One of the big advantages cryptocurrency has over traditional currencies is the ability to set its own maximum supply; hence, currencies cannot be minted indiscriminately. Excessive supply of a currency leads to a devaluation; hence, one important way to maintain the value of a currency is to ensure some sort of scarcity.
Bitcoin, the first cryptocurrency, was created in this manner, with a maximum of 21 million tokens; to further enable scarcity, Bitcoin has a halving mechanism, where the reward for mining a Bitcoin block is halved after every 210,000 blocks (approximately every 4 years). The initial reward was 25 BTC per block mined, but after two halving events, the Bitcoin reward is 6.25 BTC, making it scarcer and more difficult to reach the 21 million cap; hence, Bitcoin’s economics is regarded as “deflationary.”
Ethereum, the second-largest cryptocurrency and Bitcoin’s closest competitor, is quite the opposite. Despite having the same “currency minting” system (the Proof-of-Work (PoW) consensus that rewards miners for validating transactions on the network with new cryptocurrency), Ethereum neither has a fixed maximum supply nor a halving mechanism like Bitcoin; hence, Ethereum’s supply is unlimited, and like traditional currency, prone to inflation; however, with Ethereum’s latest shift from a Proof-of-Work consensus algorithm to Proof-of-Stake, things are set to change.
What Does It Mean For A Cryptocurrency To Have A Deflationary Economic Model?
From the explanation above, you probably have a hint as to what a deflationary model is all about. In simpler terms, a deflationary model is one that seeks to induce scarcity into a cryptocurrency’s economy to maintain its value; as long as demand increases, a scarcer supply means that those who want the crypto asset would gladly pay a higher fee to acquire it.
In addition to a fixed supply, Bitcoin’s halving model is one popular deflationary mechanism used; some other cryptocurrencies employ a “buyback and burn” model, and so on. As long as the economic model induces scarcity to raise the value, and keep demand levels consistently higher than supply, then it can be said to be a deflationary model.
ETH 2.0 – Is It Deflationary?
The migration of Ethereum from Proof-of-Work (PoW) to Proof-of-Stake (PoS) means the end of the road for Ethereum mining activities; hence, to become an Ethereum validator, you must stake a minimum of 32 ETH; hence, in the bid to “mint new Ethereum currencies,” validators must lock up some of their existing tokens, such that they aren’t spendable. Staking a cryptocurrency involves locking it up for a specific amount of time, for which the assets will be unspendable; although you still own the asset, you can’t spend a dime out of it until after the staking period elapses.
The Proof-of-Stake algorithm randomly chooses validators from the pool of stakers to validate transactions and earn new Ethereum; the higher your stake, the higher your chances of becoming a validator. Hence, many people are incentivized to lock up a huge part of their Ethereum holdings to make new ones, reducing the amount of tradeable Ethereum on marketplaces; consequently, scarcity is induced, and with increased usage of the Ethereum network, demand will outweigh supply, increasing Ethereum's value in a deflationary manner.
Given the rich history of the Ethereum blockchain, it is a very busy network with a lot of demand – 2020’s DeFi summer and the NFT craze in 2021 easily come to mind, not to mention the slightly booming Play-to-Earn ecosystem that the bear market put into a premature halt. Nevertheless, the Ethereum network has proven to be eventful; hence, increased demand for Ethereum is a definite guarantee, making its switch to ETH 2.0 a potentially profitable one for Ethereum holders.
Should I Invest In Ethereum?
Even with its previously inflationary model, Ethereum has been one of the most lucrative cryptocurrency investments, particularly among the high-cap coins; hence, several analysts have suggested that Ethereum’s new deflationary model will make its investment value soar even higher. As we have extensively analyzed, demand and supply metrics are the major determinants of value; hence, if, after the bear season, the Ethereum network gains traction (and demand), holding ETH would become very profitable. Hence, in the eventuality of a new blockchain trend, Ethereum investments may be worth it.
Unlike the Bitcoin halving, the Buyback & Burn, and other deflation models, Proof-of-Stake doesn’t actively reduce the supply schedule; instead, it only creates scarcity due to reduced availability of tradeable tokens; hence, Ethereum and other PoS blockchains with no active supply reduction mechanism are totally dependent on increased demand to stay deflationary.
Good enough, the Ethereum blockchain, as one of the most active blockchain networks, has a high guarantee of steady demand; hence, upon a new bull season, the real heights of Ethereum’s deflationary economics will be seen.
All Information Highlighted In This Article Is Informational And Should Not Be Taken As Financial Advice; You Are Advised To Do Your Own Research.