Intricacies of scarcity and fixed supply of crypto-currencies
In the world of crypto currencies, Bitcoin initiated a view that scarcity is the absolute best scenario for creating value. However, there are complex intricacies to understand in this regard as the reality is often a lot more complex than the beautiful and easy to understand abstraction.
There are several scenarios to consider when comparing a fixed supply versus a fluctuating supply asset when taking market adoption into consideration.
First, let’s consider the misconception surrounding Bitcoin that it has a fixed supply. It is true that the fully diluted supply is fixed at 21 million Bitcoin, however, new Bitcoins are minted every day through the process of mining. Every 4 years, the mining process is halved to produce half the amount of bitcoin. Currently, the mining process of Bitcoin produces nearly the same % of new Bitcoin versus the amount of Bitcoin in circulation compared to gold mining. However, in 2024, when the Bitcoin halving occurs, the production of new Bitcoin in terms of % will be approximately half of what the production of gold is in % of the total amount of the commodity in circulation. Every 4 years after, the production of new Bitcoin will shrink by half making it more and more interesting to hold versus gold assuming everything else remains the same. This is what scarcity brings to the table. However, scarcity alone doesn’t drive market adoption, in a market where market adoption is decreasing, even in scarce asset can lose value, and the same is true if the asset has a burning mechanism that destroy a portion of the asset in circulation, if the burning process destroy less than the decrease of market adoption, the price can still go down. So, it is important to note that scarcity alone in absence of market adoption would not lead to an increase in price of the asset.
In the case of USD, it is an inflationary production, and historically, the US government has been prone to mint an ever growing supply regardless of market adoption, resulting in inflation that is positive almost every year.
The table above is not perfect, it may seem that Ethereum can increase prices in more cases than Bitcoin, but that is not necessarily true. The reality is that minting moderately in periods of market adoption can reduce volatility and excessive price growth, while burning in periods of market decrease can prevent price collapse, however I have yet to see such an asset, not even Ethereum follow that model perfectly. It is in the realm of possibility to build one though, and I welcome the day where such an asset will achieve mass adoption.
Burning can lead to Liquidity Crunch
The reason why I want to go over the intricacies of fixed supply versus unlimited supply, is that there is a misconception that fixed supply in the crypto industry is always preferable to unlimited supply. The truth is that it depends on market adoption versus the amount of minting & burning occurring. There are drawbacks to burning and having a fixed supply.
For one thing, a fixed supply & burning can lead to a liquidity crunch on exchanges where the price becomes too volatile. Let’s look at the math behind a liquidity pool on a Decentralized Exchange such as Uniswap.
Y * X = K is the bounding curve formula, assuming you have 1,000 of USDT as X and 1,000 of an imaginary token called YOLO, then K being constant is now set to 1,000,000. The price of Y = $1 in this case.
Then, if a user buy $200 worth of Y, the formula solve to Y * 1200 = 1,000,000 => quantity of Y = 833.3333, and the price of Y = $1.44. Now imagine, you have a burning mechanism that burns 50% of Y when it gets swapped back to X. Then, you are back to 1,000 X tokens in the pool, but 83.333 Y tokens were destroyed and are no longer in the pool. Now, the pool has 916.666 Y tokens, and 1000 X tokens, your K now becomes 916,666.666, and the price of Y = $1.09. So far, no adverse effect except the price of Y is now higher, which typically benefits all other Y token holders that remain. However, as the amount of Y tokens available in the pool decreases, the fluctuation becomes larger and larger, this leads to higher volatility. In a sense it has enriched remaining holders, but there is not more USDT in the pool, so when users start cashing in their profit, the price may collapse more easily since it can lead to a bank run. Overall, the increase of value is artificial and the entire system did not necessarily accumulate more of the base asset in this case X. The profits and gains are imaginary to a certain extent.
I would argue that burning is a great mechanism when there is a market adoption decrease, but it shouldn’t be used in a constant or increasing market adoption. If the overall market is decreasing 10% in terms of number of users computed at their average value per user, then burning 10% of the liquidity pool amount can make sense, burning more could lead to a liquidity crunch. Ideally, the supply of a token should be minted slightly below market adoption, and burning should be relatively equal to the decrease of market adoption, in such way you can have price increasing moderately, and hopefully the project is generated enough revenues that can be injected as new liquidities to protect against an economic collapse.
Conclusion
As I said earlier, reality is always more complex than the beautiful abstracted generality. A deeper understanding is favored to assess the economic circumstances of crypto currencies, and an even deeper understanding is required to design new economic models that can be programmed into new tokens.
About
Crypto Rookies is a crypto investor, serial entrepreneur in Artificial Intelligence and Web3/crypto with expertise in tokenomics and market making. Currently CEO of Smooth, which focuses on solving the problem of 95% of crypto-currencies failing in their first 2 years.
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