Ethereum Inflation Surges with Burn Rate Decline: Layer-2s Vital in Dynamics – ETH Price May Bottom
What's Causing Ethereum's Supply to Increase? | Credit: Getty Images
Key Takeaways
- The ETH supply has become inflationary since the beginning of April, at an average annual inflation of between 0.3% and 0.5%.
- Ethereum Layer-2 fees have fallen since the Dencun upgrade in March, contributing to the inflation.
- Will the ETH price react in the same way as the previous time the Ethereum supply became inflationary?
The Ethereum Dencun upgrade brought greatly reduced transaction fees on Ethereum Layer-2 solutions. In turn, this increased their usage, as evidenced by the higher number of transactions.
However, the miniscule fees have contributed to a decrease in the ETH burn rate, in turn causing the Ethereum supply to become inflationary. When combined with the increase in issuance due to the rise of Liquid Restaking protocols, this could be a cause for concern unless the issuance mechanism is adjusted or the number of Layer-2 transactions continue to rise.
Ethereum’s Supply Becomes Inflationary
Since the Ethereum Merge in September 2022, the Ethereum supply has been deflationary, at an annual inflation of negative 0.2%. However, in the short-term, Ethereum’s supply has become inflationary since the start of April. The token issuance has exceeded burnings by approximately 30,000.
This level of inflation has been seen only once since the Ethereum merge, more specifically in September and October 2023. At the time, the ETH supply increased by 50,000 tokens.
The ETH issuance rate has been relatively steady since the merge, at 750,000 ETH per year. In the last week, that has increased to 900,000, a noticeable 15% uptick but not the main reason for the inflationary supply.
So, that leaves the burn rate as the primary cause behind the inflation. Since the merge, roughly 1,000,000 tokens are burned each year. In the past 30 days, the burn rate has fallen to 500,000 tokens.
This rate is even smaller at 300,000 in the past week and 240,000 today. At this rate, the annual Ethereum inflation is between 0.30% and 0.50%. While this is still well below the 3.11% rate pre-merge and 1.7% inflation of BTC, it pales in comparison to the negative 0.2% inflation since the merge.
Several categories contribute to the burn rate. The biggest one is Decentralized Finance (DeFi) with 37% of the total share. It is followed by NFTs, Layer 2-s and ETH transfers. In the case of Layer-2s, Arbitrum is quickly gaining traction as the Layer-2 with the highest number of transactions and TVL.
For DeFi, Uniswap is the clear leader with the biggest share of burned ETH tokens.
Why is the Burn Rate Decreasing?
Firstly, there has already been concern about the Ethereum issuance due to the increase in staking as a result of liquid restaking protocols such as EigenLayer. In fact, there have been proposals regarding the adjustment of the issuance rate if staking continues to increase.
So, the increase in staking has affected the issue of supply increase. However, as outlined prior, this is not the main cause for the increased inflation.
Ethereum transactions use gas, which burns ETH tokens. So, a decrease in transactions can cause a reduction in the burn rate. This, though, is also not the reason for the Ethereum inflation, since transactions per day have remained steady between 1,000 and 1,500.
The most significant change lies in the fees users pay and transaction costs. Fees paid by users fell from a high of nearly $40 million on March 5 to only $3 million on May 6. This is likely because of the decrease in transaction costs, which fell from an average of $25 on March 5 to $3 on May 6. The decrease resulted shortly after the Dencun upgrade.
Gas Fees Drop in Both Dollars and ETH
While it is normal for gas fees to fall in dollar value when the ETH price is falling, fees are also decreasing in ETH value, despite transactions remaining the same. This is clearly visible when plotting the ETH price against the fees.
Fees are currently at the same level as they were in October 2023, when the ETH price was at $1,500. Interestingly, this was the only other time since the merge when the supply became inflationary.
So, there are lower gas fees in dollar terms even though the ETH price is significantly higher than in October 2023. The number of transactions, which can be seen as a gauge of the interest in the network has remained constant.
Importance of Layer-2 Solutions
So, the reduction in gas fees can be attributed to the Dencun upgrade. While the transaction fee reduction is a positive development when looked in isolation, it has had the negative side effect of reducing the burn rate, and in turn increasing the ETH supply inflation.
For every transaction sent by a L2, the Ethereum network burns a portion of ETH. The substantial drop in ETH Layer-2 transactions following the upgrade led to a decrease in ETH burned within these transactions.
Besides Scroll, no other Layer-2 solution has fees higher than $0.10. Scroll has a very small inflow from Ethereum, currently ranking at #10. Rather, Arbitrum is in the lead with over $10 billion in bridge deposits, followed by Optimism, Blast and Base. All three have average transactions costs of less than $0.10.
The Dencun upgrade effectively cut transaction fees on Layer-2. This led to a notable shift of transactions from Ethereum to these solutions. However, the decrease in transaction costs has caused a drop in the burn rate for ETH.
When combined with the rise in liquid staking and restaking interest, which in turn increased the number of stakers and ETH issuance, this turned Ethereum’s Supply Inflationary.
In March, Layer-2 solutions paid nearly $1 million in rent to Ethereum. This figure is now less than $100,000. The release of the Blast mainnet in February helped. Blast is leading the charge by paying $40,000 in rent daily, but it is not enough to subset the drop in all the rest of Layer-2 solutions.
Unless transactions on Layer-2 increase massively, or there is a change in issuance as proposed, this problem could persist for Ethereum.
ETH Price Prediction: Has the Correction Ended?
In the first section, we noted that the only other time the ETH supply became inflationary after the merge was in October-September 2023. The price action and indicator readings are also quite similar to that time.
The price action shows a triple bottom pattern followed by an increase. More importantly, the triple bottom was combined with bullish divergences in both the RSI and MACD (green lines). No other divergences akin to this occurred between October 2023 and now, giving rise to the possibility of a similar increase.
If ETH breaks out from its resistance trend line, it can increase by 55% to the next resistance at $4,880. The 1.61 external Fib retracement of the most recent drop creates this target. The current ETH price all-time high is at $4,868, so it is possible that ETH breaks it.
Ethereum Inflation Could Persist
To conclude, the reduction in the burn rate as a result of reduced Layer-2 transaction fees has been the main culprit for the increase in Ethereum inflation. The increase in ETH staked due to Liquid Staking and Restaking protocols has also been a contributing factor.
In any case, the ETH price might have reached a bottom. If a significant price increase occurs, this could result in higher gas fees, curtailing the inflation issue in the short-term. However, with the reduced Layer-2 transaction fees, it is possible the inflationary pressure will continue.
