Michaël van de Poppe - 23 March 2022
The effect of EIP 1559
On August 5th this year, the much-anticipated London Hard Fork was implemented on the Ethereum Mainnet. The network update included five Ethereum improvement proposals, known as EIPs. The most notable one was EIP-1559 that had the goal to solve speed and the problem of the fee model at that time. This short blogpost is designed to get you up to speed on how Ethereum works from a very high level perspective, what EIP-1559 has changed, and how we foresee the future for Ethereum.
Ethereum in a nutshell
Before diving into EIP-1559, it is important to have some basic understanding of how the consensus process of Ethereum works. Note that the following comparison is a very simplified version of reality and used only to give you some knowledge about the mechanisms behind Ethereum.
Ethereum has a Proof-of-Work consensus protocol. It allows the network to come to consensus, or agree on the state of the network (balances) and transactions. In this mechanism miners are the ones validating, reaching consensus, and adding blocks to the chain. The validators are rewarded for their work in the form of standard block rewards. Originally the rewards were 2 Ethereum per block. Recently, this was changed to 3 Ethereum per block and is decreasing to 1 ETH within 2 years (EIP-3368). By design Ethereum has no supply cap and is inflationary.
At the moment, Ethereum struggles with scalability. Due to restrictions in block time and space, Ethereum can handle only about 15 transactions per second. Due to the popularity of Ethereum, the network is often overloaded. During times of high demand, gas fees rise because users are overbidding each other to have their transactions included in the block. This model causes users to often overpay for their transactions and it makes the Ethereum network less capital efficient.
EIP-1559 is designed to make gas fees more predictable and less vulnerable to manipulation. The proposal introduced a change to the model by establishing a “Base fee“ or a “gas market rate” for block inclusion and burning a portion of Ethereum in the transaction fee. The gas market rate is increased when the network is experiencing a high level of traffic, and vice versa. With EIP-1559 users can still bid up their transaction to be processed faster by increasing the priority fee that is paid to miners.
The market rate or gas fee market rate in EIP-1559, however, is burned.. The network already rewards validators in the form of block rewards, if they were to receive the gas fee market rate, it would be overpaying as the validators also receive tips/priority fees from the users. Thus, there is no need to reward them the market rate and instead that is burned.
Additionally, EIP-1559 works against Ethereum’s inflation rate and, if the network is in high demand, can cause deflationary blocks and a declining supply (more ETH is burned than that is issued). You can monitor this for yourself on https://watchtheburn.com/. The deflation causes the supply of Ethereum to shrink which is expected to have a bullish effect as scarcity increases. This would make it harder for actors to attack the network as Ethereum becomes higher in price. It makes EIP-1559 a much needed and important upgrade for the Ethereum network.
The burned fees are categorized as protocol revenue and the remaining fees are supply-side revenue (going to the validators). These statistics can be monitored on the Revenue share dashboard on Tokenterminal. It shows that protocol revenue started around the fifth of August, when EIP-1559 was implemented, and has grown significantly over time as the Ethereum network was in more demand. This is bullish for the token.
At the time of writing EIP-1559 has burned over 298.000 Ethereum which is almost $1bln. This translates to a burn rate of 5.05 Ethereum per minute. You can find these statistics on https://ultrasound.money/ .
We can already see the effects on inflation as the amount of Ether burned is over 50% of the amount of Ether rewarded to block producers in the same period. As long as the network grows we expect this number to decline due to the changes of EIP-1559 and EIP-3368. We expect the inflation to decrease even more over time and eventually even see deflation as we feel that the Ethereum ecosystem is only just beginning its massive expansion.
The bullish case for Ethereum
EIP-1559 has brought some significant improvements to the Ethereum network. Through the deflationary mechanism of burning a portion of the transaction fee, EIP-1559 adds scarcity to the network and improves the long term security. Furthermore, EIP-1559 ensures any stakeholder benefits indirectly from network usage as more traffic leads to more fees burned and thus scarcity. As Ethereum is expected to see a lot of growth in the coming years, this could turn out to be an incredibly bullish feature. This will be even more so once Ethereum 2.0 launches, leading to more Ether being staked and thus even more scarcity.