Bankless Co-founder: Ethereum Will Ignite the Industrial Revolution of the Internet

Written by: Bankless co-founder David Hoffman

Compiled by: The Way of DeFi

The crypto-economic system must find balance.

For crypto systems to withstand the test of time, they must possess the flexibility to adapt to the ever-changing environment around them. Rigidity is fragile. Rigid systems will ultimately require human intervention to prevent collapse.

The structure of crypto economics must automatically discover a natural state of balance; otherwise, the following image will become our inevitable future:

"You are a foolish animal"; "You are waiting for the Federal Reserve to tell you how much value your anti-establishment digital currency will lose."

Humans have long used self-balancing mechanisms to control chaos and complex situations.

The early development of steam engines was marked by a series of explosions and uncontrollable chaos. For steam engines to function, they needed to produce stable and predictable power output, but controlling the speed of that output was an unresolved issue.

By applying a clever little mechanism known as a centrifugal governor, a negative feedback loop was established between energy input and output. As the power output of the system increased, the governor would begin to reduce the amplitude of its input.

With a simple application of ++control theory++, the infinite potential of steam was transformed into the Industrial Revolution.
Control theory: A mathematical field that studies the control of dynamic systems in engineering processes and machines. Its goal is to develop a model or algorithm to apply control to system inputs to drive the system to an ideal state while minimizing any delays, overshoot, or steady-state errors, and ensuring stability of control; typically aimed at achieving a certain degree of optimization.

Additionally, when a wing is parallel to the ground, its effect is maximized. When an aircraft tilts, the lift on the wing decreases because the wing is no longer fully "upward."

The dihedral angle of the wing automatically balances to maintain the stability of the aircraft. When this type of aircraft rolls to one side, the upward force on the wing naturally shifts to push it back. This is a negative feedback loop that helps maintain stability.

The role of an anhedral wing is the opposite. When an anhedral aircraft tilts to one side, the pressure on the wing changes, leading to a greater degree of roll! This is a positive feedback loop.

So why do we design aircraft with anhedral wings? Because their instability can easily be controlled by external intervention (also known as steering), allowing pilots to benefit from the other advantages of anhedral wing design. However, it still only works due to external influences on the system!

Can we apply these same principles of automatic dynamic balance to crypto-economic systems? How do we construct the Ethereum economy to maintain balance, even in an era where foolish humans are doing crazy things to it?

Similar to the centrifugal governor of the steam engine or the self-correcting design of aircraft, cryptography enables us to create self-governing economic systems.

Ethereum is an attempt to create and optimize autonomous properties, making it an engine of the economy. Through key upgrades to the Ethereum crypto-economy, we can now effectively harness the power output of the Ethereum economy and convert it into productive economic output.

Can we build the world's first self-sustaining financial system? Is this what is needed to create a new Industrial Revolution on the internet?

I believe all the signs are there. Let's explore together!

Ethereum, a Self-Balancing Economic System

In May 2021, Ethereum's engine was at its hottest point ever.

Gas fees of over 200+ gwei persisted for months, sometimes even reaching 600+ gwei for 24 hours straight. The cost of a single Uniswap transaction was $175. A position on Aave required $400. Curve LPing cost $1000 per transaction.

Token speculation, yield farming, minting, and overall economic activity were so profitable that the high gas fees were an afterthought; there was so much money to be made! Ethereum was all the rage.

Moreover, Ethereum's PoW miners were also raking in profits. But due to the economics of PoW, miners were forced to sell their ETH to pay for electricity and GPUs; these were external to Ethereum.

At that time, Ethereum was leaking its economic energy.

Ethereum's revenue source, the gas fees for block space, ultimately led to:

• Growth in mining operations
• Growth in energy production (and corresponding consumption).
• Growth in chip production

But these things did not actually help Ethereum's economic growth. The external PoW industry absorbed the value of Ethereum's block space without recycling any value back into the economy.

Ethereum's economic engine produced a large output, but this energy failed to be captured by Ethereum's actual economy. The revenue gained by the PoW industry focused on Ethereum represented the total economic leakage that Ethereum failed to contain.

Ethereum's New Circulatory System

Two mechanisms added to Ethereum greatly enhanced its power output and transformed that power into effective economic productivity.

EIP1559

++EIP1559++ converts the demand for block space into ETH value, which serves as the fuel powering the Ethereum engine. When ETH values are high, Ethereum's fuel has more power, and the engine is more productive.

EIP1559 is a mechanism that extracts heat from the Ethereum economy and uses that energy to refine ETH into a more powerful economic fuel.

Proof of Stake

Proof of Stake converts the demand for block space into ETH staking rewards.

Through PoS, the transaction fees received by stakers (the fees exceeding the EIP1559 base fee, primarily paid by MEV bots) have reached 20% of total transaction volume. By treating transaction fees as rewards for staking ETH, a channel is created between the heat of the Ethereum economy and staking returns.

