Max supply: an overrated quality

Max supply: an overrated quality

By Allen Walters | Publish0x posts | 9 Jun 2020

Investing in cryptocurrency means doing a good amount of research on potential projects. There are many factors to considder and some factors are more important than others. One of the factors that pops up in many discussions is, the question "does this project have a max supply?"

Max Supply:
Max supply is all about the total amount of coins/ tokens a project has (and will have). For most cryptocurrencies, the current supply changes daily: a certain amount of coins is added every day. As an incentive for people to mine or stake and validate transactions, blockchain protocols create extra coins to give to miners or stakers as rewards. Without rewards, no one would help running a blockchain. Rewards can also be payed in fees, by people that send transactions. But since all blockchains must start somewhere, and in the beginning there is a low level of adoption and thus a low amount of transactions, the rewards need to be guaranteed so they are being created (minted) by the blockchain protocol. This causes inflation.
Having a maximum supply means that the rewards are decreased from a minting perspective and expected to increase from transaction fees. When a maximum supply is set, this means that eventually all rewards come from transaction fees and inflation eventually goes to 0%. This is obviously an interesting quality. But there are a few things to consider:

Time frame
First of all, the max supply for most projects is only reached in a very long time, which means that the max supply won't happen in your lifetime. So inflation takes place for as long as you live. And halvenings, where rewards are lowered at a certain point in time, are events that are overrated as we just witnessed in the last halfening. 

PoW or PoS
The effects of inflation is different for people holding coins in PoW systems than for people holding coins in PoS systems. The difference lies in the way the rewards are distributed. Both in PoW (Proof of Work) and in PoS (Proof of Stake), rewards go to people that validate transactions for the blockchain. In PoW, the rewards go to people that run specialized hardware that is used to solve hard mathematical problems. The more computing power, the more you share in the rewards that are distributed by the blockchain protocol.
In PoS, however, you get rewarded for the amount of coins you hold while validating transactions.
Now if we look at the inflation rate (let's set the inflation rate at 5% yearly for this discussion) and how that affects people in the ecosystem, we see that that full 5% goes to anyone that validate transactions both in PoW, as in PoS. But in PoS, these people are also holders of the coins. If you hold a 100 coins, you receive 5%, so 5 extra coins yearly if you stake all year long. This results in the fact that rewards cancel out inflation: You receive 5% of what you own and at the same time inflation is 5% too. Stakingrewards cancel out inflation, netting zero inflation. In PoW, on the other hand, rewards are not divided per coin ratio. So inflation is real and really affecting holders of PoW coins.

Moving towards a max supply, and thus towards 0% inflation, is interesting if that means that inflation goes to zero for holders. If inflation is already zero for holders that stake (bake or delegate), reaching a max supply that sends inflation to zero, would not be important from a holders perspective.

It is important though, to understand that not all PoS systems are alike. Although the hardware requirements and electricity costs are a lot lower in PoS than in PoW, in PoS it is still necessary to run a computer (node) to validate transactions to receive staking rewards. And not everyone will be willing or capable to do so. This means that inflation does affect anyone that is not sharing in the staking rewards. If we look at a project like Tezos, we see that coins do not only play a part in staking, but also in voting rights for their on-chain governance system. (More about that here) Since the stakers (which are called bakers in the Tezos ecosystem) are the ones that do the voting, anyone that holds coins, can delegate their coins to bakers. This way everyone that owns coins can take part in the democratic process. At the same time, everyone that delegates their coins earns staking rewards.
This means that it is possible for anyone that owns coins to receive rewards. So for a PoS blockchain like Tezos, inflation is not an issue. And neither is a max supply.

Max Supply in PoS?
You could set a max supply in PoS. This would mean that in the end, all staking rewards would need to come from transaction fees. So setting a max supply would mean that transactions costs would need to become more expensive. Users of the chain, either people using coins for payments or in smartcontracts, will pay that price. Which is unnecessary since we can use the inflation model that doesn't hurt both holders and users. Adoption is key for any project, so a model that caters users is preferred. If users can choose between blockchains, the cost of transactions is an important factor. A max supply is not always desirable.

If you scouting new projects and look into supply models, make sure you consider the above and realize that max supply is not a relevant factor in all systems, and in some systems not even desirable.

Allen Walters
Allen Walters

Fascinated by blockchain and future proofing cryptocurrency. Discover the tech before it gets relevant.

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