What Does Ethereums Inflation Mean for Investors as it Enters Another Phase of Expansion

Reported by Coin World:


The argument of Ethereum’s supply change
Ethereum (ETH-USD) has recently transitioned from a deflationary supply to an inflationary supply, which has a neutral impact on investors. While inflation gradually dilutes investors’ share, it also reduces transaction fees. This will increase the usage of Ethereum, potentially leading to more demand and driving up the price of Ethereum.
I remain optimistic about the long-term prospects of Ethereum.


Ethereum’s supply change


The chart above shows the supply of Ethereum over the past year, which appears to fluctuate significantly at first glance. There have been periods of inflation, deflation, and relative stability. However, since April, the supply has been steadily increasing.
However, when looking at the chart over a five-year period, since Ethereum transitioned to Proof of Stake in late 2022, the supply has been very stable. The recent inflation is barely noticeable on a chart that includes data from before 2022:


Although the current inflation rate may be small, it is still worth discussing because it has a clear reason behind it, rather than just temporary fluctuations. Specifically, the Dencun upgrade is scheduled to go live in March 2024. This “hard fork” upgrade releases nine different improvements. One of the improvements, proto-danksharding, is the recent cause of supply inflation.
Proto-Danksharding and transaction fees
Proto-danksharding reduces the cost of “layer 2” transactions, which are bundled together before being added to the Ethereum blockchain. This is because it allows some transaction-related data to be deleted after about 18 days, instead of permanently stored on the Ethereum blockchain.
Specifically, some preliminary verification and processing data for transactions do not need to be permanently stored. These data are redundant with more space-efficient data available after the transactions are eventually completed (such as validator attestations). In other words, proto-danksharding simply allows Ethereum users to temporarily synchronize some important data without permanently storing it on the blockchain.
Like other cryptocurrencies, transaction fees for Ethereum transactions are variable, with higher fees for transactions requiring more permanent space. By reducing the permanent storage used by each layer 2 transaction, proto-danksharding has lowered the transaction fees for layer 2 Ethereum transactions.
Ethereum’s supply rules
Those unfamiliar with Ethereum’s supply rules may not immediately see the connection between the decrease in transaction fees and the increase in supply. After all, Bitcoin’s supply rules are simpler, only allowing for the issuance of a fixed amount of new Bitcoin at fixed intervals determined in 2009.
Ethereum’s supply rules are more complex, with the total supply depending on various factors, including transaction fees. Like Bitcoin, Ethereum issues new supply to reward validators who secure the network. The specific issuance depends on the amount of Ethereum staked by validators.
To offset this new supply, some Ethereum users pay transaction fees that are “burned” or destroyed. If the transaction fees are high enough, the burned Ethereum exceeds the newly issued supply, resulting in deflationary supply.
Conversely, if the transaction fees are low, the burned Ethereum is less than the newly issued supply, resulting in inflationary supply.
When proto-danksharding leads to a significant decrease in transaction fees, the amount of Ethereum burned is reduced, resulting in recent supply inflation.
Impact on Ethereum users
The decrease in transaction fees is good news for Ethereum users as it reduces the cost of transactions. This makes transactions more economical, particularly for frequent small transactions. Forward-thinking investors have already started positioning themselves and we recommend using the new multi-asset trading wallet BiyaPay, which not only allows the purchase of Ethereum, Bitcoin, and other cryptocurrencies using USDT, but also supports USDT trading of US and Hong Kong stocks. In addition to simple spot trading, it also offers margin trading for US and Hong Kong stocks. After making profits on BiyaPay, you can securely and quickly withdraw to your bank account by exchanging USDT for mainstream fiat currencies such as USD and HKD.


The chart above shows the daily transaction volume of Ethereum over the past year. Overall, even after the Dencun upgrade in March, the transaction volume has remained stable at around 1.1 million transactions per day. However, this does not mean that the Dencun upgrade has failed. The chart only includes “layer 1” transactions, which are currently almost saturated due to space limitations on the Ethereum blockchain. The Dencun upgrade primarily targets “layer 2” transactions, which bundle multiple users’ transactions into a single “layer 1” transaction to save space and reduce fees.
There are many “layer 2” networks on Ethereum, and since March, the most popular networks have seen a significant increase in transaction volume:


As shown in the graph, the average daily transaction volume of Arbitrum has increased from less than 1 million transactions before the Dencun upgrade to over 2 million transactions after the upgrade. Base has seen even more significant growth, processing over 3 million transactions in the most recent day. While this is still only about 1% of the transaction volume of large payment processors like Mastercard, it is an impressive growth in a short period.
Based on this data, we can conclude that the lower transaction fees brought by the Dencun upgrade have had a positive impact on Ethereum users. With lower fees, people can trade more frequently and economically.
Impact on investors
From an investment perspective, the current inflation rate of Ethereum can be considered negligible. Although Ethereum was previously deflationary, there has been almost no significant change; since transitioning to Proof of Stake in 2022, the total supply of Ethereum has fluctuated by less than 1%. Since the Dencun upgrade in March, the supply of Ethereum has only increased by 0.1%, with an annual inflation rate of less than 1%, lower than the average inflation rate of traditional stores of value such as gold and silver.
Furthermore, unlike gold, silver, or even Bitcoin, investors can stake Ethereum to earn rewards and offset the impact of inflation. Even using centralized staking services like Coinbase, they can earn an annual return of around 2.5%, enough to offset the 1% inflation rate.
Even those who do not stake Ethereum can theoretically benefit from the Dencun upgrade, as the decrease in transaction fees may increase demand for Ethereum, which could offset the dilution caused by inflation. Considering Ethereum’s relatively stable supply, the bullish logic for Ethereum is more based on its adoption rate (and the weakness of the US dollar) rather than deflation.
Although the transition to inflation theoretically has little to no impact on the bullish logic of Ethereum, investors are not always rational. In the past two years, Ethereum has been promoted as a deflationary asset, and some investors may see the transition to inflation as a failure of their investment thesis.
Currently, it can be fair to say that Ethereum’s supply rules are more complex and unpredictable than some investors expected. For example, if there is a significant increase in transaction volume, Ethereum may once again become deflationary in the future, but it is almost impossible to predict if and when this will happen.
Conclusion
The transition of Ethereum from deflation to inflation is an interesting and noteworthy change. This article showcases Ethereum’s supply mechanism and why the Dencun upgrade has led to inflation.
However, overall, this is a relatively minor development that should not change the long-term prospects of Ethereum bulls. Bulls should focus on the new features brought by the Dencun upgrade, plans for similar upgrades in the future, and bigger developments like the upcoming Ethereum ETF.