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Models of cryptoasset inflation

One of the tremendous paradigm-breaking functions of cryptoassets is the potential to predict and prepare for inflation. When advocates of the technology criticize central banks, it is often because of their proclivity to increase the supply of fiat without sufficient prior warning, reducing purchasing power. Citizens of the European Union will know this phenomenon well — the European Central Bank embarked upon a policy of quantitative easing to combat the spectre of deflation in 2015. As a result, inflation in the European Economic Area increased from -0.5% to 2.3% where it stands at present. The desired effect was achieved, but of course savings and investments are hurt by this as their effective purchasing power has been cleaved. Decisions such as these fall to the economists running the show, giving rise to uncertainty and in the past, not much room for alternatives. While one can of course purchase other fiat currencies, they are all still controlled by central banks and we are really only choosing the nationality of the economists we want making those choices.

The growth of cryptoassets is at least partially a response to this. Cryptocurrencies use mathematical models which are transparent and publicized, and give investors a choice not only on their digital currency of preference but the type of token supply they will see. However, this logic only works if the investor actually understands the inflationary policy of the currency they are purchasing. Here we will look at some of the different models of inflation in cryptoassets, and their implication for the total supplies over time.

The most famous digital currency, Bitcoin, is capped at 21 million coins. Coins are mined every day, bringing us closer to that 21 million total, but as time goes on mining rewards will reduce until more are lost daily than created. As such, in the long term Bitcoin is deflationary, not inflationary (which has been used as a point of contention among its critics). The same is true of Litecoin, Dash, ZCash and the various Bitcoin hard forks. Ripple (XRP) is capped at 100 billion coins, but only 40% are in circulation currently and the rest are distributed month by month, capped at 1 billion per month but otherwise completely at the whim of Ripple Labs, which sounds suspiciously like the role played by central banks.

On the other side, many more currencies are uncapped and have some level of real inflation. This ranges from very small percentages every year to large annual supply growth. An example of the former, Monero has a ‘soft cap’ at 18.3 coins, after which mining rewards will slow and no more than 0.3 coins will be mined per minute. This means 432 Monero will be created every day, a little over 155,000 per year. This will account for a 1% increase the first year after the soft cap, and gradually less as time goes on. Monero is not deflationary, but its inflation rate is very low. Similarly, Stellar has a 1% annual inflation rate, distributed to ‘inflation pools’ or wallets with more than 0.05% of the supply.

Ethereum is a tricky one, because we don’t know how the future updates that will allow for proof-of-stake will affect the supply growth. At present Ethereum’s inflation is quite high — around 15% in 2017. The supply has grown from 72 million coins at the genesis block to 103 million presently. With exactly this problem in mind, Vitalik Buterin has recommended a hard cap at 120 million ETH, and a scaling down of rewards when proof-of-stake is implemented. These changes would go a long way towards halting the significant inflation of Ethereum and move it more in line with Bitcoin — towards an eventual deflationary model. Ethereum Classic will remain as proof-of-work and highly inflationary, but will eventually be capped at 210 million coins (double the current supply). This is expected to happen in 2025.

Inflation rates are not of critical importance to those who intend to keep their crypto assets for a very short period of time — day traders, for example. But those who wish to make long term investments should consider this aspect, especially with bear markets in mind. Should one choose to hold inflationary coins as a long term investment, their currency and share of the market cap will devalue over time unless they are staking, delegating or generating passive income through some other method, thus earning further assets to offset the inflation. For any investment in the medium-long term, research on the supply and inflation models of potential digital currency purchases are highly advisable.

Article by Byron Murphy, Editor at ViewNodes.

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