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Deflationary Tokenomics of Ethereum

May 22, 2023 - 2 min read

Explaining how ether becomes deflationary and what that means for the ecosystem.

EIP-1559 Changes Fee Mechanism

The tokenomics of ether can be deflationary at times, primarily due to EIP-1559, which was included in the London hard fork implemented back in 2021. Before EIP-1559, Ethereum miners used an auction model for pricing transactions: the more users bid to pay in gas, the faster transactions would be included in the mempool and settled. This led to unpredictable and often uneconomical prices, particularly so for smaller transactions.

EIP-1559 introduced a new pricing mechanism for transactions called a base fee, to be determined by the level of activity on Ethereum’s network. When the network is busy, the base fee increases, and decreases in the opposite cases, allowing for better predictability regarding the cost of transacting.

However, the most salient point of EIP-1559 regarding deflationary tokenomics is that the base fee is now burned instead of going entirely to validators. This means that ether tokens are being permanently removed from circulation all the time.

Sometimes Deflationary, Sometimes Not

So, while Ethereum’s supply was initially inflationary because miners were rewarded with new ether for validating new blocks of transactions, burning a part of the base fee can lead to a reduction in the total circulating supply, turning it into a deflationary asset. However, for ether to become sustainably deflationary, more ether must be burned via transaction fees than is issued in block rewards.

This is crucial to note, since deflationary tokenomics are not guaranteed, but rather a possibility under if network adoption passes a critical threshold. Having mentioned this, around 150,000 ETH tokens have been net burned in the past 30 days, and follows a trend of consecutive months to start off 2023 as a deflationary asset. The meme “ultra sound money” has been adopted by the community as a way to convey that this deflationary trend makes it even more sound of a currency than Bitcoin. Using Ultra Sound Money, users can track on-chain data, like the ratio of tokens burned to tokens issued, and a myriad of other metrics.