Part 2: Technical Overview
The Incentive Layer
Carrots and Sticks and Sudden Death
Permissionless blockchains are cryptoeconomic systems: cryptography enforces correct behaviour where possible; economics incentivises correct behaviour where it cannot be enforced. The correct behaviours we're looking for roughly correspond to availability and security. We want the chain to keep making progress, and we want the chain to give reliable, non-contradictory results under all reasonable circumstances.
This chapter describes the economic tools the beacon chain uses to incentivise its participants; the cryptography side is covered elsewhere. Broadly speaking, the tools available to help us meet these goals are (1) rewards for behaviour that helps the protocol, (2) penalties for behaviour that hinders the protocol, and (3) punishments for behaviour that looks like an attack on the protocol.
One of the few attractive aspects of Proof of Work is the simplicity of its economic model. Miners receive block rewards for creating blocks that get included on chain, and receive fees for including transactions in their blocks. The block rewards come from newly created coins (issuance), and transaction fees are from previously issued coins. There are no explicit in-protocol penalties or punishments. Combined with the "heaviest chain" fork choice rule, this simple model has proved to be incredibly robust. Ethereum 1 added a little complexity with uncle rewards for miners and the EIP-1559 fee burning mechanism, but it remains fundamentally simple and fairly easy to reason about.
By contrast, the Ethereum 2.0 Proof of Stake protocol employs an array of different economic incentives. We will break things down into the following elements over the next sections.
- The most fundamental economic component is the stake itself.
- Within the protocol, the stake is represented in validator balances, in particular a quantity called the "effective balance" that is the actual measure of the influence a particular validator has on the protocol.
- Similarly to proof of work, the protocol issues new coins to provide the incentives we are discussing. We'll look at this in the section on issuance.
- An array of rewards is used to incentivise desirable behaviours such as publishing beacon blocks and timely attestations.
- Penalties are used to disincentivise undesirable behaviours such as failing to make attestations, or making late or incorrect attestations.
- The inactivity leak is a special regime that the beacon chain may enter in which rewards and penalties are modified to much more heavily penalise non-participation.
- Slashings are punishments for breaking the protocol rules in very specific ways that look like attacks.
- Finally, we close with a note on how aspects of these incentives combine to make diversity of deployment of beacon chain infrastructure the safest strategy.
Be aware that the discussion in these sections considers the consensus layer in isolation. Now that we are post-Merge, this is no longer the whole picture. In addition to protocol-generated rewards, Ethereum stakers can now profit from transaction fee tips, and MEV (maximal extractable value). In future, they might be able to profit from restaking. All of these can modify the protocol incentives. For example, a validator behaved economically rationally when it got itself slashed (at a cost of 1 ETH) to gain around $20 million of MEV income, although it acted dishonestly by the protocol rules in doing so. The effects of these things are the subject of much discussion, development and debate, and merit an entire book to themselves. Nevertheless, for the purposes of this work, I am focusing only on the consensus layer cryptoeconomic stack.
Vlad Zamfir's memoirs on the development of the Casper Protocol are not only a great read, but a good introduction to the challenges of designing a proof of stake protocol. They discuss the background to many of the design decisions that led, eventually, to the protocol we see today. Part 1, Part 2, Part 3, Part 4, Part 5.
Much of the material in the following sections is also covered in the more recent report by Umberto Natale of Chorus One, Analysing Ethereum Cryptoeconomics: the validator's perspective.