Crypto’s Dirty Secret

(This is a four-minute read)

Inflation is the core mechanic in a bear market.

Even though crypto has onboarded millions as refugee asset from inflationary money-printing regimes, crypto’s dirty secret is that the entire industry is based on inflation–the steady release of new tokens on the market to incentivize growth.

While Bitcoin is advertised as completely sound money with a totally capped supply, for now the network is inflating at about 1.8% per year. For Ethereum, the number is a bit lower thanks to the deflationary EIP-1559, but at the moment, most protocols are paying out the wazoo for security, mining, growth, or liquidity.

In fact, one of the reasons we cover the protocols we do (most recently GMX, check out the report here) is because of their superior, non-inflationary tokenomics. The chart below will give you a rough look at some of the biggest names paying for growth and security by minting and giving away new tokens.

Note that these percentages are based on the daily issuance rate on May 31st, not the average issuance rate over time.

Cryptocurrencies can basically issue new ‘equity’ (in the form of tokens), then use it to incentivize users in various ways at the cost of current token holders. With the massive inflation rate north of 80%, a protocol like Osmosis requires $1.4m dollars a day in new demand. For bitcoin, that number is roughly $31m a day.

And that’s just new token issuance. Supply also expands as team tokens unlock for:

  • VCs
  • Advisors
  • Team
  • User Rewards (trading rewards, liquidity rewards)

Protocols like dYdX and SpookySwap, despite having TradFi metrics that are absolutely off-the-charts impressive, have trended consistently down in price over time.

Why? Well, a strong argument is that those cryptos have token supplies that expand due to rewards (SpookySwap with LP rewards, dYdX for trading rewards). Every token that comes on the market represents more supply pressure that likely gets sold off and pulls the price down.

Retail Demand is Not Structural Demand

The picture in TradFi is completely different. Supplies are capped–you can’t easily issue new equity. Stocks create structural demand (deflation) via buybacks. Households and institutions alike buy month in, month out. Price is basically designed to go up.

In crypto, during periods of panic selling, there is just not enough widespread structural demand to pull the price back up as token supplies increase (in the form of VC unlocks, liquidity rewards, trading rewards, and tokens sold to pay for the project).

Because of this, in crypto we see FOMO-inspired bubbles, then long periods of decline.

Structural Inflation

Bitcoin holding a price level is actually quite bullish–as of writing, Bitcoin rewards miners about $31 million per day, (admittedly, a small percent of daily flows), but nonetheless, liquidity which needs to be soaked up by incoming capital to the tune of $11 billion a year.

Friend of the newsletter 0xHamz produced this chart around token inflation/monthly issuance. The below cryptos emit about $102b in assets a year, averaging an annual inflation rate of 7% (nearly as much as the 40-year high 8.3% inflation rate of the US dollar, for the record)

A fair conclusion to draw is that the space needs to attract $8.5b in fresh capital every month just to hold static prices.

Luna is an interesting case as it shows both sides of this inflationary/deflationary token phenomenon. Luna outperformed $ETH in large part thanks to the deflationary mechanism of seigniorage that it used to mint its stablecoin. But when the death spiral kicked in, $LUNA had to mint millions of new tokens, driving per-token price into the ground as price collapsed into the earth on a supply that inflated from 340m tokens to 6 trillion tokens in just a few days.

The right column is Luna’s supply inflation over just a few days

The Takeaways for Investors

Many people attempt (some successfully) to swing trade around FDV bombs and farm yield into the depths of the earth: but for the average retail investor who’s looking for longer-term holdings, this is a compelling framework.

And what fits into the deflationary/non-inflationary asset camp? Well, very few assets, the most evident one being Ethereum after The Merge sometime this year (hopefully). With this, Ethereum will become net deflationary, causing positive and permanent structural demand pressures combined with a deflationary supply pressure.

The Cure: Structural Demand, Reducing Emissions

All of this discussion can lead us to a compelling conclusion: in crypto, the asset and the product/business are completely different (and often unrelated). Uniswap has become the preeminent market maker, but hasn’t figured out how to create a material benefit for the token.

  1. If You Don’t Understand the Forces Pulling Supply and Demand, Don’t Invest
  2. If You Don’t Have a Theory on Why Demand Will Outpace Supply, Don’t Invest
  3. Don’t Invest in FDV Bombs/Farm Tokens
  4. Understand Emissions Time Schedules and Unlock Dates

When evaluating economic systems, the exact mechanics are a lot less important than the basic supply and demand function. Everything should be based around one concept: does supply go up or down?

Supply going up creates inflation that will drive token prices into the earth and dilute your equity. Supply going down gives investments a phenomenal tailwind over time.

Crypto Pragmatist