What is a Deflationary Token?
Cryptocurrencies are based on a blockchain network. A blockchain usually has a pre-determined mechanism that it uses to issue new tokens. Developers use various economic models to control the total supply of a given cryptocurrency to maintain its intrinsic value. The price of a given cryptocurrency depends on its total circulatory supply relative to market demand.
If the total supply of a token is more than its demand, the price will decrease over time. However, if the total supply is less than its total demand it means that price will go up. Therefore, different blockchains implement different types of token issuance mechanisms to ensure long-term price stability.
In this context, deflationary cryptocurrencies are assets where the underlying value of a given asset increases over time on account of diminishing supply over time. This is done by reducing the issuance of new cryptocurrencies over time using different methods such as halving and burning addresses.
What Makes Ethereum a Deflationary Asset?
Ethereum blockchain has the second highest market cap among all cryptocurrencies in the world. Ethereum blockchain did not start out as a deflationary network as it kept the total supply infinite. However, after the Merge event in September 2022 Ethereum transitioned into a deflationary blockchain.
Before this update, Ethereum’s annual supply continued to grow at a rate of 4.5%. The Merge update shifted Ethereum’s consensus mechanism from a proof-of-work (PoW) model to a proof-of-stake (PoS).
The shift expedited the burn rate of ETH in circulation in comparison to the newly minted ETH coins. Merge upgrade implemented EIP-1559 protocol to the blockchain such that dedicates a portion of the gas fee on the Ethereum blockchain to burn addresses. On this account, some analysts opine that Ethereum has become more deflationary in comparison to Bitcoin.
Bitcoin, the flagship blockchain, has capped its total supply to 21 million and also incorporated a halving method that reduces total Bitcoin rewards for miners by half after every four years.
Does the Deflationary Mechanism Add More Value to Ethereum?
No, as per analysts Ethereum’s transition into a deflationary blockchain does not make ETH more valuable in comparison to other cryptocurrencies. The impact of limited supply leading to a price appreciation is visible in asset classes such as NFTs and Ethereum Naming Service (ENS).
NFTs that have a limited supply are said to have a higher price. In the same manner, ENS that issued 3-digit shortened names to replace public wallet addresses were purchased for up to 100 ETH.
Ethereum incorporates deflationary mechanism by sending a small portion of ETH collected as gas to burning addresses. However, analysts argue that if no one is using the Ethereum blockchain its total supply or deflationary mechanism would not matter.
Ethereum blockchain retains massive demand among investors by the way of offering innovative solutions such as decentralized application development and hosting. These applications have the ability to solve real problems and offer practical solutions for investors.
Therefore, Ethereum brings value on account of network effect via its development ecosystem that allows it to gain more value or increase demand over time as more users join the network.
How does Inflation Control Work?
Fiat currencies do not have a definite total supply. Therefore, the total supply of fiat currencies in an economy increases over time. On this account, the currency devaluates leading to drop in purchasing power and a rise in inflation.
Therefore, Central Banks can use different types of monetary policies such as managing money supply, purchasing bonds, and changing interest rates to contain inflation. Just about all sovereign nations use the Keynesian economic model to keep inflation within an acceptable range.
A blockchain network or DeFi protocol implements organic monetary policy shaped by its decentralized governance. The design of a blockchain may have a deflationary mechanism that may include a standardized burning system, total supply limit, or halving mechanism.
Ethereum depends on DAOs and smart contracts to incorporate new economic models and supply constraints via tokenomics.
Ethereum blockchain’s transformation from an inflationary to a deflationary network has added various benefits for investors such as better store of value and positive price momentum. However, a deflationary mechanism cannot have a significant impact if the blockchain does not retain and grow demand among investors through its technical ecosystem.