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Ethereum’s EIP 1559 - what is it and will much change?

source-logo  bravenewcoin.com 15 April 2021 04:01, UTC

Market optimism around the soon-to-be-implemented Ethereum Improvement Proposal, EIP1559, is high. The Ethereum EIP will arrive as a part of the London network Hard Fork in July and will overhaul the network’s much-maligned fee structure.

Excitement about the upgrade has been a factor in Ethereum’s ongoing price bull, with the ETH price rising by ~65% since the EIP1559 implementation was first confirmed on March 5th. *The Ethereum price is up 65% since the confirmation of EIP 1559*

At the time of writing ETH trades for ~US$2437. The price crossed US$2300 for the first time on April 13th and continues to push to new all-time-highs. Traders are also positive about the prospects of ETH in the near future. The price of Ethereum Futures with a June 25th expiry trade for ~US$2518 on FTX and for ~US$2523 on Binance.

What is EIP 1559?

EIP1559 was first proposed by Vitalik Buterin in 2018. It will replace the variable first-price auction model currently used to decide Ethereum transaction fees with a more deterministic base fee model. It is hoped this will remove much of the volatility and uncertainty associated with paying Gas, the fee required to successfully conduct a transaction on the network.

It will also introduce a fee burn model for each transaction, that may add a deflationary element to the ETH currency and increase its appeal as a safe-haven, hard asset.

The current Ethereum gas model is a simple auction model called a ‘first-price’ auction. In this model, transactors submit gas prices they are willing to pay for a transaction and compete with each other for space on the Ethereum block. Miners monitor these bids and filter them by who is willing to pay the highest gas price to maximize profits.

Users have to place higher and higher gas bids during times of network congestion & popularity in order to get included into blocks by miners. Bidding too low potentially means a transaction failing and the gas bid being wasted.

This system is inefficient, lacks transparency, and results in network users overpaying for transactions. Since December 2020 the price of gas has been rising in US dollar and ETH terms. This is because of an increase in demand to transact on the Ethereum blockchain and the network not being able to scale efficiently with the current model.*The price of gas in Ether/Gwei. Source: Etherscan.io*

*The price of gas in US dollar terms. Source Coinmetrics*

# The EIP 1559 solution

The implementation of EIP1559 will solve four key problems with this current gas model:

* Making transaction fees more predictable

* Reducing delays in transaction confirmation

* Improving user experience by automating the fee bidding system

* Creating a positive feedback loop between network activity and the ETH supply.

The new fee model suggested by Buterin takes a hybrid approach to gas payments. It maintains elements of the first-price auction model but adjusts operations to create more certainty around gas payments.

EIP1559 introduces a base fee to Ethereum transactions. The base fee will represent the minimum fee that will have to be paid for a transaction to be included in a block. The base fee will be set per block and will become cheaper or more expensive depending on how congested Ethereum is. EIP1559 will also have a mechanism to increase network capacity based on congestion. The max gas limit per block on Ethereum will be upped from 12.5M to 25M gas, meaning ETH’s block size will essentially be doubled.

The proposal for the upgrade states it aims to keep Ethereum close to a 50% utilization rate. If network usage exceeds 50% capacity, the base fee automatically increases. If network usage falls below 50% capacity, the base fee decreases. This model is designed to soothe out spikes in gas fees and congestion. The larger block size limits and mechanisms for fees to adjust towards a 50% capacity level essentially swap out the current high volatility in gas fees with volatility in block size.

# Ethereum mining profits will likely fall

With the new fee model, transactors can also add a miner tip, on top of the base fee, as a separate fee that can be offered to miners to incentivize them to prioritize a transaction. This mechanism is similar to the Buterin model, where paying more means your transaction gets confirmed faster.

Because there is a possibility that Ethereum miners could collude to fix the base fee in their favor, the entire base fee for each transaction will be burnt. The miner tips and block rewards will still be received by the miner.

The new gas model will also come with a fee cap option that will allow users to limit how much they want to pay for a particular transaction - instead of paying the current base fee. A user who sets a fee cap that is lower than the current base fee will then have to wait until the base fee is lower than the fee cap for their transaction to be included in a block.

Likely losers of the EIP1559 implementation are miners. The new gas rules mean they will soon be earning less profit from verifying transactions. When congestion was high on the Ethereum blockchain miners were raking in profits. There were times when fees to miners were even higher than block rewards because of the highest bidder wins fee system.

With the new fee system, miners are going to earn a block reward and the miner tip, losing out on the base fee, whereas in the previous gas system they earned the entire transaction fee. The new model is taking fees that would have previously been revenue for miners and burning it. It’s therefore no surprise that many miners have spoken out against the update.

The fee burning mechanism has also raised concerns amongst ETH holders because it may lead to ETH becoming a deflationary asset. This would happen if the amount of base fee generated and then burnt, is higher than the new ETH created as block rewards. This could occur if Ethereum is constantly congested and base fees are consistently high.

A consequence of this mechanism is that Ethereum’s monetary policy becomes muddled and will become deflationary or inflationary based on a variable metric, network congestion.

Conclusion

The major impact of EIP1559 will be simplifying the user experience on Ethereum wallets. Currently, when using wallets like MetaMask, users need to choose between slow (cheap), medium, and fast (expensive) confirmation times or specify a gas price manually. Presently, MetaMask needs to estimate what constitutes an appropriate gas fee for each of these confirmation times. With EIP1559, wallets won’t have to estimate gas fees as they will be based on base fees automatically determined based on information in the previous block. This should simplify wallet interactions and take away much of the guesswork around gas payments on Ethereum.

The new EIP is a major transition, however, it is unlikely to significantly reduce gas prices. This is more likely to come with the expansion of Layer 2 solutions and Ethereum 2.0. The network upgrade will smooth out random fee spikes, create certainty over gas fees being paid and prevent users from overpaying for computational resources on ETH.

bravenewcoin.com