What is EIP-1559 and why is it so important for Ethereum

Ethereum has dominated the crypto industry in its short six-year history. While Bitcoin has made headlines due to spectacular rises and falls, Ethereum has cemented itself as the blockchain of choice for developers to build applications.

However, with that dominance came numerous challenges. First and foremost is transaction time. Although it is faster than Bitcoin’s ‘slow’ 3 to 5 transactions per second, Ethereum’s capacity currently can handle 10 to 15 transactions per second. The popularity of Ethereum has resulted in the gas amount paid per transaction (the fee that goes to miners for including the transaction in a block) skyrocketing during times of increased demand. In January of this year, transaction fees were at one point, even $500. For miners, Ethereum has become a literal gold mine.

In May, mining revenues on Ethereum reached $2.35 billion and remained high. While this is good news for miners, it has forced a number of smaller projects that needed low transaction fees to seek alternative blockchain systems to reduce costs for users. EIP-1559, as it is called, will help improve the user experience around sending transactions via Ethereum and increase the scarcity of Ether, effectively making the second most valuable cryptocurrency scarcer and theoretically more valuable.

What is an Ethereum Improvement Proposal (EIP)?

Ethereum’s evolution is largely determined by proposals put forth by the community that maintains the network. These are collectively referred to as Ethereum Improvement Proposals in literal translation and usually involve a developer or group of developers proposing changes to the network that are then reviewed and discussed by the core developers who manage Ethereum’s code repository on GitHub, a code storage platform.

If the improvement is accepted, it is usually packaged with other improvements in broader network upgrades known as hard forks. The previous hard fork was named after the city of Berlin and included numerous security enhancements and new types of transactions. EIP-1559, first proposed by Vitalik Buterin and a group of core developers in April 2019, was added to the hard fork that took place yesterday under the name London hard fork.

What is EIP-1559?

The EIP-1559 proposal is designed to make transactions on Ethereum more efficient. Currently, Ethereum has an auction system that determines which transactions are included in which blocks.

The more a user is willing to pay, the more likely a miner is to include the transaction. The busier the network, the higher the fee, which means users must take network congestion into account when trying to estimate the total costs of sending transactions.

By transitioning to EIP-1559, this system will be replaced with a fee structure that the network automatically prices. Additionally, a system of so-called tips would be introduced to allow individuals who want their transactions to be verified faster to pay a miner to do so.

Burning Ether

Although the EIP-1559 proposal is designed to help reduce transaction costs, its design is created in such a way that it burns/destroys a certain portion of each transaction. This is because the base fee for transactions that the user pays for performing transactions, instead of going to the miner, is effectively ‘burned’, reducing the amount of supply.

Markets are excited about this prospect as ultimately removing a certain amount of Ether from circulation could create supply pressure since the amount of new Ether entering circulation is limited (currently at 2 Ether per block). Similar to how Bitcoin halving, which occurs every four years, reduces the amount of new Bitcoin entering circulation.

The reduction in the supply of Ether thus places deflationary pressure on the Ethereum network. While new amounts are still being created with each block added to the chain, a certain amount of Ether is also disappearing. The deflationary pressure theoretically pushes prices upward as the growth of supply slows, and if demand continues to rise.

Crypto investor Nikhil Shamapant wrote that there is too much supply shock to be factored into investors’ price expectations. In April, when the price was near current levels, he calculated that the selling pressure would fall by about 30 percent with EIP-1559, meaning there would be much less Ether available for purchase in the markets. He referred to the combination of EIP-1559 and the upcoming transition to proof-of-stake (POS)/Ethereum 2.0 as a ‘triple halving’, as it would reduce selling pressure by about 90 percent, equivalent to three Bitcoin halvings.

Core Benefits of EIP-1559

1. Better estimation of transaction fees

2. Creates a symbiotic relationship between Ether, the Ethereum network, and its users

3. Enables more reliable inclusion of transactions

What EIP-1559 does not do

1. Does not lower fee prices in the long term

2. Does not make Ether automatically deflationary by default

First, EIP-1559 does not make transactions on the network cheaper in the long term. Fee prices vary based on the demand for submitting transactions relative to the supply of available block space. This EIP only helps smooth out fee prices, allowing block size to increase slightly during sudden spikes in demand. It does not increase the scalability of the chain and therefore is not a solution that will lower fee prices in the long term.

Second, while a certain amount of Ether is burned for each transaction, this does not necessarily mean that enough will be burned to offset the current issuance rate. For this to happen, a base fee of 150 gweia (a unit of measure for fees) would need to be maintained to offset the current issuance of Ether on the proof-of-work system (POW), and to compensate for current issuance on the future proof-of-stake system (POS), a base fee of 20 gweia would be required.

Current Fee Auction

Currently, Ethereum uses a first-price auction for transactions, meaning that users bidding the highest prices are the ones most likely to have their transactions executed. However, the biggest problem with this model is that fee prices can wildly fluctuate due to sudden increases in demand for limited block space on Ethereum. Users often have to gamble when sending a transaction and frequently overpay to ensure their transactions are included. Overall, EIP-1559 aims to provide a better user experience by changing the way transaction fees are estimated and how the network handles spikes in usage.

Important Changes Made by EIP-1559

1. Base Fee, Priority Fee, and Max Fee
2. Variable Block Size
3. Burning of Base Fee

Base Fee, Priority Fee, and Max Fee

The base fee is the minimum fee price required for a transaction to be included in a block. It is set by the protocol and is variable, part of the block header, and part of the total fee that is burned. The priority fee (tip) is the price that the user is willing to give to the miner for processing the transaction. It is set by the user, is part of the transaction, and is paid to miners. Max Fee is the highest total fee price that the user is willing to pay for a transaction. It is set by the user and is part of the transaction. 

As a result, users will have much greater certainty when sending a transaction as they only need to ensure they include enough to pay the base fee and a small priority fee for their transaction to be included. The user does not have to worry about overbidding fee prices as the remainder is refunded to them, not paid to the miner. By creating a new type of transaction, wallets and other service/infrastructure providers will need to upgrade to support it.

Variable Block Size

Currently, Ethereum has a fee cap that covers all blocks at 15 million gas. The cap can be thought of as the block size in Ethereum that limits the number of transactions that can fit into a single block. Currently, whenever there is a spike in demand, fee prices dramatically rise as blocks are always full and limited to a certain size.

EIP-1559 makes it so that the block size can temporarily increase to accommodate a sudden influx of demand. Variable block sizes smooth out fee prices by allowing the protocol to temporarily increase the available block space. This results in easier fee price increases between blocks in the short term.

Burning of Base Fee

While miners are given a priority fee, the base fee is burned and removed from circulation. The primary reason for this is that if the base fee were paid to miners, they would be incentivized to hold it as much as possible to maximize profit (and they could also spam the network with high transaction fees that could later be compensated if they mine a block).

By burning the base fee, it ensures that miners are indifferent to it. With EIP-1559, a small amount of Ether must be included as a base fee for the network for the transaction to be accepted as valid, thus creating a healthier relationship between Ether as an asset/token and the Ethereum network.

Conclusion

EIP-1559 is set to greatly improve the user experience on Ethereum for processing transactions. Of course, most people like to focus on the aspect of burning fees and removing a certain amount from circulation, but the overall benefits of EIP-1559 far outweigh the burning of fees and will have a positive impact on end users.

{embed_digitalno_izdanje}{/embed_digitalno_izdanje}