SIMD-0228: Market-Based Emission Mechanism

proposals/0228-market-based-emission-mechanism.md

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+---
+simd: '0228'
+title: Market-Based Emission Mechanism
+authors:
+  - Tushar Jain
+  - Vishal Kankani
+  - Max Resnick
+category: Standard
+type: Core
+status: Review
+created: 2025-01-16
+---
+
+
+## Summary
+
+SIMD-0228 Introduces a Market-Based emission mechanism based on staking
+participation rates. The mechanism is a static curve that reduces the total issuance
+rate by a factor of the square root of the staking participation rate.
+
+## Motivation
+
+Solana has historically relied on token emissions to attract stake and guarantee
+security. As Solana matures, stakers are increasingly earning SOL from other
+sources (e.g. MEV). These developments have resulted in an increasing fraction
+of the Solana supply staked, meaning the network is now overpaying security
+since emissions haven't adjusted to the elevated demand for staking.
+
+According to Blockworks (<https://solana.blockworksresearch.com/>), in Q4 2024
+MEV, as measured by Jito Tips, was approximately \$430M (2.1M SOL), representing
+massive quarter-over-quarter growth. In Q3 Jito Tips were approximately
+\$86M (562k SOL), Q2 was approximately \$117M (747k SOL), and Q1 was approximately
+\$42M (300k SOL).
+
+Given the level of economic activity the network has achieved and the subsequent
+revenue earned by stakers from MEV, now is a good time to revisit the network's
+emission mechanism and evolve it from a fixed-schedule mechanism to a
+programmatic, market-driven mechanism.
+
+The purpose of token emissions in Proof of Stake (PoS) networks is to attract
+stakers and validators to secure the network. But excessive issuance is costly
+because it imposes frictions on the network and crowds out SOL usage in DeFi.
+Therefore, the most efficient amount of token issuance is the lowest rate
+necessary to secure the network.
+
+Solana's current emission mechanism is a fixed, time-based, formula that was
+activated on epoch 150, a year after genesis on February 10, 2021. The mechanism
+is not aware of network activity, nor does it incorporate that to determine the
+emission rate. Simply put, it's "dumb emissions." Given Solana's thriving
+economic activity, it makes sense to evolve the network's monetary policy with
+"smart emissions."
+
+There are two major implications of Smart Emissions:
+
+Smart Emissions dynamically incentivizes participation when stake drops to
+secure the network.
+Smart Emissions minimize SOL issuance to the Minimum Necessary Amount (MNA) to
+secure the network.
+
+This is good for the Solana network and network stakers for four reasons:
+
+High inflation can lead to more centralized ownership. To illustrate the point,
+imagine a network with an exceedingly high inflation rate of 10,000%. People who
+do not stake are diluted and lose ~99% of their network ownership every year to
+stakers. The higher the inflation rate, the more network ownership is
+concentrated in stakers' hands after compounding for years.
+
+Reducing inflation spurs SOL usage in DeFi, which is ultimately good for the
+applications and stimulates new protocol development. Additionally, a high
+staking rate can be viewed as unhealthy for new DeFi protocols, since it means
+the implied hurdle rate is the inflation cost. Lowering the "risk free"
+inflation rate creates stimulative conditions and allows new protocols to grow.
+
+If Smart Emissions function as designed, they will systematically reduce selling
+pressure as long as staking participation remains adequate. The inevitable side
+effect and primary downside to high token inflation is increased selling
+pressure. This is because some stakers in different jurisdictions have taken the
+interpretation that staking creates ordinary income, and therefore they must
+sell a portion of their staking rewards to pay taxes. This selling is a
+significant detriment to the network and does not benefit the network in any
+way.
+
+In markets, sometimes perception is as important as reality. While SOL inflation
+is technically not cost to the network, others think it is, and that belief
+overall has a negative impact on the network. Inflation causes long-term,
+continual downward price pressure that negatively distorts the market's price
+signal and hinders fair price comparison. To use an analogy from traditional
+financial markets, PoS inflation is equivalent to a publicly listed company
+doing a small share split every two days.
+
+Historically, issuance curves have remained static due to Bitcoin's immutability
+ethos—a "Bitcoin Hangover" so to speak. While immutability suits Bitcoin's
+mission to become digital gold, it doesn't map to Solana's mission to
+synchronize the world's state at light speed.
+
+In summary, the current Solana emissions schedule is suboptimal given the
+current level of activity and fees on the network because it emits more SOL than
+is necessary to secure the network. An issuance curve set by diktat is not the
+right long-term approach for Solana. Markets are the best mechanism in the world
+to determine prices, and therefore, they should be used to determine Solana's
+emissions.
+
+
+## New Terminology
+
+- Fraction of total supply staked: $s$
+- Issuance Rate $i$
+- Validator returns $v(s) = \frac{i}{s} + MEV$
+- r is the current inflation rate which is a constant (currently 4.5%) that
+automatically goes down by 15% every year until it reaches 1.5% where it
+stops changing.
+
+## Detailed Design
+
+### New Emission Rate Formula
+
+The issuance rate formula is:
+
+$$i(s) = r(1-\sqrt{s} + c \cdot \max(1-\sqrt{2s},0)) $$
+
+where:
+
+$$ c = \frac{\sqrt{\frac{1}{3}}}{1- \sqrt{\frac{2}{3}}}
+\approx 3.14626436994
+\approx \pi $$
+
+When $s>.5$ the curve corresponds to $r(1-\sqrt{s})$, the curve in the previous
+version of this proposal.
