How to correctly compose an investment portfolio? What are the typical mistakes when balancing a portfolio? Last time, we discussed in detail the crypto contagion effect and how to take this danger into account in the risk management of your crypto investments.
This time, let’s discuss another important aspect: the different economic nature of crypto assets. What exactly makes them really different? Inflationary crypto assets, for example, have the properties of regular fiat money and are poorly suited for long-term investing. But how do you distinguish between inflationary and true deflationary coins? What’s the difference between them? And how do you properly balance your portfolio?
What is inflationary cryptocurrency?
Some cryptocurrencies are inflationary because their supply increases over time. Such cryptocurrencies use a combination of pre-programmed emission and token distribution mechanisms (to maintain supply and motivate participation in the network). This usually puts negative pressure on the price of the asset, causing inflation.
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Here are two examples of inflationary assets:
- The classic example of an inflationary asset is Ripple (XRP). The Ripple cryptocurrency is characterized by inflation above 20%. This is the highest among the top 20 cryptocurrencies. The Ripple project regularly issues a huge number of new tokens from its escrow accounts. As a result, XRP inflation is higher than other cryptocurrencies, which negatively affects the price and creates uncertainty with the long-term outlook.
- Inflationary cryptocurrencies can also include stablecoins such as Tether (USDT), USD Coin, and others. In this case, they are backed by fiat (state) currency, which, due to its nature, is inherently subject to inflation. Consequently, a digital coin backed by it will, by definition, follow the price of the original asset.
What is deflationary cryptocurrency?
The supply of coins in deflationary cryptocurrencies decreases over time. Various mechanisms are used to reduce the number of tokens in circulation, including:
- Sometimes they are destroyed by burning.
- Or through transaction fees, which are also automatically burned after the transaction is processed.
- Some deflationary cryptocurrencies have a predetermined deflation level built into the protocol. This emission limit determines the percentage of the cryptocurrency’s total supply that declines over time.
- There are also hybrid options. For example, some deflationary cryptocurrencies can use transaction fees for additional burning and reduce the total amount in circulation. “Coin burning” can also involve sending a certain amount of coins to an unavailable address, directly removing the coins from circulation.
An example of a hybrid option is BNB, which implements two mechanisms simultaneously and plans to reduce its supply by 50% over time:
- The first component is to burn off some of the BNB spent as commissions on the BNB chain.
- The second deflationary mechanism is regular, quarterly token burning.
Deflationary cryptocurrencies sometimes use other tools to reduce supply, such as halving. Every four years, halving reduces the reward for Bitcoin miners, gradually increasing the deficit of the asset in the market.
The limited supply of 21 million Bitcoins means that once all BTC are issued, no more can be issued. While mass acceptance and proportional demand for Bitcoin continue to grow, its internal deflationary mechanism ensures long-term rate growth. That is why many experts are convinced that Bitcoin will remain inflation-proof due to its built-in internal mechanism.
Cryptocurrencies whose monetary model resembles (or even replicates) Bitcoin can also be classified as conditionally deflationary coins. These include Litecoin, Bitcoin Cash, Zcash, Dash, and others.
Pros and cons of both asset groups
Let’s compare the two groups from an investor’s perspective:
- Inflationary coins have some advantages over deflationary coins. They encourage spending but do not encourage saving. Depending on the market situation, they are capable of rapidly increasing their liquidity, the reason for which will be their effectiveness as a medium of exchange (payment). In addition, such assets offer a more flexible monetary policy than deflationary cryptocurrencies and some fiat currencies.
- Deflationary coins encourage hoarding and reduce the desire to spend, increasing the deficit of cryptocurrency in the market and thus preserving the value of the asset. For this reason, deflationary coins can be a defense against inflation and stagflation and are ideal for long-term investments. A stable and independent reduction in token supply will help counter inflationary pressures caused by external factors (including governments’ excessive money printing policies).
- To summarize, inflation coins are more of a means of payment, unlike conventional money, which additionally has cross-border and anonymous properties. On the other hand, deflationary coins are a means of accumulation as well as an investment (and speculative) asset. The similar nature of this type of asset can be explained with the help of the classical economic law of Copernicus-Gresham (also known as “Gresham’s Law“).
In conclusion of this review, it should be noted that the line between inflationary and deflationary tokens is partly blurred; some projects change their tokenomics over time, moving from one group to another. Here are two examples from the real world:
- Since Ethereum moved to Proof-of-Stake (217 days ago), the second cryptocurrency’s supply has decreased by 100,000 coins; had the update not happened, the ETH issue would have increased by more than 2.52 million coins ($5 billion). So for today, Ethereum has become deflationary!
- The original maximum supply of DOGE was 100 billion; this popular meme coin was deflationary and modeled similar to Bitcoin. In 2014, the founders of the project removed this restriction. Since then, the supply of DOGE tokens has not been unlimited in any way, which makes long-term investment in this asset rather questionable.