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 crypto, how does a crypto become deflationary, and is Ethereum’s new status good or bad news for investors?
What Is a Deflationary Crypto?
The first thing to note here is that the vast majority of cryptos are somewhat exposed to inflation (aside from flatcoins, such as Nuon). Though cryptos can be designed to hedge against inflation, the higher the circulating supply, the more it is likely to be affected by inflation rates. If an asset’s supply number gets too out of hand, its purchasing power will drastically reduce.
In the crypto realm, the terms “inflationary” and “deflationary” relate to supply and demand. As you may know, different cryptocurrencies have different supply caps. Bitcoin, for example, has a maximum supply of 21 million BTC. This means that, at most, there will only ever be 21 million BTC in circulation. BNB Coin, on the other hand, has a maximum supply of 200,000,000 BNB. The creators of the crypto are able to choose the supply limit themselves.
On the other hand, some cryptocurrencies have no supply limit at all, which means that the maximum number of coins in circulation is infinite. Many cryptos have an infinite supply, including Tether, Dogecoin, Solana, and Ethereum. A cryptocurrency can be deflationary whether it has a capped or infinite supply. But for an infinitely supplied crypto to be deflationary, it needs some kind of burn mechanism in place (which we’ll discuss a little later).
As is standard in the crypto market, Ethereum’s price depends on its supply and demand. If the demand exceeds the supply, the price tends to go up. If the supply exceeds the demand, the price tends to go down. So, if you’re an investor, you ideally want the demand for your chosen asset to be higher than the supply.
If the supply of a token increases, it is considered inflationary, and if the supply decreases, it is considered deflationary. There are various popular examples of deflationary cryptocurrencies out there today, including Bitcoin, BNB Coin, Shiba Inu, Polygon, and, now, Ethereum. So, what caused this change?
Why Is Ethereum Now Deflationary?
Ethereum is now being described as deflationary because its issuance is deflationary. This means that the number of Ether entering circulation is less than the number being burned (i.e, destroyed).
When a cryptocurrency is burned, a holding of assets 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 within the wallet becomes completely useless and is considered burned or destroyed. Many blockchains have burning mechanisms, as it helps to control the circulating supply and, therefore, the price (to some extent).
Ethereum has been burning coins via the EIP-1559 token standard. EIP-1559 came into play in mid-2021 via the London upgrade and involved a change to the fee process. Each time a transaction takes place on the Ethereum blockchain, a fraction of the transaction fee (the base fee), which is calculated in ETH, is burned.
Since the introduction of EIP-1559, billions of dollars worth of Ether have been burned. This has undoubtedly played a role in the changing relationship between the blockchain’s circulation and burn rates. In fact, EIP-1559 was designed to achieve this very goal.
But Ethereum’s burning mechanism has been around for years, so this certainly isn’t the only factor involved in the asset’s recent switch to a deflationary status. The network’s transition to a proof of stake consensus mechanism also played a role in this change.
In September 2022, the Ethereum blockchain’s consensus mechanism changed from proof of work to proof of stake, in what was known as the Ethereum Merge. Proof of stake is a more efficient mechanism that is used by many cryptos, and its adoption on the Ethereum blockchain has allowed Ether holders to deposit a portion of their ETH in a smart contract (known as the Beacon Deposit Contract). Users can earn a yield via this mechanism, which makes Ethereum a more desirable asset.
At the moment, there are over 16 million ETH deposited in the Beacon Deposit Contract, amounting to over $24 billion (as reported by Etherscan), so it’s evident that this new yield option has attracted many investors.
The chart above shows an evident shift in Ethereum’s supply trend. Though the supply was steadily increasing throughout most of 2022, things began to change just before the Ethereum Merge in September.
On January 4, 2023, the circulating supply of Ethereum was 120.53 million. The next day, the circulating supply had fallen to 120.52 million (as reported on YCharts). This decrease is representative of Ethereum’s current deflationary nature.
Is Ethereum’s Deflationary Status Good News?
So, Ethereum is now deflationary, but what does this mean for investors?
As you can see in the CoinMarketCap graph below, Ethereum’s price has climbed significantly between January 3, 2023, and January 18, 2023. Within this two-week window, the price of one ETH increased by an impressive 25 percent. 2022 was a pretty bad year for Ethereum (and the crypto market in general), so it’s exciting to see things begin to take a turn for this world-renowned altcoin.
Given that the supply of Ethereum has decreased, it has become easier for the price to increase (working off the integral demand/supply relationship). If Ethereum’s supply continues to slowly decrease and can remain below the burn rate, we’ll likely see a continuation of this growth in value. On a long-term basis, this may be great news for investors and could lead to hefty profits when traded.
However, it must always be acknowledged that the crypto market is highly volatile, and there are countless factors that can affect a coin or token’s price. So, while Ethereum’s price is on the rise as a deflationary asset right now, this likely won’t always be the case.
A Deflationary Ethereum Bodes Well for the Blockchain’s Future
At the moment, things seem to be going well for Ethereum, with a significantly increased value and deflationary status. This trend may continue into 2023 if the market treats Ethereum well, but there are no guarantees in the crypto realm. Time will tell whether this is the start of Ethereum’s price recovery or if it is a mere fluctuation that will soon regress.