Ethereum potentially becoming more popular for holders Ethereum potentially becoming more popular for holders Ethereum potentially becoming more popular for holders

Ethereum potentially becoming more popular for holders

Mads Eberhardt

Cryptocurrency Analyst

Summary:  Since Bitcoin launched in 2009, Bitcoin and almost every cryptocurrency launched since has been inflationary and external miners received the fees provided for validating the transactions - including freshly minted crypto. By summer, however, Ethereum might turn into the first large deflationary cryptocurrency which furthermore compensates holders with newly minted cryptos instead of miners. This will likely make Ethereum more appealing for holders.


Since Bitcoin launched in early 2009, Bitcoin and other later introduced cryptocurrencies have been based on a proof-of-work framework. In this framework, crypto miners are running and securing the network. In return, they are rewarded partly by fees paid by users of the network and partly by newly issued Bitcoins. The latter dilutes the value of Bitcoin held by Bitcoin holders due to the increased supply. In similarity with other assets such as gold and silver, Bitcoin is a so-called inflationary asset. To draw a parallel, you do not have to own gold to mine it. However, if you succeed in mining it, you fundamentally dilute gold holders due to the increase in supply. The fact that Bitcoin and other proof-of-work cryptocurrencies are inflationary has inevitably been a drawback to cryptocurrencies and decreased the appetite for investors to hold cryptocurrencies.

The rather newly deployed proof-of-stake consensus protocol has partially offset the aforementioned drawback with cryptocurrencies being inflationary. Proof-of-stake has been the consensus protocol in the majority of newly launched cryptocurrencies in the past years. As an alternative to compensating miners in proof-of-work, the proof-of-stake protocol compensates the fresh supply alongside the paid fees to the actual holders, providing they stake the native cryptocurrency, hence verifying transactions on the network instead of miners. This essentially means holders are not necessarily diluted by the fresh supply, fundamentally making proof-of-stake superior to proof-of-work for holders.

A true deflationary crypto-asset arises with transaction fees

By locking a part of your cryptocurrency in a staking protocol, you assist in validating transactions on the blockchain. The compensation received by stakers consists partly of newly minted cryptocurrency, partly with transaction fees paid by users of the blockchain. To make it attractive for holders to stake their cryptocurrency, at least one of these parts need to be large enough to put in the staking effort.

The main challenge in proof-of-stake arises from the fact that few cryptocurrencies generate substantial transaction fees to make it financially viable to stake without issuing a substantial fresh supply to reimburse stakers. For instance, the 9th largest cryptocurrency measured on market capitalization, proof-of-stake blockchain Solana with a significant ecosystem has on average generated $82,000 in transaction fees per day the last 7 days. With a market capitalization of $26bn, the yearly $30mn in transaction fees for Solana is not enough to sufficiently compensate stakers. To fairly compensate them, Solana allocates current yearly inflation of 6% – 8% by the issuance of new Solana to stakers. Based on this, the proof-of-stake protocol does not by nature turn the certain crypto into a deflationary asset.

Ethereum is the titan of transaction fees

At the time of writing, there is purely one crypto generating sufficiently high transaction fees to run the network with a limited net addition of newly issued cryptocurrency. This is the second-largest cryptocurrency namely Ethereum. Ethereum has generated an average of $9.6mn per day in fees for the past 7 days. In 2021, the cryptocurrency generated a total of $9.9bn from transaction fees. To put it into perspective, Coinbase achieved total revenue of $7.35bn in 2021.

The fees generated by Ethereum in 2021 have surely been impacted by Ethereum’s present scalability issues alongside the surged demand for speculative transactions such as NFTs. This has jointly increased users’ willingness to pay high fees for Ethereum’s limited transactional output. However, looking at the outlook, Ethereum might actually turn into a long-term deflationary asset.

It starts with a burn

In August 2021, the so-called London update was implemented on the Ethereum network. The London update contained a new fee market mechanism known as EIP-1559. In short, instead of compensating miners the entire transaction fee, it burns the majority, whereas it still compensates miners the newly issued Ether per block, around 2 Ether per block, which amounts to a total issuance of around 5.4mn ETH yearly.

