The basic properties of some currencies make them lose value over time. For these currencies, holding them long-term (or “HODLing,” as we say in crypto slang) invariably means you will end up with less than you started with. But why does this happen?
There are two broad groups of currencies out there: inflationary and deflationary. Inflationary currencies have no limit to how many units are in circulation, while deflationary currencies have a max supply. Other factors remaining the same, the buying power of inflationary currencies reduces as more units are printed. Inversely, the value of deflationary currencies increases with time, as the currency becomes ever more scarce.
Fiat currencies fall into the category of inflationary currencies, while most cryptocurrencies are deflationary in one way or another.
Inflationary vs deflationary essentials
INFLATIONARY
- The currency rates of fiat currencies are floating (their value is relative to other currencies).
- New units of fiat can be made at any time, which makes it inherently inflationary.
- The more units there are in circulation, the more likely it is that they are worth less.
DEFLATIONARY
- Fixed currencies are tied to material goods or limited by code.
- They are inherently deflationary as they cannot be made at whim.
- Fixed or decreasing supply and steady demand usually makes them grow in price.
Fixed vs floating
Traditional currencies used to be fixed. Their value was tied to material goods, most commonly a gold reserve held by a central bank. This reserve defined the value of a currency in terms of how much gold it could buy. If a citizen wanted to, they could go to the central bank and demand gold for their money.
However, in the 1970s, national banks began to abandon the gold reserve. By the turn of the century, the vast majority of countries abolished it entirely. Their currencies became floating, meaning that they were valued in comparison to other currencies. Now, traditional currencies only have value because there is a general agreement that they have value. That is why they are called fiat currencies (Latin for “let it be done”).
As an important side effect of abandoning the gold standard, fiat currencies have become inflationary. Central banks are now able to print new money at will, without announcing their actions publicly. The amount of a currency in circulation keeps increasing, which has an adverse effect on its purchasing power.
Cryptocurrencies can be seen as deflationary
On the other hand are cryptocurrencies, which are not controlled by any government or institution. Their algorithms often determine their max supply that can never be exceeded. Once such a limit is reached, the supply of the crypto comes to a halt. And if the perceived demand remains the same, prices could go up.
Bitcoin, the first and the largest cryptocurrency, will only ever spawn 21 million coins. After this pool runs dry, there will be no more new bitcoins. In fact, most of the coins (over 18 million as of writing this article) have already been mined. Since the mining reward is growing smaller and smaller, bitcoin can already be seen as deflationary. When this limit is reached, it will become truly deflationary. Cryptocurrencies such as Litecoin and Bitcoin Cash have a similar limit.
But some other cryptocurrencies have gone a different way. Ripple made XRP, its native cryptocurrency, deflationary through a different process. The Ripple company released the entirety of their XRP (100 billion) when they first began. 55 billion of this total sum has been escrowed (locked in a special account), while the rest is going down day by day, since every transaction burns (that is, destroys) a small amount of XRP.
Not all cryptocurrencies have a hard-coded limit to how many units can be created. Proof-of-stake-based crypto platforms (PoS is the development direction of Ethereum) have no max supply limit. But this does not necessarily mean that cryptocurrencies like ETH are inflationary. Unlike with central banks, which can print fiat on a whim, the way new units of crypto are made is transparent and predictable. The public nature of the blockchain allows the market to adapt to any changes even before they are made.
Due to its deflationary nature, there may come a time when people HODL crypto relentlessly. Purchasing it might become an arduous and expensive task. For now, the easiest way to purchase crypto is to buy it for fiat at an exchange, like Bitstamp.