Many cryptocurrencies fluctuate between inflation and deflation over time. And in December 2022, Ethereum became a deflationary cryptocurrency again.
But what is a deflationary cryptocurrency, how will it deflate, and is Ethereum’s new status good or bad news for investors?
What is a deflationary cipher?
The first thing to note here is that most cryptocurrencies are subject to inflation (apart from flatcoins such as Nuon). A cryptocurrency can be designed to hedge against inflation, but the higher the supply in circulation, the more likely it is to be affected by inflation. When an asset’s supply numbers get out of hand, its purchasing power drops significantly.
In the world of cryptocurrencies, the terms “inflation” and “deflation” relate to supply and demand. As you may know, different cryptocurrencies have different supply caps. For example, Bitcoin has a maximum supply of 21 million BTC. This means that only a maximum of 21 million BTC will be in circulation. On the other hand, the maximum supply of BNB coins is 200,000,000 BNB. Crypto creators can choose their own supply limits.
On the other hand, some cryptocurrencies have no supply limit at all. This means that the maximum number of coins in circulation is infinite. There is an infinite supply of many cryptocurrencies such as Tether, Dogecoin, Solana and Ethereum. Cryptocurrencies, whether capped or infinite in supply, can deflate. However, in order for the infinite supply of cryptocurrencies to become deflationary, some sort of burning mechanism is required (more on this later).
As is standard in the crypto market, the price of Ethereum depends on its supply and demand. If demand exceeds supply, prices tend to rise. When supply exceeds demand, prices tend to fall. Therefore, if you are an investor, ideally the demand for your chosen asset is higher than the supply.
An increase in token supply is considered inflation, and a decrease in supply is considered deflation. There are currently various popular examples of deflationary cryptocurrencies such as Bitcoin, BNB coin, Shiba Inu, Polygon and now Ethereum. So what caused this change?
Why Ethereum Is Currently in Deflation
Ethereum is now described as deflationary because its issuance is deflationary. This means that the amount of Ether in circulation is less than the number that has been burned (i.e. destroyed).
When cryptocurrencies are burned, they are sent to a wallet address where holdings cannot be accessed. This means that funds can be deposited into the wallet, but not withdrawn. At this point, the crypto in the wallet is considered completely useless and burned or destroyed. Many blockchains have a burning mechanism as they help control the circulating supply and therefore also control the price (to some extent).
Ethereum has been burning coins via the EIP-1559 token standard. EIP-1559 was introduced with his London upgrade in mid-2021, with changes to the fee process. Every time a transaction occurs on the Ethereum blockchain, a portion of the transaction fee (base fee) calculated in ETH is burned.
Billions of dollars worth of Ether have been burned since the introduction of EIP-1559. This has arguably played a role in the changing relationship between blockchain circulation and burn rate.In fact, EIP-1559 was designed to achieve exactly this goal.
However, Ethereum’s burning mechanism has been around for years, so this is not the only reason for the asset’s recent switch to a deflationary state. The network’s move to a proof-of-stake consensus mechanism has also played a part in this shift.
In September 2022, the Ethereum blockchain consensus mechanism changed from Proof of Work to Proof of Stake, known as the Ethereum Merge. Proof of Stake is a more efficient mechanism used by many cryptocurrencies, and its adoption on the Ethereum blockchain allows an Ether holder to deposit a portion of his ETH into a smart contract (known as a beacon deposit contract). You can now deposit to Ethereum becomes a more desirable asset as users can earn revenue through this mechanism.
There are currently over 16 million ETH deposited into the Beacon Deposit Contract, worth over $24 billion (Etherscan reports). It’s clear that this new yield option has attracted a lot of investors.
The chart above shows a clear shift in Ethereum supply trends. Supply had been steadily increasing throughout most of 2022, but things started to change just before the Ethereum merger in September.
Ethereum in circulation on January 4, 2023 was 120.53 million. The next day, circulating supply dropped to he 120.52 million (reported by YCharts). This decline illustrates the current deflationary nature of Ethereum.
Is Ethereum Deflation Good News?
So Ethereum is currently in a deflationary trend, what does this mean for investors?
As you can see in the CoinMarketCap graph below, the price of Ethereum increased significantly between January 3, 2023 and January 18, 2023. Within this 2-week window, the price of 1 ETH increased by a whopping 25%. 2022 has been a pretty bad year for Ethereum (and the crypto market in general), so it’s exciting to see this world-famous altcoin start to change.
Given that the supply of Ethereum has decreased, the price is likely to rise (to break the relationship between supply and demand). If the supply of Ethereum continues to slowly decline and can drop below the burn rate, it is likely that this growth in value will continue. can bring benefits of
However, you should always be aware that the crypto market is highly volatile and there are a myriad of factors that can affect the price of any coin or token. It’s rising as an asset, but that’s not always the case.
Deflationary Ethereum bodes well for blockchain future
Right now, Ethereum seems to be doing well, seeing a massive increase in value and deflationary conditions. This trend may continue into 2023 if the market does well with Ethereum, but there are no guarantees in the crypto space. Only time will tell if this is the beginning of Ethereum’s price recovery or just a volatility that will soon retreat.
