The deflationary Ethereum. How is this possible and how long can it sustain?

Ethereum continues to reduce its overall supply in recent months and considering its price per token resumes to stagnate at the very best it’s interesting to understand how this is still possible.

The project has several means of achieving this feat as listed below but it’s important to note that it all relies on usage, something that lacks generically during a bear market.

Here’s its various methods

1: Ethereum's Merge -

A significant upgrade known as the Ethereum 2.0 upgrade, which includes the transition from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) mechanism. This upgrade aims to improve the network's scalability, security, and energy efficiency. The PoS mechanism involves validators who lock up a certain amount of Ether (ETH) as collateral to participate in block validation.

2: Transaction Fee Burning (EIP-1559) -

Ethereum introduced EIP-1559, which changes the way transaction fees are handled. A portion of the fees paid for transactions is burned (destroyed), reducing the overall supply of ETH. This mechanism, while not purely deflationary, can create deflationary-like effects by reducing the available supply over time.

3: Scarcity through Locking -

Ethereum's transition to PoS involves validators locking up ETH as collateral. This lock-up removes ETH from circulation and reduces the available supply for trading. It's a method that contributes to scarcity, potentially leading to deflationary pressures.

4: Fixed Supply Assets -

While Ethereum doesn't have a fixed supply like Bitcoin (which has a maximum supply of 21 million), some tokens built on the Ethereum blockchain, like stablecoins or tokenized assets, can have fixed supplies. These tokens may exhibit deflationary attributes depending on their design and usage.

5: Burn Mechanisms -

Some decentralized applications (DApps) and tokens on Ethereum use burn mechanisms, where a certain amount of tokens is deliberately destroyed with each transaction. This can reduce the overall token supply and introduce deflationary characteristics.

Looking at the data, we’re currently experiencing an almost 0.05% reduction in supply each month. Whilst that doesn’t sound like an alarming number, let’s look at a 12 month set at this rate. 0.6%. Still not impressed? How about 5 years, 3%. And 6% reduction in supply in 10 years. Again, at the current rates. ETHs current supply is 120.15m so a 6% reduction would take it to 112.9m.

However, since the merge we have been in a bear market, network usage across ETH, it’s layers and Dapps has been much lower than during the last bull market. We could see a much higher deflation rate during these periods and increased adoption.

Another aspect which could be considered a double edged sword is that the amount of staked Ethereum is currently at its highest ever level of over 24 million, around 20%. This means that whilst a good portion of ETH isn’t currently circulating but potentially helping the current price, a large amount of ETH is being minted via rewards and less ETH is being transacted thus reducing the burn rates. It will be interesting to see how the bull market effects the staked amounts and the over transactional volume.

The big question is, where is the equilibrium? How long can ETH remain deflationary? Not forever surely? Unfortunately, it’s impossible to predict. This equilibrium can only be reached once the various deflationary methods find a balance with both transactional volume and current supply. It may be that 100m is the sweet spot, or as low as 50m.

For fun, let’s take a look at BTC supply and price vs these proposed ETH supply’s and relevant prices. BTC current $29,400, 19.5m supply. ETH at $1,850, 120.15m supply. BTC at 15x the price of ETH. Let’s take ETHs supply to 100m making it $2,220 per coin at current market cap, BTC 13x the price. Or $4,440 per coin at 50m in supply at current market cap, BTC at 6.6x the price. Now let’s take a speculative $150k BTC and calculate the 100m supply ETH price. $10k per ETH. Now a 50m supply. $22.7k per ETH. Potentially staggering. Of course this assumes static ratios…

Purely speculative but entirely possible in due time…

Remember though that the Ethereum ecosystem is complex, and various factors can influence supply dynamics, including network activity, token issuance, and broader market conditions.

It’s a very interesting project with some intricate tokenomics. There’s no doubt that ETH at the very least has built a huge ecosystem with many moving parts. It will be very interesting to watch its intricacies unfold over the years.