Through this channel, a negative feedback loop is established between the heat of the Ethereum economy and the incentives for staking ETH. Increasing the APY for staking has a dampening effect on the economy, as the increase in ETH returns encourages capital to flow out of DeFi and into staking.

Since we have just gone through the "crash course" of 2022 and learned about the impact of rising interest rates on the economy, this should be quite intuitive. The Federal Reserve raises interest rates to combat inflation and cool down an overheated economy. Ethereum does the same mechanism, increasing staking yields when DeFi heats up and decreasing yields when DeFi cools down. But it does so without the need for subjective economic assessments or the influence of surrounding political interests.

More on this topic will be elaborated later.

Recapture and Control

The combination of EIP1559 and PoS has transformed Ethereum's economy from one of loss to one of regeneration.

The previously one-way output of value to PoW has been redirected into the internal value of the Ethereum economy, allowing the signals generated between transaction volume and ETH returns to enable Ethereum to self-regulate between over-speculation and economic downturn.

The only input required is the human intelligence at the application layer to induce economic demand for block space. Ethereum takes care of the rest.

Economics Seeking Balance

Two key parameters enable the flexibility required by this environment: the issuance of ETH and the recapture of ETH.

The issuance rate of ETH is controlled by the PoS algorithm and changes slowly. While PoS needs to be flexible to eliminate fragile rigidity, it should only change slowly, as it is the security foundation for all of Ethereum. It should be stable, not volatile.

EIP1559 manages the capture rate of ETH. Compared to the PoS algorithm, EIP1559 quickly adapts to changes in economic conditions at the application layer. By default, blocks on Ethereum are 50% full, and EIP1559 automatically adjusts the block size and gas fees up or down based on demand.

As gas fees decrease, the block size shrinks. As demand for block space increases, the block size also increases, but gas fees will also rise! While the target block size remains constant (15m gas), the instantaneous block size is allowed to adjust up or down depending on the demands of economic actors.

EIP1559 can change the Ethereum block size by up to 12.5% based on the saturation of the previous block. A 12.5% change within a block is not much, but since a block is created every 12 seconds, the size of Ethereum blocks can double within 240 seconds. Additionally, there is a global maximum size for blocks to ensure that things do not spiral out of control. EIP1559 correspondingly raises gas prices until demand subsides, restoring the target block size level.

This mechanism acts like gears within the Ethereum economy. When the Ethereum economy is hot, the engine shifts into high gear. Block sizes increase to meet demand, fees rise, and ETH is burned. When demand decreases, Ethereum downshifts, reducing the supply of block space, and the burning of ETH also diminishes.

Ethereum Economics

The flexibility of Ethereum's crypto-economics allows it to achieve a natural state of balance, even when foolish humans are engaging in silly Ponzi games above it.

Ethereum's economics can adapt to its surrounding environment.

For example, the issuance rate of ETH -- as more ETH is staked to Ethereum, the issuance algorithm will issue more ETH. However, it proportionally reduces the issuance of ETH per validator, as the issuance is distributed among more validators.

When the total amount of ETH staked to Ethereum is low, individual return rates are high, but the total amount of ETH issued is low.

When the total amount of ETH staked to Ethereum is high, individual staker return rates are low, but the total amount of ETH issued is high.

ETH Issuance Curve:

Green line -- Network issuance %; Purple line -- ETH daily issuance

ETH Staking Yield Curve:

When less ETH is staked, Ethereum naturally pays more for security.

As more ETH is staked to Ethereum, yields decrease, and issuance increases, softening the destructive impact on economic activity by encouraging ETH to flow out of staking and into the Ethereum economy.

MEV

MEV is an important component of the Ethereum economy. MEV is the pipeline connecting DeFi activity and ETH yields. It is the transfer of value from arbitrageurs to stakers.

Whenever anyone does almost anything on Ethereum, they leave behind small traces of arbitrage. Buying ETH on Uniswap misaligns prices and creates a micro-opportunity for arbitrageurs to rebalance the liquidity pool.

Economic actors disrupt market balance, and arbitrageurs automatically reposition the system.

As the Ethereum economy heats up, arbitrage also increases correspondingly. General economic activity on Ethereum is reflected in gas prices, but MEV activity particularly appears in the gas "tips"; fees paid to ETH stakers exceed the required EIP1559 amount to allow MEV traders to jump the transaction queue and execute their trades first.

The net effect is the correlation between staking yields and the heat of the Ethereum economy.

Finding the Balance Point

All these various inputs into ETH issuance and ETH burn rates create an organic balancing system, making Ethereum an unaffected crypto-economic system that generates an exciting 'sci-fi economy'!

When the Ethereum economy is hot, gas prices are high, leading to a high ETH burn rate. In this environment, MEV is also high, increasing the yields for staking ETH.

Higher ETH staking yields enhance the incentive to stake ETH! This also encourages capital to flow out of DeFi and into staking protocols, leading to an increase in the internal capital costs of DeFi.

