If You Haven't Sold Your Ethereum (ETH -0.51%) Yet Despite Its Decline

If you haven't sold your Ethereum (ETH -0.51%) yet despite its decline of about 40% so far this year

If you haven't sold your Ethereum (ETH -0.51%) yet despite its decline of about 40% so far this year, you're almost certainly convinced of its long-term utility and there are plenty of reasons to support that thesis. But if you're holding this coin for the long haul, you should be aware of one insidious risk in particular that's quickly emerging. It's an issue that's probably significant enough to encourage some investors to sell their holdings right now. Let's evaluate this new threat to see if that's a smart move or not.

Tech upgrades may make it a victim of its own success

As you may know, for each transaction processed on Ethereum's network, the transactor must pay a "gas fee" with the blockchain's coin, Ether. As of noon on May 1, the average gas fee to make a swap of one token for another is $1.15 on average. The majority of each gas fee gets burned -- in other words, destroyed, removing coins from the total supply.

The fact that gas fees are destroyed means that Ethereum's total supply is constantly under downward pressure. At the same time, new Ether is slowly disbursed by the protocol to the network's stakers to reward them for locking up their capital. So the coin's supply isn't inherently inflationary or deflationary, though it has trended toward mild to moderate inflation during most of its existence so far.

Separately, the Ethereum network has long struggled with high gas fees compared to its competitors. Its efforts to fix that have involved a series of upgrades to its technology as well as a few innovative solutions, like spinning off as much traffic as possible to more efficient independently operated subnetworks called Layer 2s. Those efforts have been phenomenally successful in absolute terms, even if they haven't yet made the Ethereum chain as cheap to use as its peers. During the past three years, average Ethereum transaction fees have fallen by more than 98%.

But that's a problem from the perspective of the coin's total supply. As gas fees have fallen dramatically, so have the amounts of the coin burned with each transaction. With much weaker downward pressure on supply, the impact of its new coin issuance is higher, and because of the tech upgrades already made -- not to mention future updates on the way that will likely send gas fees even lower -- there's not going to be as strong of a counterweight to its supply growth ever again. There's thus now a risk that Ethereum's value will get steadily diluted more rapidly over the next few years.

For investors who had expected Ethereum to retain its value over time -- as misguided of an expectation as that may have been -- this new risk is doubtlessly quite alarming.

Don't sweat too much about this just yet

Let's put the risk in context. Right now, Ethereum's supply is expected to grow by about 0.7% annually. Meanwhile, its total supply only rose by 9% during the past five years.

That means that supply growth is not a reason to sell your coins. Nor is it a reason for panic. The Ethereum protocol could be adjusted to be net-neutral or even slightly deflationary given gas fees that are the same or even lower than they are now. That would likely further drive down the rewards for staking, discouraging some investors from parking capital on the chain, but it would at least protect the value of the coin over time. There is also a chance that volume could increase on the network in a durable fashion if sentiment improves, which would result in a higher burn rate and a reduction of the already fairly low supply growth rate. So there are at least a couple of ways this risk could be defused entirely.

There are also a couple of ways that the supply growth could escalate into a real problem that would warrant selling your holdings. Those would likely require strategic mistakes by the chain's developers (such as orienting tech development in a direction that doesn't result in a better ability to compete in growth segments) or for capital devoted to staking to flee to another chain. Neither of those two things is destined to occur, but the chance of at least one of them happening at some point is moderate, and it's important to recognize that a bad strategic move would likely spur capital flight.

In short, this is an issue worth keeping an eye on even if it isn't extremely threatening today. The longer you plan on holding Ethereum, the more you should care about whether it's trending toward a higher inflation rate or not.