Ethereum Upgrade – EIP 1559

Introduction

Decentralized technology has made great strides in the last decade, slowly gaining wider acceptance in the global consciousness. A big challenge remains in the growth of this sector, the process of staging upgrades. In a centralized company, the decisions are taken by the team internally, and the general public does not have a say in the growth and direction of said company. However, this hurts a decentralized protocol like Ethereum as millions of people are running Ethereum nodes and developing on the network which these changes would significantly impact.

Ethereum Improvement Proposals or EIPs are a great tool to grow and improve the protocol in a decentralized manner. “Ethereum Improvement Proposals (EIPs) are standards specifying potential new features or processes for Ethereum. EIPs contain the technical specifications for the proposed changes and act as the source of truth for the community.”

How does an EIP work?

Any user can submit an EIP by creating a pull request to Ethereum’s EIP Github repository, and highlighting the core changes and the intended effect in a standard predetermined format. Once an EIP is proposed, it goes through a series of iterations and changes proposed by the members of the Ethereum community. It is then reviewed and the core Ethereum developers encode an EIP into the new version of the Ethereum client as part of a future hard fork.

Generally speaking, this process allows for members within the community to contribute to the growth of the protocol, hence allowing for a change in a truly decentralized manner. 

However, certain EIPs are disputed after getting approval. One such case is EIP-1559, one of the most controversial EIPs ever introduced. It was heavily contested by the Ethereum miner community. 

Current State of Ethereum 

Before exploring the improvements planned for the Ethereum network, we must first understand the current state of affairs when it comes to a few important features of the Ethereum network, such as volatility of gas fees, its auction mechanism as well as the transaction fees eclipsing block rewards.

Gas Auction Mechanism

A block has a limited amount of space in it. This cap is decided on the protocol level. Blockchains with bigger blocks can accommodate more transactions, but the cost of running and maintaining the blockchain grows significantly, which requires more sophisticated equipment that in turn hurts the level of decentralization of the network. Due to limited block sizes and a network that supports only 15 transactions every second, the Ethereum network tends to get very congested. To get the valuable real estate of the blocks on the Ethereum network, participants in the network need to incentivize miners to include their transactions in a block. 

Each transaction (operation on the Ethereum network) requires a “gas” fee to be paid to ensure that the miners are compensated for the computational effort they put into verifying these transactions. Since the exact amount of gas required differs from time to time based on the amount of transactions taking place and the number of miners available, each transaction is given a “gas limit” stating how much the sender is willing to spend on the transaction being processed.

This mechanism allows miners to reject transactions that have a gas limit below what is necessary to complete the transaction and process those that have been allotted enough. 

Ethereum follows a “First price” auction mechanism wherein each sender enters a bid of the amount of gas that they are willing to pay for a transaction, and miners pick transactions that are desirable to be entered into the next block. Since there is not much transparency as to how much other users are paying in the form of gas per transaction, the sender often ends up paying more than what is necessary. A lot of this is considered a side-effect of the unpredictable nature of the gas fees on Ethereum.

Volatility of Gas Fees

The volatility in gas fees creates a bad user experience, and transactions sometimes get stuck for multiple hours and sometimes even days, especially at times when the network is congested. On the 1st of September 2020, Ethereum miners ended up earning over $500,000 USD in just one hour, which was an all-time high as far as gas fees were concerned. While this meant that miners earned handsomely for their efforts, it also meant that users had to pay ridiculously high fees for their transactions, which led to longer wait times, congestion on the network, and an increased number of unconfirmed transactions. During this month in 2020, for the first time, miners earned more from transactions (gas) fees at $172 million in comparison to the $150 million they earned from block rewards. 

A blockchain that relies primarily on transaction fees and not block rewards leads to instability in the market and incentivizes the creation of “sister blocks” and opens the network up to other mining attacks. With only transaction fees, the variance of the block reward is very high due to the variable transaction fees in a given block, and it becomes attractive to fork a “wealthy” block to “steal” the rewards therein. This not only raised concerns about the stability, and scalability of the network but also became a potential obstacle to the DeFi boom which was putting more transactions on the network than ever before. 

Here’s a look at the average transaction fees on Ethereum over the last year, expressed in USD

(Source: Ycharts; Ethereum Average Transaction Fee)

What is EIP 1559?

EIP-1559 would replace the auction system of the gas price with a new transaction price mechanism based on gas rates. This would introduce a concept of base fee – a dynamic rate of conversion from gas to gwei – into the Ethereum protocol, which would vary according to the activity on the network. 

