Summary: Since Bitcoin launched in 2009, Bitcoin and almost every cryptocurrency launched since has been inflationary and external miners received the fees provided for validating the transactions - including freshly minted crypto. By summer, however, Ethereum might turn into the first large deflationary cryptocurrency which furthermore compensates holders with newly minted cryptos instead of miners. This will likely make Ethereum more appealing for holders.
Since Bitcoin launched in early 2009, Bitcoin and other later introduced cryptocurrencies have been based on a proof-of-work framework. In this framework, crypto miners are running and securing the network. In return, they are rewarded partly by fees paid by users of the network and partly by newly issued Bitcoins. The latter dilutes the value of Bitcoin held by Bitcoin holders due to the increased supply. In similarity with other assets such as gold and silver, Bitcoin is a so-called inflationary asset. To draw a parallel, you do not have to own gold to mine it. However, if you succeed in mining it, you fundamentally dilute gold holders due to the increase in supply. The fact that Bitcoin and other proof-of-work cryptocurrencies are inflationary has inevitably been a drawback to cryptocurrencies and decreased the appetite for investors to hold cryptocurrencies.
The rather newly deployed proof-of-stake consensus protocol has partially offset the aforementioned drawback with cryptocurrencies being inflationary. Proof-of-stake has been the consensus protocol in the majority of newly launched cryptocurrencies in the past years. As an alternative to compensating miners in proof-of-work, the proof-of-stake protocol compensates the fresh supply alongside the paid fees to the actual holders, providing they stake the native cryptocurrency, hence verifying transactions on the network instead of miners. This essentially means holders are not necessarily diluted by the fresh supply, fundamentally making proof-of-stake superior to proof-of-work for holders.
A true deflationary crypto-asset arises with transaction fees
By locking a part of your cryptocurrency in a staking protocol, you assist in validating transactions on the blockchain. The compensation received by stakers consists partly of newly minted cryptocurrency, partly with transaction fees paid by users of the blockchain. To make it attractive for holders to stake their cryptocurrency, at least one of these parts need to be large enough to put in the staking effort.
The main challenge in proof-of-stake arises from the fact that few cryptocurrencies generate substantial transaction fees to make it financially viable to stake without issuing a substantial fresh supply to reimburse stakers. For instance, the 9th largest cryptocurrency measured on market capitalization, proof-of-stake blockchain Solana with a significant ecosystem has on average generated $82,000 in transaction fees per day the last 7 days. With a market capitalization of $26bn, the yearly $30mn in transaction fees for Solana is not enough to sufficiently compensate stakers. To fairly compensate them, Solana allocates current yearly inflation of 6% – 8% by the issuance of new Solana to stakers. Based on this, the proof-of-stake protocol does not by nature turn the certain crypto into a deflationary asset.
Ethereum is the titan of transaction fees
At the time of writing, there is purely one crypto generating sufficiently high transaction fees to run the network with a limited net addition of newly issued cryptocurrency. This is the second-largest cryptocurrency namely Ethereum. Ethereum has generated an average of $9.6mn per day in fees for the past 7 days. In 2021, the cryptocurrency generated a total of $9.9bn from transaction fees. To put it into perspective, Coinbase achieved total revenue of $7.35bn in 2021.
The fees generated by Ethereum in 2021 have surely been impacted by Ethereum’s present scalability issues alongside the surged demand for speculative transactions such as NFTs. This has jointly increased users’ willingness to pay high fees for Ethereum’s limited transactional output. However, looking at the outlook, Ethereum might actually turn into a long-term deflationary asset.
It starts with a burn
In August 2021, the so-called London update was implemented on the Ethereum network. The London update contained a new fee market mechanism known as EIP-1559. In short, instead of compensating miners the entire transaction fee, it burns the majority, whereas it still compensates miners the newly issued Ether per block, around 2 Ether per block, which amounts to a total issuance of around 5.4mn ETH yearly.
By interpreting the numbers since August, the impact of the London update is surely vast. In total, around 1.97mn Ether has been burned, essentially offsetting the yearly 5.4mn ETH issuance by 60%.
Goodbye, miners
However, unless fees significantly increase, the burning mechanism does not turn Ethereum into a deflationary asset. Here, we must turn our attention towards Ethereum’s transition from proof-of-work to proof-of-stake. By around June or July, Ethereum will complete its consensus transition to proof-of-stake known as the merge, phasing out miners completely. Instead, holders are able to stake their Ether to verify transactions on the network. In return, stakers receive the non-burned part of the transaction alongside the new issuance. However, at the time of the merge, the issuance drops from the 5.4mn to 0.5mn ETH yearly, so stakers are compensated less than miners are today.
The less issuance entails, though, that the supply will most likely turn deflationary due to the Ether burned by transaction fees. If we assume that the burned Ether rate stays identical following the merge, the Ethereum supply is expected to decrease by 2.3% yearly. This signifies that non-staking Ether holders are also expected to benefit following the merge. On top of the deflationary supply, stakers are compensated the yearly issuance of 0.5mn Ether plus the non-burned transaction fees. The staking reward is expected to be as high as 10% yearly, depending on the total amount of stakers and non-burned transaction fees. In reality, if this will be the case, Ethereum will in our view not only turn deflationary but also disburse stakers considerably.
The pull by traditional investors
Ethereum definitely has challenges to overcome, for instance, severe scalability constraints, regulation, and elevated competition from other smart-contract cryptocurrencies such as Solana, Cardano, and Polkadot. On the other hand, if Ethereum confidently belie these issues and ensures a constant and sustainable demand from users to execute transactions on its blockchain it turns deflationary while compensating stakers appreciable rewards. If such a demand is proven over time, as we see it, the new unique economics of Ethereum will make it more appealing for particularly investors not previously familiar with crypto. Not to mention that greater demand for handling transactions on Ethereum in the future will enhance the economics further since it increases the transaction fees. As we see it, this economic transition simply has the prospect of changing the broad sentiment to hold Ethereum. Likewise, this is true for other proof-of-stake cryptocurrencies in case they demonstrate substantial revenue from fees similar to Ethereum.
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