not respond to several emails requesting additional information.
In addition, Dietrichs pointed out that for any given revenue and issuance level, with constant investor preferences, there is essentially one specific equilibrium market cap that the market would trend towards. Any change in these factors—revenue, issuance, or investor preferences—shifts this equilibrium market cap point. This dynamic feedback loop suggests that addressing the deflationary challenge is not just about tweaking a few parameters, but about understanding and influencing a complex system of interrelated factors.
As Ethereum continues to evolve, the question remains: Can the foundational promise of ultrasound money be restored, or will Ethereum have to adapt to a new economic reality?
Learn more: A Beginner’s Guide to Ethereum Layers: Data Availability, Consensus, and Execution
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