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Will Ethereum Be a Deflationary Currency Post-Merge? (#120 - 19 September 2022)

The Future of Money with Henri Arslanian
Will Ethereum Be a Deflationary Currency Post-Merge? (#120 - 19 September 2022)
By Henri Arslanian • Issue #109 • View online

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This week saw the completion of the Ethereum Merge, which as we covered in last week’s issue of the newsletter, was a historic moment in the history of crypto assets. 
An interesting question following Ethereum’s transition from a proof-of-work consensus to a proof-of-stake consensus is whether or not Ethereum’s native currency, Ether (ETH), will actually become deflationary.
The short answer is: potentially
And to understand this we need to look at two major elements: the ETH issuance and the ETH burn.
The ETH Issuance
Each crypto asset issues coins in a different way. In the case of XRP, for example, all coins were issued at the start (with a significant part held by Ripple).
In order cases, the supply is capped and the coins are issued gradually. Bitcoin is a good example, with a hard cap of 21 million Bitcoin; new coins are issued every 10 minutes with the new issuance halved every 4 years.
Ethereum operates slightly differently.
Prior to the Merge, new ETH was issued via two sources. 
The first source of ETH issuance came from the execution layer, with miners validating new blocks on the Ethereum mainnet using a proof-of-work consensus mechanism. 
Under Ethereum’s pre-Merge proof-of-work consensus, miners received block rewards if they were the first miner to solve the next block.
Following 2019’s Constantinople upgrade, this reward has amounted to 2 ETH per block with a new block issued every 13 seconds and a total of approximately 13,000 ETH per day.
The second source of ETH issuance came from the Beacon Chain, which was launched in December 2020 as the process of migration to PoS began. 
Unlike the Ethereum mainnet, the Beacon Chain has been secured by validators using proof-of-stake. 
Validators on the Beacon Chain have been rewarded with ETH for verifying the validity of transactions on the chain whilst proposing new blocks with such rewards calculated and distributed roughly every 6.4 minutes in what is called an epoch, with staking rewards amounting to a total of 1,600 ETH per day.
As we can see, the key difference from a rewards perspective is that validator rewards are significantly lower than the miner rewards issued on proof-of-work.
Following the Merge and the end of proof-of-work, issuance via the execution layer will fall to zero and the only source of issuance will occur on the Beacon Chain. 
To put things in perspective, the approximate current inflation rate of Ethereum is around 5% (4.6% to be more precise) but almost 90% of that figure comes from proof-of-work mining on the execution layer. 
Post-Merge, the annual inflation rate is expected to fall to around 0.5%.
To make things a bit easier to understand, here is a breakdown using data from the Ethereum foundation.
Total annual issuance rate: ~5% 
~90% of the issuance is going to PoW miners (13,000 ETH/day) - 4.5%
~10% is being issued to PoS stakers (1,600 ETH/day) - 0.5%
Total annual issuance rate: ~0.5% + ~4.5% = ~5%
Total ETH supply: ~122,000,000 ETH (as of Sept 2022)
No more PoW miners - 0%
New ETH issued to PoS stakers (1,600 ETH/day or 584,000 ETH/year) - ~0.5%
Total annual issuance rate: ~0.5%
So the annual issuance rate of ETH post-Merge will be about 0.5%.
But this still leaves the currency inflationary (although way less than pre-Merge) and not deflationary. 
But this is when the burn kicks in.
The ETH Burn
In August 2021, Ethereum went through an upgrade called the London Upgrade when it implemented EIP-1559 (EIP stands for Ethereum Improvement Proposal).
We covered this upgrade in detail here but in short, EIP-1559 changes how fees on the Ethereum network are paid by separating the fee into two components: the base fee and the priority fee.
The base fee is adjusted up and down by the protocol based on how congested the network is. When the network exceeds a certain target per-block gas usage, the base fee increases slightly. Likewise, when capacity is below the target, it decreases slightly.
Then there’s the priority fee, which some have been calling a “tip” to the miners.
But the important aspect of this fee system is that miners only get to keep the priority fee and the base fee is always burned (i.e. it is destroyed by the protocol) and removed from circulation. 
More than 2 million ETH have been burned in such a manner since the launch of EIP-1559.
So in short, if the Ethereum network becomes popular and more and more transactions are taking place, it is likely that the ETH burn rate will be higher than the annual inflation rate of about 0.5%.
For those interested in running scenarios, I am a big fan of the website that has many excellent visual graphics.
Now whether this will actually happen and ETH will become deflationary remains to be seen.
Definitely a development to follow. 
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See you all next week!! 
Henri Arslanian
*Please note that this newsletter reflects Henri’s personal views and not those of any organisation he is involved with. This newsletter is for educational purposes only and none of its content should be construed as investment or financial advice of any kind.
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Henri Arslanian

Future of Finance and Money - PwC Global Crypto Leader, Best Selling Author, Keynote Speaker, University Professor, Host of Crypto Capsule™ - Views are my own

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