For many years, Bitcoin has been touted as a premier store of value and has even drawn comparisons to gold due to its inherent scarcity and low inflation rate. But another cryptocurrency might be poised to beat Bitcoin at its own game: Ethereum (ETH -2.44%).
In August 2021, Ethereum developers implemented the London hard fork, an upgrade to the blockchain that added a few new perks to the way the Ethereum network functions. The most meaningful change to come out of this was a new feature that would make Ethereum deflationary.
A crucial upgrade for price increases
Until the London hard fork, there was no limit to the amount of Ethereum that would enter circulation. And while that still technically is the case, the newly introduced deflationary mechanism will ensure that the rate at which new Ethereum enters circulation is reduced. And rather than only slowing the rate of newly minted coins, developers took it a step further and made it so that the total supply of Ether can actually be reduced.
It's a complicated process, but essentially, what has happened is that after the switch to a proof-of-stake consensus mechanism, the fee that previously would have gone to miners is now burned. The size of the fee varies depending on network demand, referred to as gas. Theoretically, the dynamics of the London hard fork make it so that as demand picks up, more Ether is burned.
As demand increases and more Ether is burned, Ethereum's price will probably climb. At this stage, Ethereum users are more likely to hold and not spend, while investors will look to reap the rewards of price increases. This will lead to fewer transactions and, therefore, less Ether getting burned, thereby increasing supply and perhaps lowering its price.
As the price comes down, users will have less of an incentive to hold and more pressure to spend. But as more spending occurs, more Ether will be burned, and the cycle between supply and demand and inflation and deflation will unfold once again.
Ethereum in the post-Merge world
We have yet to experience a full iteration of this cycle, but we are in the beginning stages of one. Since the Merge, the number of Ether tokens in circulation has remained nearly stagnant, hovering around 120 million. Before the switch to proof of stake and introducing burning, Ethereum's inflation rate was at about 4.5%, but since the Merge, it has moved to -0.009%. For comparison, Bitcoin's current inflation rate is about 1.7%.
If Ethereum still utilized proof of work and hadn't introduced the burn mechanism, there would have been an additional 1.5 million tokens in circulation just since the Merge in September 2022. But since implementation, the total supply of Ether has actually dropped by about 4,000.
An opportunity awaits
Due to the recency of the Merge, we probably still haven't seen the true effects of this phenomenon, but when that day comes, it could bring some serious returns for investors. Despite its price being down more than 60% from its all-time high, Ethereum still is one of the most widely used blockchains in the world. As activity on the network picks up -- which it seems to be doing as of late -- demand should follow and add further deflationary pressure.
Over the coming years and even decades, Ethereum might become subject to the whims of limited supply and increased demand, a phenomenon similar to the one that made Bitcoin the most valuable cryptocurrency today and spurred people to view it as a supreme store of value.
Could Ethereum take over Bitcoin's role? Perhaps. But whether it does isn't too important right now. Instead, investors should use this time as an opportunity to grab some Ethereum while its price is still struggling and enjoy the benefit of its new deflationary feature for the long haul.
