The recent spectacular pump in the price of Ethereum (ETH) is largely a function of the hype that has been consistently building around the upcoming merge event and the oft-repeated prognosis that the world’s second-largest cryptocurrency by market capitalization is about to turn into an almost perfect deflationary asset in a world beset by raging inflation. However, as with almost all things in life, the reality is much more nuanced.
As a refresher, the upcoming merge event will formalize Ethereum’s transition from a Proof-of-Work (PoW) transaction authentication mechanism, where miners expend computational power to win the right to authenticate incoming transactions, to one based on a Proof-of-Stake (PoS) framework, where validators lock up a specific amount of Ethereum in dedicated nodes in order to compete with each other to authenticate transactions and introduce new blocks into the chain.
We’ve explained Ethereum’s deflationary case in detail in a dedicated post. Please do try to go over that article to gain critical insight into the opposite view to the one that will be explained here.
Jordi Alexander is the CIO of Selini Capital and a game theorist. Bankless recently explained his bearish take on Ethereum’s deflationary characteristics in a dedicated newsletter. We’ll add to Jordi Alexander’s analysis in this post.
Everyone agrees that the upcoming merge event will drastically reduce Ethereum’s issuance. After all, a PoS framework is much more efficient than one based on PoW and requires the expenditure of significantly fewer resources. Currently, miners are responsible for the issuance of around 13,000 ETH per day. With the advent of the PoS transaction authentication framework, just around 2,000 ETH per day would be issued in the beginning to authenticate transactions. As the coins staked on the Ethereum network grow, this daily issuance is expected to rise to around 5,000 ETH, still corresponding to a decrease of over 60 percent.
Ethereum’s burn mechanism underpins much of the recent deflationary projections. This mechanism was introduced as part of the Ethereum Improvement Proposal (EIP) 1559 innovation. The overhaul introduced a base fee that was determined in real-time using network congestion as its primary input. This base fee is burnt, while the validators’ rewards predominantly consist of two variables: the tip fee, which is the cost incurred by a user to prioritize the processing of a particular transaction, and the block subsidy, which is currently fixed at 2 ETH per block and is divided equally among all of the validators. Please go through the YouTube video above for additional clarity.
However, there is a problem here. Elevated burn requires network congestion, which has not existed for quite a while now. In fact, barring a new sensational phenomenon – such as the launch of virtual real estate bidding in BAYC’s metaverse initiative, Otherside, which had last caused Ethereum fees to jump drastically – the base fee, hence the burn, is expected to remain muted. This undercuts Ethereum’s deflationary projections.