Ethereum as a Net-Deflationary Asset: An Emerging Narrative

Ethereum was first proposed in late 2013 by Vitalik Buterin. A programmer and co-founder of Bitcoin Magazine, he wrote and published the Ethereum white paper that same year. Ethereum has since become the second-biggest cryptocurrency in the world. 

However, changes made in 2022 to this digital asset may push its price even higher. In this article, we explore why the supply of Ethereum is deflationary and why the price is inflationary.

In 2014, investors bought the first Ether (ETH) using Bitcoin (BTC). This is important because it showed that the world of digital currencies was becoming more interconnected. Before then, digital currencies were mainly isolated and only worked on their own blockchain. 

It showed that ether was not just a digital currency. It’s the native currency of the Ethereum network whose main network launched on July 30, 2015. Now, over 6,000 nodes power the Ethereum network making sure it runs securely and reliably.

What made Ethereum different was the recognition that blockchains can do more than just power cryptocurrencies. Its originator built in a flexible programming language to Ethereum’s blockchain. 

This meant that developers could create applications that represented real-world assets. Now, for example, stocks and bonds could be digitally represented as well as cryptocurrencies.

Ethereum could also power smart contracts. These are self-executing contracts whose terms of the agreement are directly written into lines of code. 

With smart contracts, there’s no need for intermediaries to take action to fulfil the conditions of a contract. This opened the door to the possibility of automating even more complex transactions. This thereby also reduced the potential for fraud and enhanced transparency.

To run these smart contracts and execute transactions, users pay “gas fees” with ether. They’re transaction fees that compensate for the amount of computing energy required. The Ethereum blockchain’s history is filled with major milestones like these.  

When it launched, Ethereum used a system called Proof of Work (POW). This meant that, to mine it and create new Ether, computers had to solve complex mathematical puzzles.

This rewarded miners with the biggest rigs and led to a continuous increase in the supply of the currency.

Having the best mining machines, ASIC integrated circuits and GPUs made all the difference. According to Douglas Turner:

“The better quality of equipment you have, the more Bitcoin you’ll be able to mine. It also may be worth your time to make sure you’re on the lowest electricity rate possible, as electricity will be your biggest cost.”

To combat this, Ethereum switched to a Proof of Stake (POS) consensus mechanism. Now, instead of computing power, users locked up some of their Ether as a security deposit. This allowed them to participate more easily and equally in mining and other activities on the network.

This change from POW to a Proof of Stake system has been called the ‘Merge’. This Ethereum “merge” caused the digital asset to become deflationary for these reasons:

EIP-1559

EIP-1559 was a major upgrade rolled out by the Ethereum Foundation in August 2021. 

The upgrade introduced a base fee for transactions and burned a portion of the fees paid. This portion of every transaction on Ethereum is permanently removed from circulation. 

This new burning mechanism reduced the overall total supply of ETH. It also affects the economics of verifying transactions as miners no longer receive a base fee portion of transaction fees.

The update also enables users to pay an optional tip to miners to speed up their transactions.

Proof-of-stake

Proof-of-stake is a more energy-efficient consensus mechanism. It requires validators to stake ETH so they can take part in block production. 

As a result of this transition to proof-of-stake, the number of ETH minted per block will reduce. This also further reduces the total supply of ETH, providing another reason why Ethereum was deflationary after the Merge.

Increased demand

The demand for Ethereum has been increasing recently. This is thanks to the growing popularity of decentralised finance (DeFi) and non-fungible tokens (NFT) trading. 

As demand for Ethereum increases, so too do the transaction fees paid on the network. These higher transaction fees lead to more fee burning, reducing the ETH in circulation.

Here is a more detailed explanation of each factor:

 EIP-1559 was a major upgrade to the Ethereum network that was implemented in August 2021. The upgrade introduced a base fee for transactions and burned a portion of the fees paid. This means that a portion of every transaction on Ethereum is permanently removed from circulation, reducing the total supply of ETH. This update also enables users to pay an optional tip to miners to speed up their transaction.

Proof-of-stake is a more energy-efficient consensus mechanism that requires validators to stake ETH in order to participate in block production. As a result of this transition to proof-of-stake, the number of ETH minted per block will be reduced, further reducing the total supply of ETH.

The demand for Ethereum has been increasing in recent months due to the growing popularity of decentralised finance (DeFi) and non-fungible tokens (NFTs). As demand for Ethereum increases, so too do the transaction fees paid on the network. These higher transaction fees lead to more ETH being burned, further increasing the deflationary pressure on the asset.

Ultra Sound Money is a website that tracks the amount of ETH being burned. It’s showing that significantly more ETHs are being burned than issued right now. 

In the time since the Merge, Ultra Sound Money has shown us the following:

• Supply has shrunk by 0.21% per year
• 987,000 ETH have been burned while 734,000 have been issued
• US$1.8bn a year is being burned as opposed to US$1.3bn being issued

September 2022 saw the completion of the shift from a Proof of Work (PoW) to the Proof of Stake (PoS) model. It’s been a success in terms of energy efficiency, scalability, and transaction speed.

At the time of writing, investors and speculators no longer use the term ‘Ethereum 2.0’. Instead, it’s an example of the currency’s story continuing as its use becomes more popular.

The Merge has seen a reduction in Ethereum’s energy consumption by 99.95%. A further upgrade proposed for the future by the Ethereum Foundation includes “danksharding”. This is a way of splitting up the network into smaller parts to allow even more transactions.

Speculation about Ethereum becoming deflationary after the Merge was widespread. Many expected the volume of currency in circulation to fall and they were right.

However, while there is deflation in the Ethereum supply, there has been inflation in the price of the coin. Correlation does not equal causation though and there may be many reasons why the price has gone up. 

Unlike Bitcoin which has a cap of 21 million tokens, Ethereum has no such cap. The current supply is hovering around 120m ETH, a figure Vitalik Buterin has suggested may become the natural maximum. 

It is important to note that the deflationary nature of ETH supply is not guaranteed to continue indefinitely, though. 

The base fee and the tip, both set by the market, determine the amount of ETH being burned. If the demand for ETH decreases or the cost of transactions increases, the amount of ETH burned per block could decrease. This will likely lead to price inflation.

Many thought the long-term effect would be deflationary. However, since Sep 2022, the price of the token has more than doubled which has guided many investment decisions in its favour. While Ethereum deflation is true in terms of its supply, it’s not true in terms of its value.

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This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not digital asset or cryptocurrency trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.