Ethereum, the second-largest cryptocurrency by market capitalization, has seen a significant drop in its network fees in recent months. This is due to a combination of factors, such as lower speculative activity, reduced demand for NFTs and DeFi, and the adoption of layer 2s for scaling. While this may be good news for Ethereum users who can enjoy cheaper transactions, it also poses a challenge for Ethereum’s ultra sound money thesis, which relies on high network fees to burn more ETH tokens than new issuance.
Ethereum’s network fees, also known as gas fees, are the costs that users pay to execute transactions and smart contracts on the blockchain. Gas fees are determined by supply and demand, and they tend to increase when the network is congested or when there is high demand for certain applications or services.
According to data from IntoTheBlock, Ethereum’s income from network fees has fallen to its lowest level since April 2020 and is down 90% from its peak in May 2021. This means that Ethereum is generating less revenue from its users and that its security budget is also reduced.
One of the main reasons for the decline in network fees is the emergence of layer 2s, which are solutions that aim to improve Ethereum’s scalability and performance by moving some transactions off the main chain. Layer 2s can offer faster, cheaper and more secure transactions than the base layer, while still inheriting its security and decentralization.
Some of the most popular layer 2s on Ethereum include Optimism, Arbitrum, Polygon and zkSync. These solutions have attracted many users and developers who want to avoid high gas fees and enjoy a better user experience. For example, Optimism has partnered with Uniswap, one of the largest decentralized exchanges on Ethereum, to launch a layer 2 version of its platform. Arbitrum has also onboarded several DeFi protocols, such as Aave, Balancer and Curve. Polygon has become a hub for NFTs and gaming projects, such as OpenSea, Decentraland and Axie Infinity.
While layer 2s are beneficial for Ethereum’s ecosystem and adoption, they also have an impact on ETH’s supply dynamics. ETH is the native token of Ethereum, and it is used to pay for gas fees, stake in the proof-of-stake consensus mechanism, and access various applications and services on the network. ETH’s supply is determined by two factors: issuance and burning.
Issuance is the process of creating new ETH tokens as rewards for validators who secure the network. Burning is the process of destroying ETH tokens as part of the network fees. Burning reduces the circulating supply of ETH and creates a deflationary pressure on its price.
Ethereum’s ultra sound money thesis is based on the idea that ETH’s supply will become deflationary over time, as more ETH tokens are burned than issued. This will make ETH more scarce and valuable than other forms of money, such as fiat currencies or even bitcoin.
However, this thesis depends on high network fees to sustain a high level of burning. If network fees are low, then less ETH tokens are burned and more ETH tokens are issued. This will keep ETH’s supply inflationary and undermine its ultra sound money thesis.
This is what is happening right now on Ethereum. According to IntoTheBlock data, over the past 30 days, ETH’s supply has grown by 33,500 ETH – worth some $52 million – driven by the low activity on the base layer. This means that more ETH tokens are being issued than burned.
IntoTheBlock’s head of research Lucas Outumuro said that network fee revenue will likely stay low as speculative activity dries up and users continue migrating to layer 2s. He said that NFT trading was responsible for the bulk of tokens burned in 2021 and early 2022, but last week, it only represented 8%.
“The low fee regime represents a major transition for Ethereum, trading off high revenues and deflationary supply for the promise to be able to attract mainstream users through layer 2s,” he said.
Ethereum’s low fee regime challenges its ultra sound money thesis, but it does not invalidate it. Ethereum still has other sources of value proposition, such as its network effects, its innovation, its programmability and its community. Ethereum also has plans to upgrade its protocol and introduce new features that could boost its network fees and its burning mechanism.
One of these features is EIP-1559, which is a proposal to change the way gas fees are calculated and paid on Ethereum. EIP-1559 introduces a base fee that is adjusted dynamically according to the network demand and that is burned entirely. It also introduces a tip that users can pay to prioritize their transactions and that goes to the validators. EIP-1559 aims to make gas fees more predictable, more efficient and more deflationary.
Another feature is the merge, which is the final step of Ethereum’s transition from proof-of-work to proof-of-stake. The merge will eliminate the need for miners who consume a lot of energy and create new ETH tokens. Instead, it will rely on validators who stake their ETH tokens and receive rewards for securing the network. The merge will reduce the issuance rate of ETH and increase its security and sustainability.
Ethereum’s low fee regime is a challenge for its ultra sound money thesis, but it is also an opportunity for its growth and adoption. Ethereum’s layer 2s are enabling more users and developers to access its network and its applications, while its protocol upgrades are enhancing its performance and its economics. Ethereum’s ultra sound money thesis may not be realized in the short term, but it is still possible in the long term.