Ethereum Merge Upgrade: How Deflation Nature Became the Cornerstone of Cryptocurrency's Future?

The platform that hosts the majority of the world's DeFi, NFT, and GameFi protocols has completed the historical upgrade that promises scaling and massive environmental benefits as Ethereum marches towards becoming a more significant part of modern life.

Ethereum Merge Upgrade: What Was Changed?

Ethereum had its long-awaited software upgrade called "Merge," which has shifted the consensus mechanisms of one of the most popular crypto platforms from proof-of-work (PoW) to energy-efficient consensus strategy proof-of-stake (PoS).

PoW is a mechanism where miners create blocks and secure the network through the process of mining. In contrast, PoS is an alternative consensus mechanism that delegates control of the network to validators, the people who stake at least 32 ETH.

According to Justin Drake, one of Ethereum's key researchers leading the landmark event, "the Merge dramatically increases the security of Ethereum." Instead of physical resources like in PoW, financial resources are used in PoS for security.

This shift also cut the network's energy usage by 99.95% and lays the foundation for further improvements to its core infrastructure.

The upgrade went public on September 15, a move towards sustainability that will optimize the value proposition of crypto and blockchain applications for crypto users. However, for all the crypto world's hype about the Merge, it is not the end but the latest step to make the blockchain faster, safer, and more decentralized.

Ethereum co-founder Vitalik Buterin rightly calls it "the first step in Ethereum's big journey towards being a very mature system." According to him, it is just the beginning, with other parts of the ecosystem still to be built to "turn Ethereum into what we want it to be."

Effect on ETH Supply

Introduced in 2015, Ethereum expanded upon the core concepts of Bitcoin with self-executing computer programs called smart contracts. This innovation is the core of DeFi and NFTs — the main catalysts of the most recent crypto boom and mainstream adoption.

In 2021, Ethereum implemented the London hard fork with EIP-1559, which introduced a fixed-per-block network fee to burn and dynamically expand/contract block sizes to deal with the congestion—burning the fees paid in ETH results in a decrease in Ethereum supply.

Currently, the amount of ETH burned is at the level of 900-2400 ETH, and the maximum value of all time is approximately 71000 ETH.

Now, in 2022, Ethereum has officially shifted to PoS to reduce ETH emissions significantly. The combined Ethereum overhaul is supposed to result in an immediate reduction in ETH supply, but the opposite has happened.

According to data from ultrasound.money, Ethereum's token supply has grown by more than 8,100 ETH since the blockchain was successfully upgraded (instead of projected growth by more than 150,000 ETH if PoW would remain).

Right after the Merge, the supply of ETH experienced a brief drop. However, it has now reached a new all-time high. But this doesn't mean Ethereum Merge failed to live up to its promises.

Before the Merge, Ethereum distributed about 13,000 ETH per day to miners (who ran the execution layer) and 1,600 ETH per day to validators (who ran the consensus layer). As per this, Ethereum's total supply, at the time, was inflating by roughly 4-4.5% a year.

Now, after the merge of the two layers, rewards are no longer distributed to miners, resulting in ETH emissions to be dropped by 89.4%. Validators, meanwhile, account for 10.6% of the previous rewards that bring ETH yearly emissions to just 0.49%.

For the network's monetary system to become deflationary, it needs higher transaction fees which currently lacks in the ongoing bear market.

Ultrasound Money: Will ETH be One?

Unlike "inflationary" money like the US dollar, a deflationary system is characterized by a gradual reduction in the money supply over time.

For instance, Bitcoin's supply is capped at 21 million. On top of that, every four years, Bitcoin goes through a "halving," which cuts the rewards paid out by miners by half. But now, with the ETH inflation rate dropping by almost 90%, this massive reduction is dubbed the "triple halving."

With the promise of decreased issuance (thanks to the Merge) and the continued burn of ETH supply (as a result of EIP-1559), the Ethereum community believes ETH has the potential to become the ultrasound money.

Speaking of the term "ultrasound money," it is a meme in the Ethereum community, mocking Bitcoiners describing Bitcoin (BTC) as "sound money."

According to ETH proponents, if Bitcoin's fixed supply makes it "sound" money, then Ethereum's decreasing supply should make it "ultra-sound" money,

Last year, ConsenSys founder and Ethereum co-founder Joseph Lubin said that Ethereum is democratizing the global decentralized finance system, which will make it ultrasound money.

Simply put, with ETH issuance cut down drastically, fees paid in ETH being burned regularly, and huge amounts of ETH being locked in DeFi protocols, ETH can definitely become the ultrasound money.

However, the path to that won't be without issues, as with the rise of Layer 2 solutions, there might not be as much demand for transactions on the Ethereum base layer.

Crypto Deflation Mechanisms

The concept of deflation is a positive element for cryptocurrencies, but there's nothing new. There are several deflationary mechanisms used in the crypto market that decrease the market supply of an asset over time.

Coins with fixed supply are deflationary by default since as long as investors buy and hold the coin, its supply reduces. Bitcoin is one such example that also makes use of "halving" as a deflation mechanism.

One of the most popular deflation mechanisms in crypto is token burns. In this mechanism, tokens are burned from circulation by sending and locking them in a wallet that no one can access, rendering them unusable.

Burning mechanisms are of two types: buyback and burn and transaction burning. In a buyback, the platform buys back its own tokens, using parts of its profits, from holders and locks them in an inaccessible address.

As for burning on transactions, a protocol employs a smart contract that automatically burns part of transaction fees. This mechanism depends on the number of transactions on a platform, so the more the number of transactions, the more tokens the platform burns, and vice versa.

The Deflationary Trend

Making cryptocurrencies deflationary has become a trend in the crypto space. For instance, Binance destroys BNB tokens every quarter to reduce its supply.

Moreover, after the implementation of BEP-95, the Binance chain network will burn a fixed ratio of each block’s gas fees that validators collect.

The Polygon blockchain network has its own implementation of Ethereum’s EIP-1559. Ripple, meanwhile, has locked away a chunk of its supply, which it releases periodically to maintain liquidity.

More and more projects are employing deflationary mechanisms to remove excess supply and prop up the prices of their tokens. With Ethereum's success, we can see even new projects take this route to become deflationary.