Ethereum (ETH) is changing. Not only is it undertaking the gradual process of transitioning to a proof-of-stake (PoS) consensus mechanism, but it’s only a couple of months away from significantly revamping its monetary system, via Ethereum Improvement Proposal (EIP) 1559.
EIP-1559 proposes to split Ethereum gas fees into two parts: a tip which can be set by a transaction’s sender, and a base fee which is then burned. It’s this latter element which some have claimed will transform ethereum into a deflationary cryptoasset, and, according to the ETH camp, make it a serious store-of-value rival to bitcoin.
According to industry players speaking with Cryptonews.com, this shift may not occur overnight, with Ethereum needing to move fully to PoS before the deflationary aspect of EIP-1559 really kicks in. Some analysts also suspect that Ethereum might not reach the level of traffic whereby token burns outpace inflation.
‘Only time will tell’
Developer Ryan Berckmans explains that EIP-1559 will result in most gas fees being destroyed, although the effect likely won’t be instantaneous.
“EIP-1559 is expected to burn an estimated ~70% of fees, that’s the deflationary pressure. However, when EIP-1559 launches on July 14, ETH won’t immediately become deflationary because the proof of work mining will continue producing net inflation until Ethereum switches to proof-of-stake this year,” he told Cryptonews.com.
However, inflation will likely turn negative when Ethereum 2.0 is finally rolled out.
“After switching to PoS, ETH is expected to be deflationary because the amount of ETH expected to be burned by EIP-1559 greatly exceeds the total expected inflation from PoS which is <1% inflation,” Berckmans added.
Not everyone agrees with this prediction, with some arguing that Ethereum could become deflationary even before PoS, and some arguing that burned ETH won’t outnumber newly minted ETH (via block rewards).
“The deflationary effects of EIP-1559 should be noticed immediately and will become even more prevalent when Ethereum moves fully to proof-of-stake,” said blockchain company ConSensys’ Lex Sokolin.
He added that, the more transactions that occur, the more deflationary the burning of the base fee will be. On the other hand, eToro analyst Simon Peters isn’t convinced that fee burning will consistently outweigh inflation.
“In my opinion this is unlikely. Given that there are Layer 2 solutions such as rollups being developed to help scale the current Ethereum blockchain and ease congestion on the network, I don’t foresee the congestion reaching a point that it becomes deflationary. But only time will tell,” he said.
A trend to keep an eye on
The picture is complicated further by Ethereum 2.0 and the shift to PoS. That’s because, aside from getting rid of mining, PoS will also result in a considerable amount of ETH being locked up in Ethereum 2.0’s staking contract.
“Since the inception of the deposit contract in November 2020, approximately 4.4 million ethereum tokens have been locked up, which is not too far off the total amount that has come into existence in the last 12 months. However, this staking has occurred in half the time, and could accelerate as more exchanges and wallets start supporting staking on Ethereum 2.0, so it’s definitely a trend to keep an eye on,” said Simon Peters.
As of writing, the quantity of staked ETH has actually risen to 4.6 million, and could accelerate further once the transition has happened. This will be helped in part by the fact that validators might earn considerable interest from staking ETH.
“The validator APR is 7.4% today and is expected to rise to 20%+ the day of the merge. Of course, 20% is an extremely great deal for validators and the result will be a dramatically increased level of participation among validators, which will further stimulate the demand for ETH,” said Ryan Berckmans.
Now, one needs ETH 32 (currently almost USD 86,530) to become a validator.
Also, without proof-of-work mining, validators will have fewer costs to cover.
“On the supply side, miners need to sell a lot of ETH to cover their hardware and energy expenses, which increases the circulating supply. After switching to proof-of-stake, validators don’t necessarily have to sell any ETH because validators are so inexpensive to run that they’re effectively free,” Berkmans added.
In other words, there will be “a supply crunch” after switching to EIP-1559 and PoS, since validators will sell less ETH and holders will stake more of it.
Ethereum vs. Bitcoin
The eternal question in crypto has almost always been whether Ethereum is ‘better’ than Bitcoin (BTC) (and vice versa), and, unsurprisingly, the Ethereum camp says that EIP-1559 and PoS will give Ethereum a distinct advantage.
“I think that ETH is 100% guaranteed to flip BTC within the next few years, and is likely to flip BTC in the next 6 to 18 months. It’s important to understand that BTC will struggle to maintain a multi-trillion-dollar valuation because of Bitcoin’s cost problem,” said Berckmans.
As a more neutral observer, Simon Peters said ethereum could certainly rival bitcoin as a store of value in the future, but that it depends on a number of factors.
“Although ethereum is not a fixed supply, there are arguably more factors which could make it more deflationary than bitcoin — such as ethereum being locked up, its staking ability, by investors holding ethereum and because it is often a requirement for transactions and smart contract operations. Therefore, there is the potential that fewer tokens will be in circulation yet demand will remain, thereby pushing up the price,” he said.
However, as some argue, the flaw of the deflationary argument is that anyone can create a “new digital currency that reduces supply by 5% per year and is controlled by a single issuer in a Google Spreadsheet” and “with ETH’s monetary policy being changed once again, the credibility that the policy won’t change in the future is weakened.”
In either case, more broadly, Peters concluded that if Ethereum manages to retain its status as the main platform for decentralized finance (DeFi), smart contracts, and so on, and also prevents competing platforms from taking market share, “then it has the potential to grow further.”
Regardless of whether it will rival or overtake bitcoin, the potential for further growth is ultimately the primary message Lex Sokolin extracts from upcoming changes.
“Giving Ethereum more computational power and transaction throughput via multiple software developments will attract more developers, applications, and enterprise. That will lead to better software, larger economies, and more usage,” he concluded.
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