High ETH yields increase the opportunity cost of capital in DeFi, naturally raising the threshold for viable speculative activities.

Arbitrageurs will always ensure that the cost of borrowing ETH in DeFi is higher than the staking yield. If not, there would be an opportunity for free arbitrage, borrowing funds from DeFi at a lower rate, staking them through the protocol, and pocketing the difference.

By increasing the base layer's ETH yields, Ethereum raises the capital costs in DeFi.

This is the marvelous and elegant homomorphic mechanism by which Ethereum balances its own economy, and it is the reason why humans do not have to intervene in the economy. The only input from humans is the sum of market activities! The rest is taken care of by Ethereum. Ethereum does the rest.

As the Ethereum economy heats up, it naturally increases pressure for its own downtime! This also happens in reverse; as the economy cools, the pressure is released. A cooled economy will produce a high supply of staked ETH, but with low staking yields, making external opportunities appear more attractive.

Economics 2.0

In TradFi, there is a tug-of-war between bond yields and stock valuations.

Low bond yields increase risk appetite, causing capital to flow from bonds to stocks. Asset inflation begins to occur, and credit supply increases. The economy heats up, and inflation begins. The Federal Reserve responds by raising interest rates, and yields follow suit. Stocks are sold off as bond yields become attractive again.

The Federal Reserve has a tough job on its hands.

Humans are foolish, and the Federal Reserve is not external to the system it governs. The inputs the Federal Reserve uses to make governance decisions will respond to the Federal Reserve's decisions.

Chaotic systems can take two forms:

• Systems that do not respond to predictions about them. Weather forecasts do not change the weather.
• Systems that change due to their predictions. Enter game theory.

The Federal Reserve operates within a chaotic system that responds to the Federal Reserve's own predictions about it. The Federal Reserve is fundamentally limited in its ability to generate stability for the economy it manages because the Federal Reserve's own inputs are the source of chaos within the system!

Among all the amazing technologies that constitute Ethereum, its greatest achievement may simply be the elimination of the central manager of the economy. Economic participants no longer need to look to the Federal Reserve to make their financial decisions because Ethereum has placed the Federal Reserve's work into EIP1559 and Proof of Stake.

An Internet Industrial Revolution

Ethereum is the existing ++first profitable++ blockchain.

It is the first crypto system to capture its own energy and direct it towards productive output. By converting the income from block space into the value of ETH, Ethereum naturally increases the total capital value of DeFi!

As ETH absorbs traffic from the Ethereum economy, DeFi grows accordingly.

Since ETH is the primary collateral in the DeFi economy, as the value of collateral increases, the availability of credit will also expand!

The Ethereum economy is priced in ETH, and when the value of ETH increases, everything downstream of ETH also grows.

Many tokens trade directly against ETH on Uniswap or other DEXs. Tokens priced in ETH mean that an appreciation of ETH also leads to an appreciation of the tokens. Most tokens traded with stablecoins are still influenced by the price of ETH, as when ETH can be used to borrow or mint stablecoins, people's appetite for stablecoins increases, and as ETH becomes more valuable, more stablecoins will be borrowed.

EIP1559 brings a tailwind of economic growth to the entire Ethereum economy. As the value of ETH increases, the availability of capital increases.

The generation of wealth becomes easier. Investments in Ethereum will also grow.

The positive effects of EIP1559 do not merely stop at simply increasing the value of ETH. ETH is closely tied to DeFi, and the appreciation of ETH has significant positive downstream effects on the entire Ethereum economy!

We call it the "ETH Wealth Effect."

Some mistakenly believe that ETH deflation will suppress economic activity in Ethereum. Quite the opposite. ETH deflation increases the availability of all other forms of capital and encourages investment and activity with that capital.

Ethereum will be able to finance its own future.

Unlocking the Internet Industrial Revolution

We are witnessing the world of crypto-economics unlocking a new engine of productivity for the internet age.

The internet revolution is incomplete without crypto-economics. Before digital-native currencies and finance, we were still in the pre-adolescent phase of the internet; the "pure data" version of the internet.

Crypto-economics is the study of building economic engines for the internet. With the invention of Bitcoin in 2009, a new category of engines was discovered, and a whole new industry was born around it.

Since then, Ethereum has been optimizing the science of crypto-economics. Once a productivity engine marked by losses and inefficiencies, it has now transformed into a super engine for the digital age.

Ethereum is heralding an industrial revolution on the internet. Just as the steam engine was the input needed to kickstart the Industrial Revolution, Ethereum's new crypto-economic engine is opening a new era of economic productivity and prosperity for the internet.

We have seen this story and know what will happen next.

The points connected here are not so far apart.

Growth, entrepreneurship, invention, connection, wealth, prosperity, improved standards of living, and enhanced quality of life.

This is the future, as long as we figure out how to drive this thing.