Ethereum is an open source, distributed one-layer blockchain network capable of executing smart contracts. In this article, we will explain together why Ethereum is a deflationary asset.
What is a deflationary cryptocurrency?
A college economics major might say that the basis of money, economics, and market forces is balancing supply and demand. The relationship between the amount of an asset in circulation and demand, that is, how many people want that particular asset, helps determine its value. This equation of supply and demand is the basis of all economies, and it applies to cryptocurrencies as well.
A deflationary cryptocurrency is one in which the value of a cryptocurrency increases due to a decrease or stagnation in supply. This ensures that the market value of the coin is attractive to more people and can be used as a store of value. While deflationary cryptocurrencies may seem more attractive, not all cryptocurrencies are designed that way.
Many well-known cryptocurrencies are not deflationary currencies. Furthermore, they usually provide no restrictions. Some cryptocurrencies are deflationary because inflation decreases over time due to their economic performance. For example, Bitcoin will not deflate until all 21 million coins are mined. Ethereum will also not be deflationary until its September 2022 “merger.”
How does Ethereum compare to other deflationary coins?
Token developers create deflationary mechanisms during the design process of the token’s economic model. Token economics may be critical to how stakeholders increase and accumulate value in the Web3 ecosystem.
The supply and demand dynamics of a token are determined during the development phase. Deflationary properties, such as the burning mechanism, are determined when developing the economic model of the token. This can be a point-in-time process like Bitcoin, or a development mechanism like Ethereum.
When creating Bitcoin, Satoshi Nakamoto ensured that there was only a limited supply of 21 million coins. Once 21 million Bitcoins have been mined, it will be impossible to create new BTC. This limited supply helps Bitcoin become a true store of value, as opposed to fiat currencies where central bank monetary policy increases the supply.
In contrast, Ethereum had an inflationary supply at creation. The supply of Ethereum is growing at an annual rate of 4.5%. However, after the "merger", Ethereum switched from Proof-of-Work to Proof-of-Stake and is now a non-inflationary asset due to its burn rate. To keep the network running, more Ethereum is burned than is issued.
The implementation of the EIP-1559 protocol changes the economic nature of the Ethereum token, burning the gas fee portion of each transaction. As a result, some experts believe that Ethereum is more deflationary than Bitcoin.
Since deflationary tokens are considered better stores of value, new tokens created at the protocol and application layers can be designed to be deflationary.
Does Ethereum’s transition to a deflationary token make it a more attractive asset?
Investing in deflationary cryptocurrencies can generate growth and returns for investors. But austerity alone may not be considered a better investment criterion.
Due to its supply constraints, deflation is often considered more valuable by holders and investors. This is also evidenced by the rise of non-fungible tokens (NFTs), where the rarity of the NFT often determines the price. The limited supply driving the price is also true in ENS, with several three-digit ENS names even having sold for over 100 ETH.
Ethereum is not necessarily classified as a better asset after the squeeze. Ethereum has a rich ecosystem that facilitates on-chain transactions, and the more Ethereum is burned in the process, the more deflationary it becomes. An unused Ethereum blockchain would not be able to achieve this economic feat.
The fundamentals of the underlying chain must remain strong in order for Ethereum to thrive as an investment. A chain with a strong foundation usually has an ecosystem of developers creating a variety of applications that are widely adopted by users. As users flock to these apps, developers are encouraged to keep innovating.
The resulting network effect will cause Ethereum to contract, making it a more attractive investment asset.
Who controls inflation in the Ethereum ecosystem?
In the United States, the Federal Reserve System (FED) is responsible for keeping inflation at reasonable levels by implementing tools such as interest rate changes, bond purchase programs, and currency printing. In most other countries, this obligation is generally similar. In Web3, inflation is controlled by the protocol’s monetary policy, which is determined by the community through decentralized governance.
Squeeze mechanisms are closely intertwined with Tokenomics in creating ecosystems. Since the token supply is unlimited, there will be more opportunities to burn as the token ecosystem matures. Therefore, token custodians must proactively identify these opportunities and embed them into the token system to reduce supply.
Ethereum’s consolidation is a prime example of how Ethereum supply and demand can adjust to achieve deflation. These major Tokenomics changes are typically proposed, approved, and implemented by a Decentralized Autonomous Organization (DAO), which governs the tokens and the platform behind them.
These Tokenomics changes are then embedded into smart contracts as the rules of the ecosystem. Smart contracts promote new business rules and economic models of ecosystems. Therefore, DAOs can play an important role in ensuring efficient and effective governance of tokens.
Since decentralization is one of the tenets of the blockchain world, an economic system that is not controlled by founding teams, investors, venture capitalists, and whales is crucial for sustainable tokenization based on healthy business models.