Introduction
After a blistering start to the year, breaching the magical $4000 mark in April 2021, Ethereum has lost significant momentum so far in May, retracing well over 60% of its all-time high (ATH) on 20 May.
While external factors such as Elon Musk’s U-turn on Bitcoin as well as U.S. and China regulations and parabolic market conditions have been identified as culprits, the systemic issues plaguing the world’s second biggest (and arguably the most important) cryptocurrency have not done the price of ETH any favors.
Savvy investors took advantage of ETH’s dip to under $1800 this week, snapping it in order to stake it on platforms like Cybavo’s Ethereum staking service and also driving the price back up to over $2,500 at present.
With gas fees spiraling out of control, hitting an unthinkable $900+ at one stage during the Elon Musk-induced market meltdown, the leading smart contracts network is at an existential juncture in its brief existence as it transform itself into its Ethereum 2.0 Proof-of-Stake (PoS) final form: Reduce gas fees and network latency, or face losing users and developers to rival network upstarts with native PoS architecture like Binance Smart Chain (BSC), Solana (SOL) and soon Cardano (ADA) and Polkadot (DOT).
Enter the controversial Ethereum upgrade called EIP 1559, which has split the ETH community due to a dramatic new resolution to its current problems.
What is Ethereum’s EIP 1559?
The Ethereum Improvement Proposal (EIP) 1559, also known as the “Ethereum Burn Mechanism”, is a proposed network upgrade by creator Vitalik Buterin, aimed to address the network’s gas fee issues. The upgrade is scheduled for implementation along with the London Hard Fork this coming July 2021.
How will EIP 1559 change Ethereum?
The new EIP will change the current transaction mechanism to direct gas payments to the network to be burned instead of being awarded to miners, which explains why some miners see it as a tough bullet to bite. Senders reserve the right to tip the miners via ‘inclusion fees’.
The upgrade will also make Ethereum’s block size dynamic and elastic, which will enable it to adjust based on the degree of congestion in the network. This also doubles the gas limit for blocks from 12.5 million to 25 million and allows more transactions in each block.
The Problem With Ethereum’s Current Gas Fee Model
Ethereum is currently using the ‘first-price auction’ mechanism to determine which transactions to prioritize in block creation. Users can choose to pay higher gas fees to be able to finalize their transactions relatively faster through a bid on gas fees, which miners receive as rewards, incentivizing them to process transactions that pay higher fees.
Unfortunately, this model can become problematic during times of high-volume traffic within the network since fees can skyrocket, preventing individuals who can’t afford to pay them to be left out or have their transactions stuck in pending mode indefinitely. Additionally, this mechanism makes transaction fees non-deterministic, often resulting in inaccuracies in gas fee estimates and forcing users to sometimes pay more than they need to.
Ethereum’s New Fee Model
EIP 1559’s model introduces two separate fees:
- A base fee and
- An inclusion fee.
Base Fee
The base fee will replace the previous gas implementation and designate a fixed-per-block network fee for any transaction, which means that users will pay the same amount in fees for each block. The deciding factor for each block’s fee will be the state of the network’s traffic instead of how much some users are willing to pay to be prioritized.
The more congested Ethereum is, the higher the target gas limit becomes. Furthermore, transactions are also expected to settle faster with the new model since bigger blocks can include more transactions.
Inclusion Fee
As for the inclusion fee, users can opt to pay them out of generosity instead of being forced to do so due to market supply and demand.
Deflationary Tokenomics
Unlike Bitcoin that has a capped supply and a decreasing emission rate, Ethereum currently has an unlimited supply and an increasing emission rate. The latter is caused by Ethereum’s growing user base and lack of fully functional scalability solutions. EIP 1559 requires accumulated base fees to be earmarked for burning to create deflationary pressure on ETH, which is why this new proposal is so significant.
Once the protocol upgrade is rolled out, the annual issuance rate of Ethereum is expected to go down to 0.5%-1%, which is a relatively healthier inflation model; far from today’s 4.5%.
Burning is also anticipated to benefit ETH holders since the rate of increase in ETH payments translates to less circulation of the coin. This can theoretically help increase the value of ETH and counter any future inflation.
How EIP 1559 Affects Ethereum Miners
The new proposal deals a significant blow on ETH miners, whose source of income comes from block rewards and network fees. In April alone, Ethereum miners collected a total of $1.65 billion in revenue, $716.43 million of which come from transaction fees.
Despite the presence of inclusion fees, users are not incentivized to pay extra since it won’t affect the speed of their transaction. Hence, this could potentially give miners’ revenue a 35-45% haircut.
Various mining pools such as Sparkpool and F2Pool have made their stance on the proposal public. While F2Pool (18% hash rate share) fully supports EIP 1559, Sparkpool (16% market share) opposes it. Ethermine (27%), the largest Ethereum mining pool as of May 2021, appears to remain neutral in its stance but has nevertheless offered its own solution to offset miners’ revenue loss via a front-running software.
Why EIP 1559 is Important
The EIP 1559 offers a much-needed solution for the excessively high gas costs on Ethereum and can likely help the project regain its footing against booming aforementioned competitors like Binance Smart Chain, Cardano, Polkadot, and Solana.
It also serves as a testament to the project’s aim of transitioning into a pure proof-of-stake (PoS) ecosystem in the long run. Miners are slowly being weeded out and replaced by stakers as the Ethereum 2.0’s development progresses. This provides a positive environmental impact since staking requires significantly less computing power than mining.
However, this doesn’t mean that it’s gameover for Ethereum miners since the network’s PoW chain will still be running alongside the Beacon Chain for a while. Despite the new proposal, the Ethereum Foundation and core developers have not made any official announcement pertaining to the removal of mining from the ecosystem, but some developers have shared that it would be best for miners to break even by the end of 2021.
Overall, EIP 1559 is expected to help propel the value of ETH upwards in the long run since it improves the experience of its users, introduces scarcity mechanisms, and helps alleviate the crypto environmental concerns brewed up by Bitcoin mining.