Inflation and the Blockchain
Inflation is a general economic term. It is the rate of increase in prices for goods and services and is typically measured on a quarterly and annual basis. Inflation is a key concept to understanding and measuring blockchains and cryptocurrencies. This is because almost all cryptocurrencies are subject to price volatility. Inflation on the blockchain is the process by which a cryptocurrency loses value over time. This is often, but not exclusively, due to an overly abundant supply of cryptocurrency tokens. The blockchains that underpin cryptocurrencies have different mechanisms that work to control inflation, each working to maintain a level of profitability that is commensurate with risks.
Four Ways Blockchains Fight Inflation
- Fixed Supply: One impactful way that blockchains can avoid inflation is if their specific cryptocurrencies are created with a fixed supply. The most widely known example of a fixed, predictable, level of supply is Bitcoin, which maintains a controlled issuance of tokens. Each Bitcoin enters circulation at a relatively predictable time interval. As more people become aware of Bitcoins, there is increased demand and competition for them. Bitcoins, therefore, command higher prices.
- Fixed Max Supply: Fixed max supply is a “predetermined number of coins that can never be increased or decreased, regardless of demand” (CoinMarketCap, Glossary) Bitcoin’s 21,000,000 tokens is an example of fixed max supply. This creates predictability, which boosts both consumer and investor confidence.
- Limited Stake Rewards: A different tactic used to avoid inflation is limiting Proof of Stake rewards. For example, the amount of ETH awarded to validators on the Ethereum network can be controlled to maintain a balance between incentivization and inflation.
- Fee Burning: An additional technique Ethereum uses is “fee burning”. This can occur if blockchains implement the technology to automatically “burn” a portion of associated transaction fees. When validators are rewarded, a portion of that reward is permanently destroyed to balance the number of coins in circulation.
What are Stablecoins?
Stablecoins are a category of cryptocurrencies that are tied to other assets. These currencies can include other cryptocurrencies, commodities like gold, but they are most commonly tied to fiat currencies, such as the U.S. dollar. Stable coins provide value in that they serve as a “stable” cryptocurrency: their value is pegged to less volatile assets, which makes them more practical for everyday use. They can aid in the adoption of cryptocurrencies, as they are much more reliable. Tether (USDT) currently holds the most value of any stable coin. Its market cap is currently valued at $136.98B (Forbes).
“Adopting cryptocurrencies as a direct replacement for conventional fiat currency requires stability. A volatile currency can compromise the purchasing power of a holder” (Hedera).
The most obvious way that stablecoins directly combat inflation is by reducing volatility and uncertainty while increasing trust and confidence. Being pegged to a fiat currency allows for supply to be relatively predictable, as contrasted with some cryptocurrencies that are neither capped nor pegged. In this sense, stablecoins can be used as hedges against inflation as long as the currencies they are pegged to are stable.
Blockchains create new opportunities and risks for investors and other stakeholders. Inflation is an ever-present economic risk, and blockchains are consistently devolving and being built to manage and resist inflation.
Sources
1.https://www.coinbase.com/learn/crypto-basics/what-is-inflation
2.https://coinmarketcap.com/academy/glossary/max-supply
3.https://www.forbes.com/digital-assets/categories/stablecoins/?sh=3f587fed1cd0
4.https://hedera.com/learning/tokens/what-is-a-stablecoin