The scarcity of cryptocurrencies and the complexity of fixed supply

The Limited Availability of Cryptocurrencies and the Complicated Nature of Fixed Supply

Author: Crypto Rookies
Source: Medium
Translation: Shanooba, LianGuai

In the world of cryptocurrencies, Bitcoin has introduced a viewpoint that scarcity is the best scenario for creating value. However, there are some complex issues to understand in this regard, as reality is often much more complicated than beautiful and easy-to-understand abstractions.

When considering market adoption, various scenarios need to be considered when comparing fixed supply assets with fluctuating supply assets.

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First, let’s consider the misconception surrounding Bitcoin, which is that the supply is fixed. It is true that the fully diluted supply of Bitcoin is fixed at 21 million BTC, but new Bitcoin is minted every day through the mining process. Every four years, the mining process is halved, producing half the amount of Bitcoin. Currently, the new Bitcoin produced through the mining process is almost the same as the circulating Bitcoin supply, compared to gold mining. However, by 2024, when Bitcoin halves, the percentage of new Bitcoin production to the total circulating supply of Bitcoin will be about half of gold production. After that, new Bitcoin production will decrease by half every four years. Assuming everything else remains the same, holding Bitcoin will become increasingly interesting compared to holding gold. This is the consequence of scarcity. However, scarcity itself cannot drive market adoption. In a market where the adoption rate is declining, even scarce assets may lose value. The same goes for assets with a burning mechanism that destroys a portion of the circulating supply. If the burning process destroys less than the decrease in market adoption, the price can still fall. Therefore, it is important to note that scarcity alone will not cause the price of an asset to rise without market adoption.

As for the US dollar, it is an inflationary production. Historically, regardless of market adoption, the US government tends to mint a continuously growing supply, resulting in almost annual inflation.

The above table is not perfect, and it may seem that Ethereum can provide value in more situations than Bitcoin, but the reality may be different. The fact is, during periods of market adoption, moderate minting can reduce volatility and prevent excessive price growth, while burning during market downturns can prevent price collapse. However, I have not yet seen such assets, even Ethereum does not perfectly follow this model. Nevertheless, it is possible to build such an asset, and I welcome the day when such assets are widely adopted.

Burning can lead to liquidity tightening

I want to discuss the complexities of fixed supply versus infinite supply in the cryptocurrency industry because there is a misconception that fixed supply is always preferable to infinite supply. The truth is, it depends on the market’s adoption rate and the quantity of minting and burning. Burning and fixed supply also have their drawbacks.

On one hand, fixed supply and burning can lead to liquidity tightening in exchanges. Let’s take a look at the mathematical principles behind liquidity pools in decentralized exchanges like Uniswap.

Y * X = K is the formula for the boundary curve. Assuming you have 1,000 USDT as X and 1,000 fictional tokens called YOLO, then K is a constant, currently set at 1,000,000. In this case, the price of Y = 1 USD.

Now, if a user buys Y worth 200 USD, the formula solves as Y * 1200 = 1,000,000 => Quantity of Y = 833.3333, Price of Y = 1.44 USD. Now imagine you have a burning mechanism where 50% of Y is burned when exchanged back for X. Then, the pool goes back to having 1,000 X tokens, but 83.333 Y tokens are burned and no longer exist in the pool. Now, the pool has 916.666 Y tokens and 1,000 X tokens, and your K becomes 916,666.666. The price of Y = 1.09 USD. So far, there is no adverse impact except for the higher price of Y, which generally benefits all the remaining Y token holders. However, as the available Y tokens in the pool decrease, volatility increases, leading to higher volatility. In a way, it enriches the remaining holders, but there is no additional USDT in the pool. Therefore, when users start cashing out profits, the price may be more prone to collapse, as it could trigger a run on the bank. Overall, the increase in value is artificial and the entire system may not necessarily accumulate more underlying assets in this case.

I believe burning is a good mechanism when the market adoption rate decreases, but it should not be used when the market adoption rate is continuous or increasing. If the number of users in the entire market decreases by 10% based on the average value per user, it makes sense to burn 10% of the liquidity pool amount. Burning more could result in liquidity tightening. Ideally, the token supply should slightly be lower than the market adoption rate, and burning should be relatively equivalent to the decrease in market adoption rate, allowing for moderate price increase and hoping the project generates enough revenue to inject new liquidity as a safeguard against economic collapse.

Conclusion

As I mentioned before, reality is always more complex than beautiful abstract generalizations. Assessing the economic environment of cryptocurrencies requires a deeper understanding, and designing new economic models that can be programmed into new tokens requires an even deeper understanding.

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