Deflationary cryptocurrencies are designed to be scarce digital assets that increase in value over time through built-in mechanisms that reduce the supply. This contrasts with inflationary cryptos that have an expanding supply.
The deflationary model aims to create an asset that appreciates in value as demand grows while the limited supply shrinks. Proponents argue this promotes speculation, drives up prices, and incentivizes holding long-term rather than spending.
The Key Characteristics
Some key characteristics of deflationary cryptocurrencies include:
- Hard caps on maximum supply.
- Protocols that burn tokens over time.
- Locked liquidity pools that decrease volume.
- Consensus mechanisms that make mining rewards scarcer over time.
Well-known deflationary cryptocurrencies include Bitcoin, Binance Coin, and various meme coins like Dogecoin.
Why Create a Deflationary Cryptocurrency?
There are a few motivations behind designing deflationary cryptocurrencies:
- To develop assets that function as stores of value and incentivize long-term holding — their scarcity aims to drive price appreciation.
- To promote speculative investment, as investors hope to profit from rising prices.
- To more evenly distribute tokens, as limiting supply makes it harder to hoard.
- To fund projects long-term, as developers hold reserve tokens that gain value.
- To avoid hyperinflation, as unlimited inflationary cryptos risk spiraling downward in value.
The deflationary model ultimately aims to create demand cycles that repeatedly drive up prices based on speculative interest and the urge to hold a scarce asset of seemingly increasing value.
Mechanisms for Creating Deflationary Cryptocurrencies
There are a few common mechanisms built into cryptocurrency protocols to make their native tokens deflationary:
Maximum Supply Caps
Protocols like Bitcoin limit the total number of tokens that will ever exist. This constraint on the maximum supply helps drive up value as demand grows since no new tokens can be created beyond the cap.
Some protocols permanently destroy or «burn» tokens already in circulation to deflate the total supply. Burning sends tokens to an unspendable address where they are locked away forever.
Diminishing Mining Rewards
Cryptocurrencies like Bitcoin halve the block rewards issued to miners over time. This gradually reduces the rate of new supply entering circulation as the network matures.
Locked Liquidity Pools
Locking tokens into smart contracts or liquidity pools takes them out of general circulation, reducing transferable supply.
Transaction Fees and Deflation Taxes
Charging fees or «taxes» on transactions in the form of burnt tokens subtracts from total supply each time. This acts as a deflationary force.
Examples of Deflationary Cryptocurrencies
Here are a few major examples of deflationary cryptocurrencies:
The 21 million BTC supply cap and halving mining rewards make it the original deflationary cryptocurrency.
BNB utilizes coin burning to deflate supply and has burnt over $800 million worth of tokens so far.
A declining annual issuance rate after its merge to proof-of-stake will make ETH more deflationary over time.
DOGE lacks a supply cap but its diminishing block rewards result in lower inflation rates each year.
SHIB tokens are burnt with each transaction and over 410 trillion tokens, 41% of supply, has been burned so far.
Tokenomics tax 5% on each SAFEMOON transaction which is burnt to deflate supply. Over 223 trillion tokens have been burned.
While their designs differ, these all utilize core deflationary mechanisms like supply caps, burning, diminishing rewards, and transaction taxes.
Criticisms of Deflationary Cryptocurrencies
Despite their popular appeal, some economists criticize deflationary cryptocurrencies for issues like:
- Concentration of wealth from speculative gains.
- Volatility from price appreciation cycles.
- Lack of incentives to spend or invest the assets.
- Susceptibility to hoarding behavior and illiquidity.
- Built-in models that aren’t sustainable long-term.
- Misalignment with monetary policy objectives if widely adopted.
The deflationary model ultimately remains controversial and somewhat experimental. Its effects at a large scale are not well understood.
Deflationary cryptocurrencies aim to create scarcity and inherently drive up value through protocol design. Their appeal lies in the idea of assets that appreciate and incentivize holding. But their open-ended deflation models create economic risks and remain unproven at a wider macro scale so far. Their ultimate impact on currencies, savings, and economies involve complex tradeoffs that merit continued analysis.