Ethereum is often referred to as ultrasound money. This is because it maintains purchasing power due to its deflationary nature. If you did not know, the recent migration to proof of stake has led to a decrease in the total supply of this popular cryptocurrency.
This has had widespread implications as it continues to become more scarce. In this article, I will be covering the basics of Ethereum deflation. So without further ado, let’s jump right in.
Is Ethereum deflationary?
On November 9th, 2022 Ethereum first became deflationary. At this point, more tokens were being burned than issued. As shown by the tweet above by the data firm Messari there was a negative coin issuance starting in the middle of November 2022 with an inflation rate of -0.03%.
Before Ethereum transitioned to proof of stake it had an annualized inflation rate of 4.5%. All in all, 13,000 ETH/day was issued to compensate miners.
However, with the transition to proof of stake came a 90% decrease in issued ETH as miners converted to validators. Ultimately, validators are more energy efficient when compared to miners.
Now the issuance is just 1,700 ETH/day. Moreover, the recent EIP 1559 proposal further compounded its scarcity.
How is Ethereum deflationary?
All in all, Ethereum deflation was largely spurred by the “Ethereum Improvement Proposal (EIP)-1559”. Simply put, this development takes a portion of each transaction fee and burns it.
Therefore if the burn rate is greater than the coin issuance rate then Ethereum becomes deflationary. In other words, as the network becomes more widely adopted and processes more transactions the greater the deflation rate.
The implications
As you may know, the driving force of price is simply supply and demand. If all else remains equal and supply decreases there will be a price increase.
Ultimately, as Ethereum becomes more and more deflationary it will be harder for investors to accumulate. As a result, the asset price will have a greater probability of increasing in price provided demand remains constant or increases.
This is all well and good but this may dissuade Ethereum from functioning as a currency as it would disincentive spending as people expect future price increases.
As a result, investors would horde the asset and this would lead to it functioning more as a store of value than a medium of exchange. Not to mention, fee burning effectively cuts validator revenue in half.
Therefore, this reduces the economic inventive for validators to secure the network. This could raise potential security concerns if validators migrate away from Ethereum.
Why does Ethereum burn coins?
In a nutshell, the burning of tokens provides an effective yield for all token holders. This is because their purchasing power increases as the supply decreases provided all else is equal.
Without the burn mechanism, only the network validators would receive rewards. Therefore, there would be a large opportunity cost for token holders.
If you want to view this article in a more visual format then please check out my video below:
Conclusion
As you can see, Ethereum has become deflationary as of late. This recent development has created an asset that is more scarce than Bitcoin itself.
With this decrease in supply will likely come an increase in asset price. This will be further compounded as cryptocurrency demand increases over the coming decades. I hope you found this article useful and thanks for reading it.
Want to learn about the Ethereum Virtual Machine? Click here to read my previous article.