EIP-1559 introduced three new changes to Ethereum in order to combat these problems –

  1. The gas limit will be increased to 15M gas from 30M gas. The size of blocks will be adjusted dynamically based on the utilization of the network, and allow block sizes to float from 0M to 30M gas without any disruption or lag. The gas limit pre-EIP-1559 will serve as the target block size. The target block size will serve as the equilibrium point that the network wants to maintain. If block sizes are below the target block size, the network is underutilized, and the base fees are decreased. Similarly, if the network is congested, the block size will be higher than the target block size, and the base fees will be increased.
  2. The structure of the transaction fees will be changed and will include two components, a base fee, and a tip (optional). The base fees will be calculated based on the gas cost of the previous block and the target block size, as explained later
  3. The base fees collected every block will be burnt, and the tip fees (optional) will be awarded to the miners, to incentivize the miners for including a particular transaction in a given block.

Impact of EIP 1559

EIP-1559 will make Ethereum’s fee market more efficient and improve the user experience. It will help in having supply pressure, gas price stability, and optimized block sizes. EIP-1559 makes Ethereum & web3.0 more usable and frictionless. Here are a few reasons why:

Simpler Gas Fee Estimation 

Most interactions on any web3.0 application are transactions. And every transaction involves paying a gas fee. Thus, the gas fee experience is a major factor for the whole web3.0 experience. And currently, the gas fee experience is frustrating and painful. The crux of the problem is that gas fee estimation is really hard. Users need to constantly predict the gas fees, set it on their wallets, and hope the transaction goes through. Many of them end up failing altogether but still cost valuable ETH. And if the transaction is successful, the user may end up overpaying for gas. 

EIP-1559’s pièce de résistance is it’s easier gas fee estimation. Users no longer need to constantly estimate their gas fees. And suffer from pending & failed transactions. Post EIP-1559, the user simply needs to set the maximum they are willing to pay for a transaction. And they can be reliably certain that their transaction will go through. They can also be assured that they won’t overpay for gas. This improved mechanism will make the gas fee experience far less daunting for crypto newbies as well.

Moreover, DApps & wallets can also provide a better transaction experience to their users by being able to easily estimate the gas price to recommend to the user. 

Faster Transaction Time

From the point of view of the user, everything from clicking the ‘submit transaction’ to getting the confirmation counts as ‘transaction time’. One factor is of course the TPS (transaction per second) of the Ethereum network. But the other contributing factor is the time taken for the transaction to get included in the next block. Currently, if the gas price estimate is low, a ton of transactions stay pending for a long time. This is really frustrating, especially for new crypto users, who have no idea why this is happening. To them, Ethereum transactions take painfully long and are a terrible experience. 

While EIP-1559 won’t affect the TPS, it will make it easier and faster to get your transaction included in the next block. As mentioned above, the user can easily estimate the max gas they need to pay to be certain their transactions will go through. The DApp, or relayer networks such as Biconomy, can also perform the gas estimation for the user more reliably and ensure all transactions are included in the next block. 

Moreover, post EIP-1559 blocks will be kept half full on average. This is to ensure that during higher congested periods, blocks can effectively double their capacity. Thus, there would be a lower number of pending transactions as they would get included even in times of high traffic. And in theory, even if a transaction is pending, it will eventually go through quickly. Both these points will over time ensure faster successful transactions that will improve the UX.

Eliminate Overpaying for Gas

While EIP-1559 isn’t designed specifically to reduce gas costs, it will definitely ensure users don’t overpay for gas. Currently, during periods when blocks are full and the network is clogged, users may end up paying very high gas prices to get their transactions in the next block. Moreover, as discussed, gas prices are currently hard to estimate during highly congested times. Thus, a user may overestimate by a huge margin in fear of a failed transaction. And end up paying way more for gas than what was required.

Post EIP-1559, even if you overestimate by an enormous margin, you will only pay the fee required to get included in the block. The difference will be refunded back to you! Thus, if the user sets the max acceptable gas as 500 gwei and their transaction gets included in a block with a base fee of 10 gwei, they will only pay 10 gwei. Currently, if they estimate as 500 gwei and the transaction could have been included at 10 gwei, they would still pay the full 500 gwei. Thus, users will never overpay for gas. They can set a high gas estimate to ensure a quick transaction while being relaxed that they won’t be penalized for over-estimation and still just pay the base fee + miner’s tip.