+Based on feedback about the previous version of this proposal, we have added the
+$c \cdot \max(1-\sqrt{2s},0))$ term to make the curve more aggressive
+when a smaller fraction of the network is staked. $c$ is chosen such that the
+curve starts becoming more agressive at $s =.5$,
+when half of the supply is staked, and surpasses the current static emission
+schedule of $r$ when $s = 1/3$.
+
+The derivation of $c$ is provided in the appendix.
+
+![Issuance Rate](../suporting_images/0228-market-based-emission-mechanism/issuance_rate.png)
+
+
+This yields a vote reward rate for validators with good performance of:
+
+$$v(s) = \frac{i(s)}{s} = \frac{r(1-\sqrt{s} + c \cdot \max(1-\sqrt{2s},0))}{s}$$
+
+![Staking Returns](../suporting_images/0228-market-based-emission-mechanism/staking_returns.png)
+
+To ensure that the transition from the old static issuance schedule to this new
+schedule is smooth, we will interpolate between the old issuance rate and the
+new issuance rate over 50 epochs using the formula:
+
+
+$$i(s) = r(1-\alpha\sqrt{s} + \alpha c \cdot \max(1-\sqrt{2s},0))$$
+
+where $\alpha$ is a parameter that controls the speed of the transition, taking
+the values $\frac{1}{50},\frac{2}{50},\dots,\frac{49}{50}, 1$.
+over the first 50 epochs before settling to the
+new issuance rate at $\alpha = 1$.
+
+![Rollout](../suporting_images/0228-market-based-emission-mechanism/rollout.png)
+
+## Alternatives Considered
+
+### Alternative Design 1: Pick another fixed rate
+
+A simple alternative would be to adjust the issuance rate to a fixed number, $r$
+determined by community inputs. However, this approach presents several risks:
+Lack of Market Mechanisms: Setting a fixed rate ignores the dynamics of free
+markets and the network's real-time economic conditions:
+
+- **Lack of Market Mechanisms**: Setting a fixed rate ignores the dynamics of
+ free markets and the network's real-time economic conditions
+- **Arbitrary Adjustments**: Using another arbitrary number risks undermining the
+ integrity of the system and may lead to decisions that are disconnected from the
+network's needs
+- **Erosion of Trust**: Relying on fixed adjustments could erode trust in the
+community's decision-making process, especially if future changes seem
+disconnected from market realities
+- **Compromised Consensus Safety**: A fixed issuance rate, especially in
+ uncharted territory, could undermine consensus safety, as it would not be
+dynamically tied to staking participation or broader network health
+
+### Alternative Design 2: Fix Target Staking Yield
+
+- **Revenue Source**: MEV has become a significant revenue source for stakers.
+- **Proposed Change**: One can consider changing the issuance rate by factoring
+in MEV tips, maintaining the same target yield as the original curve but
+offsetting it by the 30-day moving average of MEV tips.
+- **Formula**: New Issuance Rate (i) = Target Staking Yield − 30-day moving
+ average of MEV tips
+- **Market Impact**: MEV tips reflect real revenue for validators and stakers,
+allowing the system to adjust to market conditions:
+  - **Hot Markets**: Higher MEV tips allow for lower emissions.
+  - **Cold Markets**: Increased emissions compensate validators, maintaining
+ network security.
+- **Inspiration**: This approach is inspired by central bank monetary policy,
+adjusting inflation based on economic conditions.
+- **Key Challenge**: The big challenge with this design is that it incentivizes
+MEV payments to move out of sight of the tracking mechanism, thereby rendering
+the design completely ineffective.
+- **Important Note**: For an abundance of clarity, we are not proposing any design
+which requires measuring MEV payments.
+
+## Impact
+
+Implemented thoughtfully, this design could have a major positive economic
+impact on the overall health of the Solana economy.
+
+## Security Considerations
+
+The biggest concern for this proposal is that it could reduce the amount of SOL
+staked more than desired. We can assure ourselves that at least with current
+market conditions the resulting equilibrium staked amount would be more than 40%
+with the following reasoning:
+
+Currently the issuance rate is 4.5% and the staked amount is 65% which comes out
+to around 6.25% validator rewards for performant stakers (not including MEV).
+If the issuance rate were instead governed by this proposal, we should expect
+the staked amount to be more than 40% because $v(41\%) \approx 6.25\%$.
+We know that $D(6.25\%)$ = 65% and therefore the staked amount under the new
+issuance rate would be more than 40% if demand stays the same.
+
+## Appendix
+
+### Derivation of $c$
+
+We the goal is to find $c$ such that $r = i(1/3)$.
+
+$$ r = r (1- \sqrt{1/3} + c \cdot \max(1 - \sqrt{2/3}, 0)$$
+
+Since $1-\sqrt{2/3} > 0$ we can remove the $\max$ function.
+
+$$ r = r (1- \sqrt{1/3}+ c  (1 - \sqrt{2/3}))$$
+
+$$ 1 = 1 - \sqrt{1/3}+ c  (1 - \sqrt{2/3})$$
+
+$$ \sqrt{1/3} = c  (1 - \sqrt{2/3})$$
+
+$$ c = \frac{\sqrt{1/3}}{1 - \sqrt{2/3}} $$