In the blockchain sphere, issuers of digital currencies adopt two token models: inflationary and deflationary. These models help to regulate the supply of a particular cryptocurrency. Moreover, they have a significant impact on market liquidity. In this article, you will learn how inflationary and deflationary token models affect market liquidity. Stay tuned.
Inflationary Tokens Explained
Crypto inflation refers to the depreciating purchase power of a certain token over time. Tokens that employ the inflationary model use the same principles, adopting a framework intended to devalue the digital currency by raising its supply.
Inflationary tokens include a mechanism in their code responsible for adding more coins to the circulating supply over time at a specified inflation rate. So, as more tokens enter circulation while demand remains constant, the value of the cryptocurrency usually drops, lowering its purchasing power. In such a scenario, crypto holders spend more coins to buy assets.
Deflationary Tokens Explained
Deflationary tokens take a completely different approach. Instead of adding more tokens to the circulating supply, like inflationary tokens, deflationary tokens reduce them in an effort to boost their value. Issuers of deflationary tokens believe that by making their cryptocurrencies scarce, they will drive up their prices over time.
Most deflationary tokens come with deflation rates, which determine the percentage of tokens that should be removed from the circulating supply within a specific period. For example, a token can have an annual deflation rate of 3%, meaning that 3% of the tokens in circulation should be burned every year.
The process of removing tokens from circulation is called burning. It involves sending coins to an address that makes it impossible to retrieve them. There are several deflationary tokens in the market. Among them is Binance Coin (BNB). Every three months, Binance carries out a burning event to remove BNB tokens. The crypto exchange has pledged to get rid of 50% of BNB’s circulating supply over the next few years.
How Do Deflationary and Inflationary Tokens Affect Market Liquidity?
All tokens desire to achieve high trading volumes. That’s because, with such volumes, order execution becomes better due to high liquidity. The primary goal of deflationary and inflationary tokens is to have high market liquidity at the same time maintaining the stability of the token’s value, which can be achieved in the following ways:
Supply Regulation
Inflationary and deflationary cryptocurrencies seek to regulate the supply in the market to achieve high liquidity. Supply regulation involves adjusting a token’s maximum supply, circulating supply, and total supply.
Mining and Staking
Proof-of-work blockchains such as Bitcoin incentivize miners to continue releasing newly minted coins, thus ensuring a continuous supply of tokens. On the other hand, proof-of-stake networks like Ethereum rely on stakers to generate new coins and add them to the circulating supply.
Token Burns
To ensure the market liquidity is stable and to prevent inflation, deflationary tokens permanently remove a particular percentage of coins from the market through a burning mechanism. For example, Uniswap’s founder burned nearly 80% of HayCoin tokens in September 2023 to minimize inflation.
Yield Farming
Crypto holders who do not intend to use their digital tokens can deposit them in liquidity pools to participate in yield farming, which boosts market liquidity. Through yield farming, users can earn interest by lending their tokens to others.
Key Differences Between Deflationary and Inflationary Tokens
Inflationary tokens tend to have more market liquidity than deflationary tokens. So, why is this the case? Well, that’s because inflationary tokens are designed for daily usage; therefore, they’re available in significant supply. Deflationary tokens, on the other hand, are regarded as a store of value, and holders use them as a shield against inflation; therefore, their availability in the market is limited, making them less liquid.
Further, deflationary tokens are more vulnerable to price manipulation than inflationary tokens. Here is an example to help you better understand: Most holders of deflationary tokens own such digital currencies in anticipation of a burning event and are likely to dump their holdings when value appreciates, thus causing price volatility.
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