Lower Issuance

To combat the instability of blockchains with transaction fees greater than issuance, the base fees are burnt. Even though miner revenue is greatly decreased, it is necessary for the long term to combat the issues of forking and creating sister blocks. This is also one of the strongest changes to the tokenomics of Ethereum. The burning mechanism removes ETH from the circulating supply and the value flows back to the Ethereum holders.

Economic Analysis

Let us analyze the changes in the token model of ETH post-EIP-1559 – 

Before EIP-1559After EIP-1559
ETH paid by the users goes to miners. Additionally, miners earn the block reward and uncle rewardsGas fee comprises base fee + tip. The tip flows to the miners but the base fee burns ETH
ETH once minted stays in circulationA portion of ETH supply is burnt depending upon the network congestion
ETH is an inflationary assetETH is potentially deflationary

Base fee will vary in accordance with the utilization of the block that is being generated. Each block will have the capacity to incorporate 15 million gas. In times of high volume, this can increase up to a maximum of 30 million gas. The base fee formula depends on the utilization of the network and the fee of the previous block. 

We can clearly see that even if the network is being utilized at a hundred percent, i.e. all the blocks are at full capacity ( previous-block-size = 2 * target-block-size), the max change in base fees with each block will only be 12.5%. This improves user experience as the transaction fees can be reliably predicted, and a user can provide the right amount of gas for a given transaction. Pre EIP-1559, the gas fees would have rocketed suddenly, and user transactions with insufficient gas fees would have been stuck for a few hours/days.

Despite adding the base fee and tip parameters, the new transactions are still backward compatible and will work with the legacy transaction functions.

Will ETH Become Deflationary?

The fact of the matter is that no one can predict whether ETH supply will deflate, but we can take estimates. We get a deflationary asset when burning outgrows the minting of the asset. Let’s dive into both these mechanisms: 

Minting

We are currently minting 13,600 ETH daily from block rewards to miners. These figures are unlikely to change after EIP-1599.

Burning

As the base fee is burned, the amount of ETH burned is highly dependent on the network congestion or rather block utilization of ETH.

So the questions remain – How much can we truly burn? Would it be enough to make it deflationary? The two primary variables to calculate the burn are Network transaction fees and Base to total fee ratio.

While we can estimate the network tx fees based on historical data, the base fee to total fee ratio is anyone’s guess until EIP-1559 goes live and generates substantial data. As of the time of writing this article, Ethereum network participants are spending 3k ETH daily on gas.

If we assume daily transactions to be around 3k/day and the base fee to be 40% of the total transaction fee then 40% of 3k = 1.2k ETH will be burned daily. While this is indeed a high amount, it is nowhere close to the ETH supply that is minted on block rewards. Hence, it is unlikely that ETH will be deflationary as more ETH can be minted than burned. Further, in the event that the network is extremely burdened for a long period of time, and the base fees are extremely high, users are economically incentivized to wait for the network to cool down.

Moreover, as Ethereum scaling solutions have started to gain traction, we anticipate activity to move towards the scaling solutions while the protocols derive security from Ethereum and maintain regular checkpoints. We witnessed a similar decline in network congestion and transaction fee as Polygon started gaining traction as a sidechain.

Can ETH 2.0 change the game?

As we have established the unlikely scenario that ETH will deflate post-EIP-1559 because of PoW (Proof of Work) rewards outpacing the burning of the base fee, the scenario will definitely be different as Ethereum transitions to a PoS (Proof of Stake) consensus with the merge of Beacon chain and Ethereum mainnet that is scheduled in 2022.

Monthly Net Issuance – Projections

PoS rewards, unlike PoW, are lesser and hence, have limited inflationary pressure on ETH. As shown by the beacon chain staking rewards page, ETH 2.0 is estimated to generate ~1.3k ETH daily. If the total transaction fees remain the same as the current system, then we can expect very low inflation and even deflation on ETH!

ETH 2.0 Staking APR Projections

Conclusion

The EIP-1559 Upgrade is likely to go live on 4th August 2021 between 13:00 UTC and 17:00 UTC, with block 12,965,000. The base fee mechanism hints at the protocol’s direction in trying to take some of the power away from the miners. The EIP-1559 update is paving the way for future progress regardless of whether it turns out to be bullish or bearish for the price in the short term. Ethereum continues to be the most talked about blockchain among its peers and with the recent London Upgrade and ETH 2.0 also under the works, it is likely to be the undisputed Layer 1 blockchain in the near future.

Acknowledgments:

Thank you Aniket and Aditya from Biconomy for their inputs and for co-writing this article.

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