Experts explained what to expect from a decline in coin supply after the network switched to PoS

“A simple market law.” How deflation will affect the Ethereum price

13.10.2022

271

5 min

For the first time since the Ethereum blockchain switched to the Proof-of-Stake (PoS) algorithm, the cryptocurrency has become deflationary, meaning that more coins were destroyed in transactions than new ones were created. This was the result of a rise in the price of the so-called gas needed to keep the network running.

Transaction gas fees help prevent malicious requests from overloading the blockchain: the greater the load on the network, the higher the gas fee. Since the completion of The Merge upgrade on September 15, the number of new coins issued on the Ethereum network has dropped by 90% compared to when ETH ran on the Proof-of-Work (PoW) algorithm.

Ethereum became deflationary because the number of issued ETH coins in circulation has decreased for the first time, explains Nikita Vassev, founder of TerraCrypto. This is due to the mechanism of burning a portion of the EIP-1559 transaction fee, activated in August 2021. If the amount of burned ETH paid as a transaction fee exceeds the number of coins issued, we can say that Ethereum has become deflationary. While about 4,9 million ETH were issued per year before the Merge, after the upgrade the issuance will be about 603 000 ETH.

As a senior analyst at the aggregator Bestchange.ru explains, the EIP-1559 mechanism was introduced to level out the potential effect of manipulation by miners. It was decided to allow them to receive only a fixed portion of the fees and to burn any excess so no one would receive them. This somewhat stabilized the situation with ever-increasing fees on the network and also allowed to artificially limit the token issuance.

What caused the deflation

The average price of gas has remained low since the transition to PoS but rose sharply on October 8 when the Xen Crypto (XEN) token was launched. XEN tokens on the Ethereum blockchain can be issued (“minted”) for free and then used to generate staking revenue under terms spelled out in a smart contract. All you have to do to create a token is pay a gas fee.

The hype around the token led to its contract starting to consume more gas than both versions of the decentralized exchange Uniswap and the NFT marketplace Opensea combined. In less than a week, more than 4000 ETH were burned in the creation of XEN tokens, causing Ethereum to deflate. At the time of publication, XEN remains the leader in gas consumption among all applications on the Ethereum blockchain, according to ultrasound.money.

A list of gas-burning leaders

Source: Ultrasound.money

XEN was created by former Google developer and crypto influencer Jack Levin. He positions the coin as a “universal cryptocurrency with no intrinsic value,” which will gain in value as more and more people join and participate in the issuance of new tokens. On October 9, the price of the token surged more than 100 times, momentarily reaching $1,04, but just 5 minutes after peaking, it collapsed below its original price.

XEN price chart on the Poloniex exchange

When XEN appeared, community members on social media quickly began calling the project a Ponzi scheme. The token was also launched on the Binance Smart Chain and Polygon blockchains. On October 13, the price of XEN dropped another 46% after a number of vulnerabilities were discovered that allowed the token to be manipulated.

According to Zuborev, XEN itself is unlikely to interest the mass investor. The project is quite controversial, with signs of a Ponzi scheme, so the project as such is not interesting from the point of view of economics. “But the effect that made ETH deflationary again is interesting to study. Will new similar projects be able to increase deflation and consequently raise the price of ETH in the future? This question has yet to be studied in practice,” comments the Bestchange.ru analyst.

The impact on the price

The moment Ethereum went deflationary for the first time since the Merge had no effect on the cryptocurrency's price. Despite the decrease in coin supply, the ETH exchange rate dropped below $1300 amid a bearish period across the entire crypto market. Overall, despite the fact that Ethereum's transition to PoS was one of the most important events in cryptocurrency history, the price of ETH did not react to it with sharp jumps.

The effect of the successful transition to PoS was absent because the event itself was being prepared for more than a year, and most of the expectations were already included in the price at the time of the upgrade, explains Zuborev. The change in the consensus mechanism itself does not introduce significant factors for the price, so there were no noticeable shifts in the market at the time. According to the analyst, the long-term effect will be more noticeable and will contribute to the ecosystem development in a much more intensive mode than the market on average, so the price of Ethereum may grow noticeably within 2-3 years.

The market hasn't yet fully felt the effects of Ethereum's global upgrade, Vassev says. “I believe the biggest effect of the Merge in the price of ETH will manifest itself by the summer of 2023, ahead of the introduction of sharding, which will increase blockchain bandwidth,” says the head of TerraCrypto.

The move to PoS will only unlock Ethereum's potential in the next upgrade, agrees Berezka DAO and Weezi co-founder Roman Kaufman. When discussing the outlook for the price of ETH, Kaufman believes both the network's infrastructure development prospects and the deflationary model will provoke demand for the cryptocurrency. “Ethereum is called the “internet of money”' for a reason, it is now the foundation for the DeFi, NFTs, and other areas. I believe that the reduction in coin supply will have a very positive effect on the price of the ETH token,” summarizes the expert.

Deflation implies that fewer new tokens are issued than they are burned, explains Zuborev: “The total circulating amount is reduced, which potentially means that the tokens become a more scarce commodity, which naturally pushes the price up – it's a simple market law.”

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