Ethereum Post Merge: Inflationary or Deflationary

One of the most eagerly anticipated outcomes of Ethereum’s transition to a Proof of Stake from a Proof of Work network is whether Ether (ETH) is going to be a deflationary currency. After all, the introduction of EIP-1559 together with the move away from mining meant that ETH should become deflationary, in theory. 

 

As of the writing of this article, it has been around two months since the Merge. So in this article, we will take a look at whether Ethereum is an inflationary or deflationary currency.

 

Inflationary And Deflationary Cryptocurrency: What Do They Mean

Let’s first take a look at what defines an inflationary and deflationary cryptocurrency. In this article, we will use cryptocurrency and token interchangeably for simplicity sake.

 

An inflationary cryptocurrency is one where there is an increasing number of tokens in circulation over time. New cryptos are typically issued through mining and staking which increases the supply of the crypto. When the supply of newly minted cryptos outstrips its burn rate (if any because not all cryptos and tokens have burning mechanisms), on balance, there is an increase in the net supply of the crypto. This makes the crypto inflationary in nature.

 

A deflationary cryptocurrency, on the other hand, is one where there is a decreasing number of tokens in circulation over time. This typically happens when the burn rate of the crypto outstrips its issuance rate thus leading to a decrease in the net supply of the crypto. This makes the crypto deflationary in nature.

 

One reason why investors pay attention to whether a cryptocurrency is inflationary or deflationary is because it can affect the price of the crypto. To understand why this is so, we have to go back to Economics 101. Based on supply and demand, when there is an increase in the supply of the crypto, the price of the crypto will drop, assuming all else remains constant.

 

Of course in reality there are a lot of moving parts which affect crypto prices. However, they all ultimately fall back to the law of supply and demand. Thus, understanding the supply and demand dynamics can give you a clearer idea of how crypto prices are determined. 

 

Ethereum Post Merge: An Inflationary or Deflationary Crypto?

While there are certainly many new features with Ethereum’s upgrade, there are two new features that we need to focus on here in this article: the implementation of EIP-1559 and the move to staking from mining. 

 

EIP-1559

EIP (Ethereum Improvement Protocol)-1559 is part of the Ethereum upgrade which will see a portion of every transaction fee on the network being burned. Before the implementation of EIP-1559, validators receive the full gas fees. After the implementation, a portion of every gas fee is burned. 

 

The implementation of EIP-1559 has and will continue to remove a portion of Ether from the total supply. 

 

Move to a PoS consensus network

Ethereum’s move to a Proof of Stake network will see stakers validating transactions instead of miners. Before the move, around 13,000 ETH was issued per day as mining rewards according to the Ethereum Foundation. After the move, the issuance of ETH per day has fallen by roughly 90%.

 

Thus, Ethereum’s move to staking from mining has substantially reduced the supply of newly minted ETH. 

 

Based on the above, Ether should be deflationary right? But ETH turned deflationary for the first time only on November 11, nearly two months after the Merge.   

 

Data from ultrasound.money highlights that the net issuance rate for Ether currently stands at -0.03% which indicates that the burn rate for the crypto has outstriped its issuance rate. 

 

Taking a look at the screenshot from ultrasound.money, we see that it is only recently that the issuance rate for Ether became negative when before it was positive. So why did the deflationary milestone for Ether remain elusive until now?

 

This is because despite the reduction roughly 90% in total new ETH issuance per day, about 1,700 ETH are still being issued per day. Coupled with the fact that activity in the Ethereum network has been relatively low only till recently, the amount of ETH burned has not kept up with the amount of new ETH issued. The official Ethereum page points out:

 

“If an average gas price of at least 16 gwei is observed for a given day, this effectively offsets the ~1,700 ETH that is issued to validators and brings net ETH inflation to zero or less for that day.”

 

It is only with the recent increase in activity on the Ethereum network, which drove up the price of gas fees, that caused the burn rate of Ether to outpace its issuance rate. Put simply, the higher the activity on Ethereum’s network, the higher the gas fees. The higher the gas fees, the higher the burn rate. The higher the burn rate, the higher probability that Ether is deflationary.

 

Thus, while Ether has been touted as a deflationary asset in theory with the implementation of EIP-1559 and the move to staking, in practice, Ether as a deflationary asset is heavily dependent on prevailing market conditions.

 

What Is Ultrasound Money In Crypto 

Ether’s potential as a deflationary crypto has led many to term it as “ultrasound money”. The term was first popularized by Justin Drake, an Ethereum Foundation researcher. Justin Drake argued that if gold and digital gold such as Bitcoin is deemed “sound money” then Ether with its decreasing supply should be “ultra sound”. 

 

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Also ETH will likely be ultrasound money in two years. We have ~5K ETH/day in transaction fees, most of these fees will be burnt, and this will more than compensate for PoS issuance. pic.twitter.com/u8R5iaHS9S

— Justin Ðrake 🦇🔊 (@drakefjustin) January 31, 2021

 

The inflationary or deflationary nature of ETH is still largely dependent on prevailing market conditions such as the demand for transactions on the Ethereum network. During periods of low demand and activity on the network, the minted supply of ETH tends to outstrip the burn rate, making it inflationary. However, during periods when there is high demand for transactions of the network, the burn rate tends to be higher than the issuance rate of ETH, making it deflationary. 

 

The positive steps taken by Ether’s tokenomics could usher in even more interest in the second largest cryptocurrency by market capitalization even as a growing number of people view cryptocurrencies as a viable hedging option against inflation.

 

Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. 

 

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