Ethereum EIP Upgrade — Facts, Misconceptions, and Investment Implications
Ethereum is no doubt the most expensive blockchain to use in the world right now. Although taking the number 2 spot behind Bitcoin in market capitalisation, it takes a leading position as the most expensive blockchain in usage cost.
In June 2021 alone, users paid over $165 million in transaction fees to interact with the Ethereum blockchain. This is over 300% greater than Bitcoins’ $42 million+ transaction fees.
To address the ridiculous market fees paid by Ethereum users, it is expected to undergo a radical change known as Ethereum Improvement Proposal (EIP) 1559. Starting from this August, Ethereum users will no longer have to participate in the blind auction-like process of determining transaction fees.
What is EIP-1559?
EIP-1559 is a proposal to make Ethereum transactions more efficient by using a hybrid system of base fees and tips to more evenly incentivise miners in high and low network congestion periods.
With EIP-1559, the network will automatically calculate a base fee according to the current demand for block space. All users need to pay this base price to have their transactions processed. However, unlike before, the base transaction fee will be burned instead of going to the miners.
This will eliminate the practice whereby miners select which transactions to process first based on the bid price. However, users can still include an optional tip to speed up their transaction processing.
How EIP-1559 Works
Currently, Ethereum miners are rewarded for their computational power through a gas-bidding process that resembles an auction. EIP-1559 will replace this with a new transaction pricing mechanism that’s based on gas rates.
So, rather than users determining their gas price, Ethereum will introduce a base fee into its blockchain protocol. This base fee will be automatically calculated based on network activity.
The Base Fee
The base fee is the minimum gas price required to verify or process a transaction in the Ethereum Blockchain. This fee fluctuates based on how much space is being used by each block on Ethereum.
Although the maximum amount of gas on each Ethereum block is 15 million, EIP 1559 would allow a 2X increase during network congestion. When this happens, the base fee required to execute a transaction will increase by 12.5%.
On the other hand, if the number of transactions on the block is very low (way below 15 million), EIP 1559 would automatically reduce the base fee by 12.5%. This reduction will be made successively until it reaches a lower bound of almost zero.
It is important to note that users can only pay the base fee in ether (ETH).
Once the user pays the base fee, it is burned and permanently removed from the total circulation of ether. This is done to discourage miners from artificially congesting the networks to keep the base fee high.
This used to be a common practice among miners during the auction-like fee bidding process.
The inclusion fee is an optional fee that users can choose to pay in addition to the base fee. It can be regarded as a tip to encourage miners to handle their transactions above others.
This optional fee is intended only to be used by individuals and businesses that need the fastest network confirmation times.
Importance of the EIP-1559 Upgrade
One may wonder why there is a need to replace Ethereum’s auction-like fee system with the base fee. Here are a few reasons why it’s important to do so.
1. Regulation of ether supply
The supply of ether is unlimited, unlike Bitcoin that can only have a maximum of 21 million coins. Compared to bitcoin with only approx. 113% increase, the supply of ether has increased by over 351% since 2016. The economic impact of this is that ether holdings will become diluted over time as more of it is created.
With EIP 1559’s burning mechanism, coins will be automatically taken out of circulation after being issued. This will help decrease the active supply rate on Ethereum.
2. Prevents economic abstraction of ether
This upgrade ensures that all transaction fees are paid in ether. Although most of the transaction fees are currently paid in ether, there is no requirement preventing users from doing otherwise.
Although uncommon, miners can receive transaction fees in other currency as seen here.
With EIP-1559, the system automatically sets a base price that is paid by the user in ether. However, a miner may decide to receive a tip (inclusion fee) from the user outside the system to prioritise a transaction.
Similar to how nations make policies to increase the value of their currency, this upgrade with help increase the demand for ether and, by extension, its value.
3. Reduces the volatility of transaction fees
As seen over the years, average gas fees can get ridiculously high when left up to users. EIP-1559 can prevent this by ensuring that fees can only record a 1.125x increase or decrease on each block. This provides some form of stability in Ethereum’s ridiculously volatile market.
Misconceptions About the EIP-1559 Upgrade
1. Decrease in transaction fees
Contrary to what a lot of people believe, EIP 1559 will not help reduce the transaction fees on ETH. Rather, it will only provide transparency and stability to the base fee computation process. The upgrade still doesn’t change the fact that there’s a limit to the number of transactions that Ethereum can handle at a time.
2. Miner attrition and sabotage
Currently, Ethereum miners make about 50% of their revenue through transaction fees. But according to recent estimates, their revenue generation rate could reduce by 20 to 30%.
Some people believe that this may cause miners to quit mining on the blockchain. Therefore, if this happens and only a few miners are on the network, the network may become vulnerable to a 51% attack. However, this is very unlikely because it could mean that miners will have to sabotage their earnings on the network, which is a lot.
Investment Implications of EIP-1559
There are 3 main stakeholders on Ethereum that will be affected by the EIP upgrade, namely, investors, miners, and users. These stakeholders invest their time, money, and other resources to building the Ethereum ecosystem.
Here are a few ways this upgrade could affect them.
1. Technology risk
The activation of EIP-1559 could result in unforeseen bugs and malicious user behaviour. Although Ethereum adapts opensource audits to review security issues, this does not completely absolve it from vulnerabilities.
An example of such happened in January 2019 when ChainSecurity discovered a security vulnerability in EIP 1283 just 48 hours before its activation on the main Ethereum network. Such a dangerous occurrence could lead to huge monetary loss and affect investor’s confidence in Ethereum.
2. Decrease in revenue
Previously, miner revenue comes from 2 major sources, block rewards and transaction fees. With the burning mechanism introduced in EIP 1559, miners are left with block rewards and the optional inclusion fee.
Since the inclusion fee is optional, some users won’t pay it, and those who do may not pay enough to replace what was being earned on transaction fees. This means that miners may not make enough money to cover their computational costs. Even if it did, they likely wouldn’t make as much money as they used to.
3. Stability and predictability
One of the major impacts of EIP 1559 for users is the increased transparency into how Ethereum gas fees are determined. It prevents unnecessary wait time for users who underestimate how much gas fee is needed to perform a transaction and generally provides a great user experience.
4. Economic value
By regulating the supply of ether and increasing its demand through base fees payments in ether, we may record an upward movement of ETH’s price. It is expected that the EIP upgrade will push the value of ether towards an increase.
The major goal of the EIP 1559 upgrade is to reduce volatility and provide transparency into how Ethereum gas fees are determined.
The main beneficiaries of this upgrade are users who no longer have to pay ridiculous gas fees to have their transactions processed on the Ethereum blockchain. This is expected to increase the adoption of the decentralised apps built on Ethereum.
Also, ensuring that the base price is paid with ether and introducing the burning mechanism will help increase the economic value of ether. This is a win for investors because their assets will soar higher in value.
On the other hand, Miners may not find this upgrade pleasing because it largely affects their revenue. Hence, creating an unsettling possibility of a 51% attack.
However, if Ethereum can significantly increase its economic value due to the burning mechanism and increasing ether demand, the miners will be well compensated.