01 March 2023 | ZebPay Trade-Desk
A Primer on Supply-Demand Dynamics of Tokens
If you look at crypto monetary systems, they have different coin creation and delivery mechanisms. Inflationary crypto assets have an ever-increasing supply of coins entering the crypto market. A standard inflation rate is usually set, which is the percentage increase in the total supply of the asset over time. Additionally, the maximum inflationary token supply is usually fixed or variable, which determines the total number of tokens that can be created. Once the maximum supply is reached, no more tokens can be minted.
However, different crypto assets still have variable tokenomics that can be adjusted over time. For example, Dogecoin (DOGE) once had a hard cap of 100 billion tokens until the supply cap was lifted in 2014. With this decision, DOGE now has an unlimited supply of coins. Inflationary crypto assets distribute newly minted coins to network participants via dedicated consensus mechanisms such as Proof-of-Work (PoW) and Proof-of-Stake (PoS) through which new coins are created.
Using Bitcoin’s Proof-of-Work consensus mechanism, miners validate transactions and are rewarded based on who solves the puzzle first. In Proof-of-Stake, when a block of transactions is prepared to be processed, the PoS protocol selects a validator node to validate the block. The validator checks whether the transactions in the block are correct. If this is the case, the validator adds the block to the blockchain and receives rewards in ETH for contribution, usually proportional to the validator’s staked ETH. For some crypto, the distribution of new tokens may be influenced by governance decisions. For example, Decentralized Autonomous Organizations (DAOs) can vote on the release of funds, change staking rewards and set lock-up periods, ultimately affecting the inflation rate of the asset and the distribution of new tokens
Deflationary crypto assets have a default deflation rate hard-coded into the protocol. This rate determines the percentage decrease in the coin’s total supply over time. For example, a crypto token can have an annual deflation rate of 2.5%, meaning that the total supply of the currency is reduced by 2.5% per year. Like many inflationary crypto assets, deflationary crypto assets can have a fixed or variable maximum supply that caps the total number of tokens created. Generally, no more tokens can be minted once the supply limit is reached, but this is not always the case.
In particular, the economics of deflationary crypto assets are influenced by the incentives of stakeholders, including miners, developers and users, who have different motivations and goals that impact crypto supply and demand. Miners mine new coins and tend to hold newly mined coins in bull markets rather than sell them in the market. Likewise, supply restrictions can be lifted, as in the case of DOGE, making some crypto assets vulnerable to manipulation
Some deflationary coins may use transaction fees to make it easier to “burn”(Burning is a mechanism where tokens are cut off from circulating supply). Coin burning can also consist of sending a certain number of coins to an inaccessible address and withdrawing them directly from circulation. Binance with its native currency BNB coined two token-burning mechanisms and decreased its supply by 50% over time. The first step is to burn part of the BNB spent as gas fees in the BNB chain, and the second is to have quarterly BNB burn events. Deflationary crypto assets also involve other tools to decrease coin supply such as “halving”. Roughly every four years, the halving event reduces the mining rewards BTC miners receive for their work, making Bitcoin more scarce.
How do Inflationary and Deflationary Cryptos Differ?
Deflationary and inflationary crypto can exhibit unique tokenomics that affect their value and usage. Deflationary crypto assets usually have a fixed limit on the total coin supply, which increases purchasing power over time. Inflationary crypto assets often have a flexible coin creation factor that is likely to reduce purchasing power over time.
Inflationary cryptos provide several advantages over deflationary ones. They encourage spending and discourage hoarding. Depending on the use case, they can enable greater liquidity and rapid adoption, either due to their utility or their functionality as a medium of exchange. In addition, they arguably offer a more flexible monetary policy than deflationary crypto assets and some fiat currencies. Moreover, token inflation can be adjusted to ecosystem needs.
Deflationary crypto assets encourage holding and discourage spending, increasing scarcity and adopting the asset as a store of value. Again deflationary crypto assets can protect themselves from inflation, hyperinflation, and stagflation and retain their value over time. A reduction in token supply may counteract inflationary pressures caused by external factors, including government policies or economic incidents.
How can Bitcoin’s Tokenomic Design Impact its Price?
The argument that BTC is deflationary is based on the fact that the supply of BTC is limited and inherently involves a deflationary measure called “Halving”. The halving event reduces rewards for miners, affecting BTC scarcity and reducing inflation over time. As the mining reward continues to decrease over time, it becomes increasingly difficult and expensive to mine BTC.
The supply limit of 21 million of BTC means that once all the coins are mined, no more will enter the market. Once the BTC cap is reached around the year 2140, inflation will stop as no new coins are circulated. Eventually, as BTC’s acceptance and demand continues to rise due to growing external demand and its internal disinflationary mechanisms, the price could continue to rise. BTC can hedge against inflation due to its internal mechanisms that gradually lower its inflation rate.
How Can Ethereum’s Tokenomic Design Impact its Price?
The Ethereum ecosystem facilitates the development of decentralized applications (DApps). Its native token, Ether, is used for transactions and as a reward for validators who process transactions. There is no hard limit to the total supply of ETH, but the rate of new coin creation is expected to decrease over time.
Before the “Merge”, the annual issuance rate for ETH was around 5%, which meant that the circulating ETH supply was increasing by that amount every year. However, the move to PoS resulted in less ETH issuance via validator rewards, arguably causing ETH to become a deflationary asset. With the Ethereum ecosystem now using PoS, validators must use their ETH as collateral. As more ETH is locked into the network, the supply of ETH available for trading decreases, which could lead to an increase in its price over time.
Additionally, those who support the notion that Ethereum is deflationary can point to its increasing usefulness and acceptance. As more developers create DApps, the demand for ETH is likely to increase, increasing its price. As the Ethereum platform continues to be used for DeFi applications, demand for ETH payments and collateral could also increase, which could lead to a further increase in price.