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Understanding deflationary cryptocurrencies — Bitcoin

deflationary cryptocurrencies

When Bitcoin was invented more than a decade ago, it’s pseudonymous creator Satoshi Nakamoto was inspired by the incredibly consequential events of the 2008 financial crisis, to create an alternate financial system. One that was free from the incumbent financial system that caused the 2008 financial crisis.

Perhaps, the revolutionary aspect of Bitcoin, among many other things, is how it combats inflation. In this article, we’ll dive deep into deflationary cryptocurrencies like Bitcoin and some newer tokens called deflationary tokens. First, let’s look at the market leader Bitcoin and its Deflation economics.

Deflationary cryptocurrencies — Bitcoin 

Bitcoin is a digital currency as hence only exists in the digital world but that doesn’t mean it’s not valuable, as the cryptocurrency has often been compared to gold and is referred to as “digital gold” in capital markets. Why? Because Satoshi Nakamoto has algorithmically capped Bitcoin’s total supply to 21 million. That’s the maximum number that can be mined, at least according to current rules. This means Bitcoin is in short supply and is a “scarce” resource.

As many as ~18 million Bitcoin or 85% has already been mined as of September 2019, which means there’s just 3 million left or just 15%. Unless you’re familiar with Bitcoins protocol you’d assume that the remaining supply would also be mined in a short time, as every 10 mins a new block is added to its Blockchain. Here’s a live ticker

But this isn’t the case. Why? Because of another algorithmic feature Satoshi has programmed into Bitcoin’s protocol. Halving events. 

Deflation economics: Bitcoin’s halving event to curb inflation

Have you ever thought why miners spent money on buying expensive mining equipment like Application Specific Integrated Circuit (ASICs), solving complex puzzles to validate transactions and add Blocks to the Blockchain? It’s because for every block added miners get a reward. Right now, the reward is 12.5 Bitcoin. Notice something here? I said, “right now”? This where halving events come into the picture. 

Halving events are algorithmically embedded into Bitcoin’s protocol. During its initial days, the block reward for Bitcoin miners was as much as 50 BTC but at the time, BTC was worth only a few pennies. But once every 210,000 blocks or 4 years, the block reward is reduced by 50%. Since its inception, there have been two “halving” events and the current block reward for Bitcoin is 12.5 BTC. The next one is estimated to be in may 2020 when the Blockchain reward will become 6.25 BTC. It’s also estimated that this process can continue till 2140 when all the Bitcoins have been mined. 

Also, the mining difficulty of Bitcoin is also adjusted over time, which means it takes more computational power for miners to get block rewards. Here’s a graph of the mining difficulty of Bitcoin from December 2018 to July 2019.

 

deflationary cryptocurrencies

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Deflation economics: How Bitcoin curbs inflation

Our capital markets work on an Inflationary model and in this model, more money is intentionally printed into the system year-by-year. For example, on 18th September 2019, the US Federal Reserve printed $75 billion out of thin air, handing it out to banks as cash in a process known as repurchase operation. Central banks have the authority and power to artificially expand the money supply and devalue your money. 

But why do this?

This is just how the inflationary model works. The underlying principle is that by devaluing your money you’re more incentivized to spend it right now rather than store your money for later. This is an ideal situation for a spending economy with free-flowing cash, as it promotes the spending of cash. But this isn’t how a deflationary model, like that of Bitcoin’s works. 

In a deflation model, less money is printed year-by-year. With Bitcoin, it’s the halving events and flexible mining difficulty that ensures a deflationary characteristic to its network. This keeps inflation at a check and by design, the value of Bitcoin keeps increasing. So if you spend “X” amount of BTC today to buy something then in the future you would have to pay an amount less than “X” to buy the same product/service, because of how the deflationary model works.

The problem with deflationary cryptocurrencies and deflation economics

Although revolutionary, the deflationary model isn’t perfect. The biggest hurdle to this model is getting people to spend their money. For example, why pay one BTC to buy a luxury watch right now when you can wait a few years and buy a luxury car. In a broad sense, since the value of a unit of currency is bound to go up in a deflationary model, it’s always more valuable in the future. Thus taking the characteristics of a good store of value. 

A store of value maintains its purchasing power in the future and it’s based on the stable demand for the asset. Bitcoin currently has value because of its potential of being the centrepiece in a new financial system that is transparent and decentralized. “It’s the future of money”. 

But because a deflationary model promotes a hoarding culture, people are less inclined to spend their Bitcoin. So the question becomes if Bitcoin isn’t going to be used for making payments what value does the network have? We’ll have to wait and see if people are willing to spend their Bitcoin, there are certain enterprises that accept Bitcoin as payment but not many.

Deflation economics — burning cryptocurrencies

You’ve likely come across a deflationary cryptocurrency that “burns” its tokens. Coin burning is the process of intentionally removing coins from circulation which reduces the total supply. This is achieved by sending a designated portion of the coins to a wallet known as an “eater address”. It’s essentially a “black hole” for cryptocurrencies because the private keys for the wallet aren’t available this means the coins, once send, aren’t retrievable.

This achieves the same end goals of increasing the value of the coins over time. Over time, coin burning can also help bring stability to the network by creating a viable mechanism of preserving the wealth of existing participants. We’ll cover this section of the article more in depth later.

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