Ethereum Estimated To Become Deflationary: Here's When And How Much

Following Thursday's London upgrade, the Ethereum ETH/USD network started burning thousands of coins each day, this is not only a welcome blow to Ether's inflation: many expect that in the future it may make it a deflationary asset.

What Happened: According to network data, over 4,418 ETH (equivalent to over $12.1 million) were burned in under 22 hours after the network implemented Ethereum Improvement Proposal (EIP) 1559 as part of the London hard fork.

With EIP-1559, users start paying a variable "base fee" for transactions that — instead of being paid to miners — is burned (read "destroyed forever") in addition to an optional miner tip. But this is far from the only change implemented by this EIP.

Blockchains process transactions in so-called "blocks" containing many transactions as opposed to just processing single transactions one at a time. The speed at which transactions can be processed is limited by the block size limit which indicates how many transactions fit in a block and the block time, which is the speed at which new blocks can be created and added to the blockchain. As miners create new blocks (on average one every 10 seconds), they are rewarded with one newly issued Ether which is where Ethereum's current inflation rate of about 4% comes from.

EIP-1559 also allows for blocks to vary in size up to double the size that they were before, reducing network strain and nearly doubling the network's throughput in times of need which is in turn expected to result in lower fees when the network sees more use than usual. This, in turn, could result in more Ethereum applications becoming practical and causing more transactions to be processed each day in the long run.

What It Means: The cost of Ethereum fees is calculated by multiplying gas price (measured in Gwei, which is equivalent to 0.000000001 ETH) by the "gas" used in a given transaction. To put it simply, gas depends on how much network resources are employed by the transaction. This in turn means that complex transactions involving smart contracts or storing more data on the blockchain will result in a higher gas price than simple transactions moving Ether from one address to another.

Previously the gas price was determined by — usually automated — guesswork based on the network's strain but now is instead determined by the blockchain itself as the "base gas price" meaning that transactions are less likely to get stuck and everyone needs to pay the same amount, unless they want to pay a miner tip for extra-fast transaction processing.

In the future, Ethereum developers plan to do away with mining altogether and transition the blockchain to the much more energy-efficient proof-of-stake (PoS) algorithm that consumes a fraction of the electricity of mining and does not require specialized hardware that has to be replaced often.

This process is also much cheaper and will allow for the issuance of new coins to be significantly reduced while still subsidizing network maintenance, which is why many hope for Ethereum to become deflationary after it transitions to PoS. This change is expected to take place sometime in Q1 2023, but no official date has been set.

After the transition to PoS, miners would be replaced by stakers who placed their Ether "at stake" and verify transactions knowing that they risk losing their assets if they try to confirm transactions that do not conform to the network's rules. The rate of issuance would largely depend on how much Ether there is at stake: the more coins at stake, the higher the issuance rate.

Now that we all understand the basics of how Ethereum's fees, burning and issuance work we can start looking at estimates of whether and how much we can expect Ether to become deflationary.

Why It's Important: According to Ethereum burning and inflation tracking service Ultrasound.Money — with 10 million ETH, an average base gas price of 20 Gwei and PoS being implemented on 31 March, 2022 — we should expect Ether to become deflationary at the very moment when it moves away from mining. On the day of the transition, there would be 120 million ETH in circulation, which would decrease by about 400,000 in the first year: a deflation rate of 0.33%. The daily burn rate would be 2,000 ETH.

That being said, July's mean gas price was nearly 32.7 Gwei and while we should expect a slight gas price decrease after EIP-1559 we should be surprised to see it tank this much. After adjusting the average gas price to 30 Gwei we get an estimated burn rate of 3,000 ETH per day, a transition day supply of 119.8 million tanking by 600,000 million in the first year: a deflation rate of 0.5%, nothing to scoff at. This is still a significantly lower burn rate than the 4,550 ETH burn over the first 23 hours after EIP-1559 implementation.

Admittedly, we did not try to guess the right number of Ether staked after PoS implementation. Still, this has much less of an impact than base gas price variation, and even triplicating it would not result in the coin avoiding becoming deflationary.

Original publication: August 7, 2021