July 2021

EIP-1559 and Ethereum's Money Supply

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In early August, Ethereum is scheduled to undergo its “London upgrade”, one of the most significant Ethereum updates ever. Included in this upgrade is Ethereum Improvement Protocol 1559 (EIP-1559), which will change Ethereum’s fee mechanism. This amendment will include the burning of a portion of the network fee in each block, reducing the supply of ETH over time.

In early August, Ethereum is scheduled to undergo its “London upgrade”, one of the most significant Ethereum updates ever. Included in this upgrade is Ethereum Improvement Protocol 1559 (EIP-1559), which will change Ethereum’s fee mechanism. This amendment will include the burning of a portion of the network fee in each block, reducing the supply of ETH over time. Such a change has both technical and economic implications that are beneficial for the network and for Ether holders. This month we are going to dive into the mechanics of EIP-1559 from both a technical and economic perspective to evaluate how important this change is for the Ethereum ecosystem.

To understand the mechanics of EIP-1559, you first need to understand how gas fees work in Ethereum. Every transaction that takes place on Ethereum has a corresponding transaction fee. This fee is paid to the miners in return for their work in powering the network. Historically, Ethereum has priced transaction fees using an auction mechanism where users send transaction bids, known as “gas prices” and miners choose the transactions with the highest bids to be included in blocks. The transactions that get included in a block pay the bid specified and there is a fixed amount of space in each block.

This process suffers from several inefficiencies:

  • Extreme volatility of transaction fees: full blocks on Ethereum result in extreme pricing volatility. Users will sometimes pay 10x the amount in fees to be included in a block that is only 2% over capacity. A more efficient alternative is to just increase that block size by 2%.
  • User delays owing to fixed block sizes: currently there are fixed block sizes that mean that at peak times, users must wait several blocks to be included. The block size is arbitrary and adding some flexibility into the system would help address demand.
  • Auction inefficiencies: miners choose the highest paying transactions. Despite this fact, all participants pay what they bid, even if their transactions take significant time to be included in a block. This is highly inefficient for bidders who are not immediately included in blocks despite paying a high fee.
  • Poor user experience: users need to define their own gas-prices and fees to miners which can be confusing and adds friction to the process of using Ethereum.

EIP-1559 has been in the works for 2 years and was created to solve these challenges. The one-line summary of EIP-1559 is:

A transaction pricing mechanism that includes fixed-per-block network fee that is burned and dynamically expands/contracts block sizes to deal with transient congestion.

There is a lot to take in here (!), so let’s break it down into three parts.

Firstly, the EIP creates a “fixed-per-block network fee”, meaning that there will be a base fee amount in every block. This fee will be adjusted by the protocol dependent on how congested the network is; the more congested the network, the higher this base fee will be. Specifically, if blocks are filled above a set “gas target”, then the base fee will increase by a set level of 12.5% and vice versa.

The main benefit of constrained base fees is that Ethereum wallets can set gas fees for users in a reliable and predictable way. This will help with the user experience on Ethereum as users will not be required to adjust their gas fees, even in periods of high network activity, and transaction fees will become less volatile. Users will still be able to add a “priority fee” to their transactions if they choose to. This additional fee will compensate miners. However, it is assumed that most wallets will automatically decide on what fees users will pay, with users able to set maximum transaction fees.

The second part of the EIP is that the fixed fee will be burned, meaning that it is destroyed, and this ETH is removed from circulation. This is crucial from both a technical and economic perspective. From a technical perspective, this means that miners will primarily be compensated from the “block reward” which is the new issuance of ETH in each block. They will also receive the small priority fee that can be included in transactions. This removes the risks associated with miner extractable value (MEV). Today, miners can manipulate gas fees to extract more fees from users. They do this by artificially congesting the network. With this new ETH burn mechanism, the incentive for miners to do this disappears.

From an economic perspective, the burning of ETH has two benefits. Firstly, it removes ETH from circulation and counterbalances the new issuance of ETH in the block reward. While the amount of ETH burn depends on the number of transactions that occur, some analysts have estimated that we will see a declining supply of ETH going forward as more ETH will be burned than created. Reduced supply with stable or increasing demand for ETH will be positive for the price of ETH. The second benefit of the ETH burn is that it ensures that only ETH can ever be used to pay for transactions on Ethereum. There had previously been core developer discussions about allowing alternative ERC20 tokens to pay gas fees. EIP-1559 cements the long-term usage and economic value of ETH on Ethereum.

The third part of EIP-1559 is that it “dynamically expands/contracts block sizes to deal with transient congestion”. This means that in periods of extremely high usage, Ethereum blocks will increase in size to accommodate more transactions. One of the potential issues here is that larger blocks take longer for miners to process. However, over time it is believed that the average block size should remain about the same as without this EIP, and so the processing time risk should only exist in short term size bursts.

While there are many positives associated with EIP-1559, miners are not happy about the upgrade as it will cost them. It is estimated that miners will lose 20 – 30% of their income with the activation of EIP-1559 as most user fees will be burned rather than going to them. There have been petitions from mining entities to try to stop EIP-1559 from being included in the London upgrade. The one action that miners can take in protest is to shut down their mining machines and thereby decrease the security of the Ethereum network. However, despite the grumbling, it seems unlikely that miners will leave the network out of protest for two reasons. Firstly, halting mining operations will pause miner revenue and increase revenue to those miners that remain on the network. From a game theoretical perspective is seems unlikely than many (or any) miners will protest to the benefit of non-protesters. Secondly, proof of work miners know that they will lose all their revenue when Ethereum fully migrates to ETH2.0 and proof of stake. With limited proof of work mining time left, there is little incentive to stage a protest today.

The London upgrade that will include EIP-1559 has already been deployed on Ethereum testnets. With these tests going well so far, the current slated deployment on mainnet is 4th August 2021. At CMCC Global, we are excited about this London upgrade. Ether becoming a deflationary asset with increased scarcity will be a driver of value appreciation over time. Should this upgrade be a success, we think that this blueprint of fee burning may be adopted by other networks. We continue to hold ETH in our portfolios and are of the view that this upgrade, coupled with the larger ETH 2.0 upgrade taking place later this year, will drive further value to ETH holders.