by Giles Coghlan, Chief Currency Analyst, HYCM
Ethereum’s EIP 1559 has been receiving a great deal of coverage lately, even in the mainstream financial media, with all sorts of outlandish claims being made about its implications. The following article will attempt to present the ins and outs of EIP 1559 to a non-technical readership and to ground some of the hype surrounding it.
For those of you who are new to EIPs, the acronym stands for Ethereum Improvement Proposal. Essentially, EIPs have proposed changes to the network that include technical specifications, along with the rationale behind them. Most EIPs tend to fly under the radar because they’re too technical for lay people to understand. However, this one has garnered a lot of attention because it has implications for two aspects of the Ethereum network that are very important to both users and holders of ether. These are transaction fees and the supply of ether itself.
Where it came from
EIP 1559 was tabled by Ethereum co-founder and current chief scientist, Vitalik Buterin, back in 2019, and was approved earlier this month for inclusion in the “London” hard fork upgrade scheduled to take place in June. EIP 1559 will introduce changes to Ethereum’s fee model. Currently, it works like an auction, where users who want to get their transactions into the next block submit a gas price (a transaction fee payable in fractions of ether) that they’re willing to pay. Ethereum miners then sort these bids, prioritising transactions with the highest fees.
This mechanism is an economically efficient way of managing a scarce resource (transaction throughput) to give high-value transactions priority over low-value transactions, which can also include spam. The problem with this mechanism is that it leads to inefficiencies in gas prices and a situation where users of the network can never be certain whether their transactions will be included in the next block due to sudden gas fee spikes. Back in 2017, these spikes routinely occurred due to the ICO craze clogging up the network. This time around, it’s the explosion of DeFi (Decentralised Finance) applications that are primarily responsible for the congestion.
What it changes
EIP 1559 has been designed to make transaction fees more predictable, while also reducing delays in transaction confirmation times. It aims to simplify the fee bidding system by introducing the concept of a base fee. This base fee is a minimum gas price required for a user to get their transaction into a block. The base fee will act as a reserve price on the cost of performing computation on Ethereum’s network and is to be dynamically adjusted up or down depending on network congestion.
The current maximum gas limit per block is set to 12.5 million. EIP 1559 doubles this maximum to 25 million, increasing the potential size of each mined block to allow for more transactions. When network congestion is below 50% (demand is low), the base fee is to be adjusted down, when it’s above 50% (demand is high) the base fee is to be adjusted up. Each adjustment up or down takes place in increments per block (currently, each block takes just over 13 seconds to confirm). This means that base fees cannot spike from moment to moment as gas fees currently do.
Another important aspect of EIP 1559 is that users can now tip miners in order to incentivise them to prioritise transactions. For example, users attempting to make arbitrage transactions that are incredibly time-sensitive can pay more to get their job done quickly. Whereas users who are not concerned with speedy confirmations can just pay the base fee. EIP 1559 also introduces fee caps for users who want to limit the amount they pay for transactions. You can think of these as a bit like limit orders for transaction fees. If the base fee should rise above the fee cap set by a user, it will remain pending until base fees drop to that specified level before the transaction is executed.
Supply Reduction
Now to the aspect of EIP 1559 that has everyone speculating on ether’s price. The network upgrade that’s set to take place in June will burn 100% of all base fees, meaning those fractional sums of ether will be destroyed as and when each transaction is confirmed. This works a little like a stock buyback, which removes ether from the supply, theoretically making circulating ether more valuable. It also necessarily means less profit for miners, who will now only receive block rewards (new ether minted to incentivise the mining of blocks), plus the user-defined miner tips.
The game-theoretic reasons for why base fees cannot be given to miners are rather arcane, but they boil down to miners and users being able to collude with each other off-chain. One of the reasons it has taken this EIP so long to pass is that the miners have generally been opposed to it for obvious reasons. They represent a large special interest group in the network who are adversely affected when sums that would ordinarily be paid to them are burned.
For Ethereum’s users, EIP 1559 will mean that their wallets no longer have to estimate gas fees (often erroneously during periods of peak load) and will simply set the base fee based on what took place in the previous block. However, the real benefit to users, holders and (some would suggest), even miners, is that burning this base fee has massive implications for the supply of ether. More network activity will necessarily lead to more ether being burned, which translates to less supply on the open market. The buzz around this specific EIP centres around this removal of ether from the supply, which can lead to a scenario in which ether becomes deflationary if more of it is being burned in base fees than is generated as newly minted block rewards.
Some Thoughts
Many have suggested that ether’s recent price volatility is due to the market attempting to price-in the shock to supply that’s due to take place in mid-2021 when this EIP is included in a subsequent network upgrade. One thing that has traditionally weighed on the price of ether is that, unlike bitcoin, there is no hard cap to the overall supply. While EIP 1559 does not introduce a hard cap, the manner in which it is set to influence supply is now widely regarded as a step in that direction. It sets the stage for a positive feedback loop between growing network use and more ether being burned. This is tantamount to, say, tightening the supply of dollars in the traditional financial system when the Federal Reserve settles outstanding bonds without issuing new ones.
As to whether EIP 1559 will actually reduce fees, this is perhaps the most misunderstood part of the story. High fees are a function of high demand combined with limited throughput. As such, EIP 1559 will not make fees cheaper during periods of sustained high demand. What it achieves is a gradual steepening, which reduces transaction fee volatility rather than the absolute price.
This leads us on to scalability. Another thing that EIP 1559 does not solve is Ethereum’s scaling issues. While the increased block sizes will allow for more transactions to be processed per block, functionally it’s likely to be a drop in the ocean as the network has been running at peak capacity for quite a while now. This congestion is only likely to increase as more innovative decentralised applications rush to launch on the world’s second most valuable blockchain. For these crucial scalability updates, we will all have to wait for the full transition to Ethereum 2.0, which is far from ready. That or upcoming stopgaps like the introduction of sidechains to ease network congestion until then.
