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Deflation is About to Whack DeFi Tokens — Is This Actually a Good Thing?

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During the crypto bull market of the last year, deflationary tokenomics were a major force in many of the record price increases in the industry. The knowledge that the amount of certain tokens was decreasing over time triggered a stampede of investors to get in early, multiplying a token’s value many times over, sometimes in just a matter of days. 

That may have been just a prelude to what’s coming. Deflationary tokenomics are likely to become an even more significant part of the crypto industry in the months to come. Why? For starters, Ethereum will soon switch to a model that burns tokens every time a transaction occurs on the network and this will likely lead to the blockchain becoming deflationary. The effect this will have on the industry is hard to gauge but Ethereum is the second largest and arguably the most influential of the blockchains, and if the fork proves successful many may adopt the model.

Just to be clear, the concept of a deflationary token is somewhat different in crypto than in traditional finance. Rather than referring to a decrease in price, a deflationary token is one where the total number of tokens on the market will decrease over time. Tokens that are spent on transaction fees or on other processes on the network are sent to a burn wallet, with no chance of retrieval.  

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Most importantly, the permanent decrease in supply creates the potential for tokens to store value even through a bear market. Or put another way, the coming upgrade to Ethereum may imbue the token with some serious hedging power.  

Ethereum Becomes Deflationary 

The deployment of Ethereum’s London Hard Fork is imminent. The fork is being integrated onto the Ethereum Network in advance of Ethereum’s full transition from a Proof-of-Work protocol to a Proof-of-Stake protocol that should take place next year. The London fork will make significant changes to better prepare the blockchain for next year’s major upgrade. 

Currently, Ethereum hosts the vast majority of DeFi and NFT projects. As the second largest blockchain, this upgrade represents a seismic shift in the crypto industry. The congestion on the network has raised fees and has proved a massive barrier to Ethereum being fully utilized but this may all be about to change. 

The London fork (also called EIP-1559) will make changes to Ethereum’s transaction fee structure. For one, there will now be a cap on the increase of gas fees. It will also introduce Ethereum Improvement Proposals (EIPs) which intend to further reduce Ethereum fees and make the blockchain more user-friendly. 

Most importantly, the permanent decrease in supply creates the potential for tokens to store value even through a bear market. Or put another way, the coming upgrade to Ethereum may imbue the token with some serious hedging power.  

Most notably though, a portion of the transaction fee will now be burned. Ethereum does not have a hard cap meaning tokens are also continually released onto the market. This means it is not necessarily true that this new model will lead to the total supply decreasing rather than just slowing down. However, the current usage of the Ethereum network means that it will almost certainly lead to Ethereum becoming deflationary. 

Deflationary Tokens In Crypto Today

Deflationary tokens have been a huge feature of this last bull run. We have already seen, many times, the effects that deflationary tokenomics can have in the short term. The hype created by the idea that a token might become more scarce resulted in huge gains for what were essentially useless meme coins. Tokens like SafeMoon and many of its clones were able to secure massive returns off the back of this hype for anybody who got in early enough. 

However, the gains associated with these tokens had very little to do with the actual tokenomics. Instead, they were a result of the market sentiment that these tokenomics provoked in the community. SafeMoon, for example, has lost three-quarters of its value since its all-time high in April, and it seems to still be dwindling with little prospect of a return. The explosion in price and eventual pullback all happened over the course of a few months without any prospect of enough tokens being burned to truly influence supply. 

Obvious Hedge

However, now that the bull market has faltered and there is genuine potential for entering a bear market we will have a chance to truly see the long term effects of the deflationary model. Economics 101 will tell you that if you reduce the supply of a token, its price should increase. This statement is only valid though, as long as there is demand for the token. Deflationary tokens that have real utility could prove a safe harbor in the long term. 

Ethereum is currently the most obvious hedge. As the second largest crypto, it now combines deflationary tokenomics with more use cases than any other blockchain in a crypto sphere. This means that there will be more instances on the Ethereum chain where tokens get burned than on any other chain so supply should decrease accordingly. Also, as one of the larger chains, its price should be more stable than most other alt-coins.

Ethereum is not the only option, though. BNB is the native token of the Binance Smart Chain (BSC). It is also known as the token with the most famous buy-back-and-burn model. Fees from BSC and Binance Chain are used to purchase BNB on the open market at market price. The coins are then sent to a wallet they can’t be retrieved from. 

Famous Token Burns

The fees from these chains are responsible for Binance being able to hold truly massive burning events. For example, at the end of the first quarter of 2021 Binance burned a total of 1,099,888 BNB. This effectively took nearly $600 million worth of BNB out of circulation forever. These events have seen BNB rise from $38 in January to highs of $638.57. 

BSC is able to deliver transaction fees for a fraction of Ethereum. This presents an opportunity for developers to create decentralized apps (or DApps) that are aimed specifically at the retail investor. This has led to a huge DeFi ecosystem growing on BSC since it was launched less than one year ago. All the transactions that this ecosystem brings to the chain are responsible for the huge rise in price. It shows the potential for a deflationary token that has strong use cases. 

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CSS is another token that utilizes a token burn model. CSS is the native token of CoinSwap Space, a new decentralized exchange on the Binance Smart Chain. CoinSwap was established as a competitor to PancakeSwap and that is reflected in the tokenomics. Similar to PancakeSwap’s native CAKE token, some of CoinSwap’s CSS tokens are burned automatically during certain actions by users. Full disclosure: I do liquidity mining on CSS’s platform and earn yield on CSS tokens.

Mass Harvest

However, unlike CAKE tokens, CSS tokens have a hard cap, that’s only 19,999,999. This means that unlike CAKE tokens, which can be released indefinitely, every time CSS tokens are burned the supply permanently decreases. 

Yet deflationary tokenomics will only lead to a price rise as long as the token has a real use-case. This means CSS relies on users navigating onto the CoinSwap exchange. Because of the service that CoinSwap offers, this is very possible. CoinSwap is able to charge transaction fees of less than $0.20 which is lower than PancakeSwap’s $0.25. 

The ability to invest tokens into an interest bearing smart contract might prove even more attractive in a bear market.

CoinSwap offers the same utilities that PancakeSwap offers, including staking, liquidity pools and swapping. CoinSwap, though, has a suite of tools that makes the user experience much easier. For example, CoinSwap has facilities like mass harvest and mass stake that will take all of your returns across all your liquidity pools and staking options, and either send them to your wallet or compound them to earn more interest. If the advantages that CoinSwap has over PancakeSwap can bring users onto the DEX it would create a huge utility for the CSS token. 

DeFi In The Bear Market

A bear market will, of course, see the demand for crypto tokens decrease significantly. That being said, the decrease in demand is potentially counteracted by the decrease in supply. So as long as the blockchain or DEX is being used enough for a significant amount of tokens to be burned, the price can stabilize.  

The bottom line is that even if we are entering a bear market, DeFi isn’t going anywhere. The ability to invest tokens into an interest bearing smart contract might prove even more attractive in a bear market. With fewer obvious opportunities across the market, investors will be motivated to park their capital in long term yield farms and earn interest. 

This makes tokens like CSS, ETH and BNB ultra-attractive. 

Masha Prusso, a partner at Millennium Partners and an advisor at Defy Trends, is a contributing writer at The Defiant.

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