Many cryptocurrencies fluctuate between inflationary and deflationary over time. And in December 2022, Ethereum once again became a deflationary cryptocurrency.
But what is a deflationary cryptocurrency, how does a cryptocurrency become deflationary, and is Ethereum’s new status good or bad news for investors?
What is a deflationary cryptocurrency?
The first thing to note here is that the vast majority of cryptocurrencies are exposed to inflation in some way (with the exception of flatcoins, such as Nuon). While cryptocurrencies can be designed to hedge against inflation, the more supply there is, the more likely it is to be affected by inflation rates. If the supply of a good becomes too large, its purchasing power will be significantly reduced.
In cryptocurrency, the terms “inflationary” and “deflationary” refer to supply and demand. As you may know, different cryptocurrencies have different bid limits. Bitcoin, for example, has a maximum supply of 21 million BTC. This means that, at most, there will only be 21 million BTC in circulation. BNB Coin, on the other hand, has a maximum supply of 200,000,000 BNB. Cryptocurrency creators can choose the supply limit themselves.
On the other hand, some cryptocurrencies have no supply limit, which means that the maximum number of coins in circulation is infinite. Many cryptocurrencies have an endless supply, including Tether, Dogecoin, Solana and Ethereum. A cryptocurrency can be deflationary whether it has limited or infinite supply. But for a cryptocurrency with infinite supply to be deflationary, some sort of combustion mechanism must be in place (more on that a bit later).
As is normal in the cryptocurrency market, the price of Ethereum depends on supply and demand. If demand exceeds supply, the price tends to go up. If supply exceeds demand, the price tends to fall. So if you are an investor, ideally you want the demand for your chosen asset to be greater than the supply.
If the supply of a token increases, it is considered inflationary, while if the supply decreases, it is considered deflationary. There are several popular examples of deflationary cryptocurrencies today, including Bitcoin, BNB Coin, Shiba Inu, Polygon, and now Ethereum. So what caused this change?
Why is Ethereum now deflationary?
Ethereum is now described as deflationary because its issuance is deflationary. This means that the number of Ether entering circulation is less than the number of Ether burned (i.e. destroyed).
When a cryptocurrency is burned, an asset holding is sent to an inaccessible wallet address. In other words, funds can be deposited into the wallet but never withdrawn. At this point the crypto in the wallet becomes completely useless and is considered burned or destroyed. Many blockchains have burning mechanisms, as this helps control circulating supply and, therefore, price (to some extent).
Ethereum burned coins through the EIP-1559 token standard. EIP-1559 came into play in mid-2021 via the London Update and resulted in a change in the pricing process. Every time a transaction is made on the Ethereum blockchain, a fraction of the transaction fee (the base fee), calculated in ETH, is burned.
Since the introduction of EIP-1559, billions of dollars of Ether have been burned. This has undoubtedly played a role in the evolution of the relationship between blockchain circulation and burn rates. In fact, the EIP-1559 was designed to achieve the same goal.
But Ethereum’s burning mechanism has been around for years, so it’s certainly not the only factor involved in the asset’s recent transition to deflationary status. The network’s transition to a proof-of-stake consensus mechanism also played a role in this shift.
In September 2022, the consensus mechanism of the Ethereum blockchain moved from proof-of-work to proof-of-stake, in what has been called the Ethereum merger. Proof-of-stake is a more efficient mechanism used by many cryptocurrencies, and its adoption on the Ethereum blockchain has allowed Ether holders to deposit a portion of their ETH into a smart contract (known as a Beacon repository). Users can earn a return through this mechanism, which makes Ethereum a more desirable asset.
Currently, over 16 million ETH is deposited in the Beacon Deposit Contract, which is over $24 billion (according to Etherscan), so it stands to reason that this new yield option has attracted many investors.
The chart above shows a clear change in the trend of Ethereum supply. While supply has steadily increased throughout most of 2022, things started to change just before the Ethereum merger in September.
On January 4, 2023, the circulating supply of Ethereum was 120.53 million. By the next day, the circulating supply had dropped to 120.52 million (as shown on YCharts). This decline is representative of the current deflationary nature of Ethereum.
Is Ethereum’s Deflationary State Good News?
So Ethereum is now deflationary, but what does that mean for investors?
As you can see from the CoinMarketCap chart below, the price of Ethereum increased significantly between January 3, 2023 and January 18, 2023. In this two-week window, the price of one ETH increased by an impressive 25%. 2022 has been a pretty bad year for Ethereum (and the cryptocurrency market in general), so it’s exciting to see things start to take a turn for this popular altcoin.
Since the supply of Ethereum has decreased, it has become easier for the price to increase (based on the integral relationship between supply and demand). If Ethereum supply continues to decline slowly and can remain below its rate of burn, we are likely to see a continuation of this growth in value. In the long run, this can be great news for investors and could lead to huge profits when traded.
However, it should always be recognized that the cryptocurrency market is very volatile and there are countless factors that can affect the price of a coin or token. So while Ethereum’s price is on the rise as a deflationary asset right now, that probably won’t always be the case.
A deflationary Ethereum bodes well for the future of the blockchain.
At the moment, things appear to be looking good for Ethereum, with its value greatly increased and in a deflationary state. This trend could continue into 2023 if the market treats Ethereum well, but there are no guarantees in the cryptocurrency realm. Time will tell if this is the start of the Ethereum price recovery or just a fluctuation that will soon reverse.