Ethereum is on course to implement a new upgrade on its blockchain network as it transitions to the next-generation Eth2.0. The network’s next upgrade, Ethereum Improvement Proposal (EIP)-1559 is tipped to change the protocol’s monetary system. The new upgrade ships with a burn mechanism that will decrease Ether’s supply and turn it into a deflationary asset.
What is a Deflationary Asset?
A deflationary crypto asset is one whose supply decreases over time. This is in sharp contrast with fiat currencies that are said to be inflationary, and as a result, suffer from inflation.
An inflationary currency is one whose supply increases. This is the case with the U.S. dollar, as it is the fate of all fiat currencies. In 2020 alone, the U.S. printed at least $3.3 trillion, which equates to anywhere between 18% and 22% of the total supply of dollars. This will inherently lead to inflation, or simply the reduction in buying power.
A deflationary asset is the opposite of this. And this applies to Ether as well.
Ether’s deflationary capabilities are bundled in the EIP-1559 upgrade. The new upgrade will enforce changes in how the protocol handles transaction fees. In the current gas fee model, network users propose — and can even analyze — the amount of gas they are willing to pay for their transactions to be confirmed. Miners will naturally choose transactions with a higher gas limit as this is economically viable for them.
However, with the new upgrade, gas fees will be more predictable. Ethereum will use standard flat fees called ‘base fees” and optional miner tips to settle transactions. The base fees, paid in Ether, are burned after every transaction. This decreases the supply of Ether, which will likely have an effect on the crypto asset’s price.
The best way to explain the impact of the burn mechanism in Ethereum is to look at bitcoin and its monetary policy. Bitcoin has a finite supply capped at 21 million, and minting new coins will cease when this figure is reached. When people forget their private keys or die without revealing their private keys, the number of bitcoins in circulation decreases. The bitcoins are lost for good. As more bitcoins exit the system, the value of bitcoins will rise. In essence, deflationary assets promote the hoarding of assets rather than spending.
Bitcoin is not the only deflationary asset, and Ether will likely join these ranks as it changes its monetary model. Besides the change it will make in the network’s economics, EIP-1559 is part of a larger upgrade to a Proof-of-Stake consensus mechanism.
The Road to Ethereum2.0
Ethereum2.0 presents the next major upgrade to Ethereum’s blockchain. The road to Eth2.0 will be done in multiple stages that will be approximately a year apart. The first step, Phase 0, went live in December 2020. Several upgrades will be implemented between each phase and the next step. EIP-1559 is one of those numerous upgrades.
Ethereum will introduce a burn mechanism through EIP-1559. Ether’s supply has no cap and this leads many to question whether Ethereum will be truly deflationary. Will Ether’s supply decrease over time or the blockchain will mint more tokens than it will ever burn?
This is a legitimate question worth addressing.
The answer to this question is not in black and white. The amount of Ether to be burned depends on network activity. If the transaction activity increases, it is possible that the network can destroy more Ether than will be issued via block rewards. This is not a guaranteed event but will likely happen if the network continues to rise in usage.
When Ethereum transitions to Eth2.0, the rate of minting new Ether tokens will decrease from around 5% to 1%. There is a high probability that the rate of burning tokens will outweigh the rate of issuance. This will make Ether a deflationary asset.
Wrapping it Up
Apart from the obvious fact that the transition to Ethereum2.0 will improve the network’s speed, there are heated debates about the proposed changes to the protocol’s monetary policy. The main bone of contention is whether the deflationary property is good for Ether or not.
A lot of stakeholders within Ethereum’s ecosystem will be affected by this change. We will start off with ERC20-based fungible tokens such as LEDU tokens that are built on top of the Ethereum network. The token holders have to pay gas fees to buy and sell their tokens. The current model in which high gas fees are required for transactions to be completed is not economically viable for the majority of token holders.
ERC20 token holders and traders have to pay a premium to buy and sell their tokens. This can force them to hold their tokens against their will. This hinders mass adoption and reduces the allure for people to buy ERC20 tokens. Thanks to EIP-1559, the reduction in gas fees could change this and lead to reasonable gas prices.
On the other hand, Ethereum miners are not impressed by the inevitable EIP-1559 update. Ethereum miners generated $830 million in January, and a record $1.37 billion in February 2021, partly due to the rising gas fees. This is the first time that Ethereum miners have generated more than $1 billion in revenue in a calendar month. And all this income is under threat from EIP-1559. Needless to say, some Ethereum miners are against the EIP-1559 update as it directly hits their pockets.