By interpreting the numbers since August, the impact of the London update is surely vast. In total, around 1.97mn Ether has been burned, essentially offsetting the yearly 5.4mn ETH issuance by 60%.

Source: ConsenSys

Goodbye, miners

However, unless fees significantly increase, the burning mechanism does not turn Ethereum into a deflationary asset. Here, we must turn our attention towards Ethereum’s transition from proof-of-work to proof-of-stake. By around June or July, Ethereum will complete its consensus transition to proof-of-stake known as the merge, phasing out miners completely. Instead, holders are able to stake their Ether to verify transactions on the network. In return, stakers receive the non-burned part of the transaction alongside the new issuance. However, at the time of the merge, the issuance drops from the 5.4mn to 0.5mn ETH yearly, so stakers are compensated less than miners are today.

The less issuance entails, though, that the supply will most likely turn deflationary due to the Ether burned by transaction fees. If we assume that the burned Ether rate stays identical following the merge, the Ethereum supply is expected to decrease by 2.3% yearly. This signifies that non-staking Ether holders are also expected to benefit following the merge. On top of the deflationary supply, stakers are compensated the yearly issuance of 0.5mn Ether plus the non-burned transaction fees. The staking reward is expected to be as high as 10% yearly, depending on the total amount of stakers and non-burned transaction fees. In reality, if this will be the case, Ethereum will in our view not only turn deflationary but also disburse stakers considerably.

Source: ultrasound.money

The pull by traditional investors

Ethereum definitely has challenges to overcome, for instance, severe scalability constraints, regulation, and elevated competition from other smart-contract cryptocurrencies such as Solana, Cardano, and Polkadot. On the other hand, if Ethereum confidently belie these issues and ensures a constant and sustainable demand from users to execute transactions on its blockchain it turns deflationary while compensating stakers appreciable rewards. If such a demand is proven over time, as we see it, the new unique economics of Ethereum will make it more appealing for particularly investors not previously familiar with crypto. Not to mention that greater demand for handling transactions on Ethereum in the future will enhance the economics further since it increases the transaction fees. As we see it, this economic transition simply has the prospect of changing the broad sentiment to hold Ethereum. Likewise, this is true for other proof-of-stake cryptocurrencies in case they demonstrate substantial revenue from fees similar to Ethereum.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank (Schweiz) AG
The Circle 38
CH-8058
Zürich-Flughafen
Switzerland

Contact Saxo

Select region

Switzerland
Switzerland

All trading carries risk. Losses can exceed deposits on margin products. You should consider whether you understand how our products work and whether you can afford to take the high risk of losing your money. To help you understand the risks involved we have put together a general Risk Warning series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. The KIDs can be accessed within the trading platform. Please note that the full prospectus can be obtained free of charge from Saxo Bank (Switzerland) ltd. or the issuer.

This website can be accessed worldwide however the information on the website is related to Saxo Bank (Switzerland) Ltd. All clients will directly engage with Saxo Bank (Switzerland) Ltd. and all client agreements will be entered into with Saxo Bank (Switzerland) Ltd. and thus governed by Swiss Law.

The content of this website represents marketing material and has not been notified or submitted to any supervisory authority.

If you contact Saxo Bank (Switzerland) Ltd. or visit this website, you acknowledge and agree that any data that you transmit to Saxo Bank (Switzerland) Ltd., either through this website, by telephone or by any other means of communication (e.g. e-mail), may be collected or recorded and transferred to other Saxo Bank Group companies or third parties in Switzerland or abroad and may be stored or otherwise processed by them or Saxo Bank (Switzerland) Ltd. You release Saxo Bank (Switzerland) Ltd. from its obligations under Swiss banking and securities dealer secrecies and, to the extent permitted by law, data protection laws as well as other laws and obligations to protect privacy. Saxo Bank (Switzerland) Ltd. has implemented appropriate technical and organizational measures to protect data from unauthorized processing and disclosure and applies appropriate safeguards to guarantee adequate protection of such data.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.