A Guide to Ethereum’s EIP-1559 Upgrade

Contents

• Ethereum’s current gas fee model
• How does Ethereum determine transaction fees?
• What is Ethereum Improvement Proposal (EIP) 1559?
• How does EIP 1559 work
• Pros and cons of EIP 1559
• Conclusion

Introduction

Ethereum Improvement Proposal (EIP) 1559 is a much-anticipated upgrade to the Ethereum blockchain that will alter the way miners are incentivized and is tipped to make Ether (ETH), the native currency of the ecosystem, deflationary. The upgrade, which is expected to be bundled with the London hard fork in July, has induced mixed emotions – fear, excitement, and panic – among Ethereum’s stakeholders. Without a doubt, it is very important and also imminent. With the hardfork’s upgrades currently being tested on the smart contract network’s testnets, EIP 1559 will soon forever change the way Ethereum operates.

Ethereum miners have publicly voiced their displeasure at the upgrade while users and token holders are generally in favor as they stand to benefit from the implementation of EIP-1559. But, is the excitement of network users – who have endured high transaction fees – really justified, or is it a minor gain coming at the expense of disgruntled miners?

It is worth noting that as of late June 2021, Ethereum gas fees are at a 6-month low as the whole crypto market has begun to cool off in recent months and developers have migrated over to other cheaper and less congested options like Solana, Tron and Binance Smart Chain. 

Ethereum’s current gas fee model

It is necessary to understand the current transaction fee structure on Ethereum to have a better grasp of EIP-1559 and why it has been received with mixed reactions. 

Activities carried out on Ethereum, regardless of their nature, are considered to be transactions. These transactions are recorded on the blockchain, and anyone can view them. 

In contrast to Bitcoin, which is viewed more as a store of value, the Ethereum blockchain has been used as the bedrock to develop Dapps, as well as other crypto areas like decentralized finance (DeFi) and the non-fungible token (NFT) frenzy.

What is the purpose of Ethereum’s gas fees?

Each transaction on the Ethereum blockchain accrues in transaction fees called gas fees, measured in gwei. Gas fees have a dual purpose: 

1. to prevent the spamming of the network by nefarious actors
2. to reward miners for their efforts in maintaining the network by validating transactions.

How does Ethereum determine transaction fees?

Ethereum currently uses an auction system to determine transaction costs. Just like any auction system, there is no set cost, but the fee paid for each transaction depends on several factors, such as network usage. In times of high traffic, miners can easily charge high fees to settle transactions. 

High demand, high premium

As with physical assets, when the demand is high, the price of goods or services tends to go up. Unfortunately, transaction fees usually skyrocket, fueled by both miners and users. 

Users who want to have their transactions settled quickly could be prepared to pay a premium. The downside of it is that it could force prices to surge as everyone on the network competes to have their transaction confirmed as quickly as possible. 

The proponents of the upgrade are convinced that the need for EIP-1559 is necessitated by these sky-high transaction fees on the Ethereum network. The transaction fee rose to a high of more than $71 in May 2021. To put it in perspective, users paid less than $5 in early January, just four months earlier, to transact on the network. As a result, many users and developers moved over to other competitor networks like Solana, Matic, and Tron, especially to conduct stablecoin transactions.

What is Ethereum Improvement Proposal (EIP) 1559?

At its core, EIP-1559 is an Ethereum Improvement Protocol (EIP) set to overhaul Ethereum’s auction gas fee model and replace it with a model that splits transaction fees into base fees and tips. It also introduces a burn mechanism that turns ETH into a deflationary asset.

How does EIP 1559 work?

Source: Medium

The new transaction model has a mandatory fee, the base fee, and it is set by the algorithm based on network demand. The idea is to keep the network usage at 50% capacity, meaning that each validated block is half full. 

Changes in the block capacity would have a corresponding effect on gas fees. If the network usage increases above the 50% threshold, the base fee increases automatically. And if the network usage falls below 50%, the base fee would decrease.

This introduces a new predictable pricing model that relieves users of the burden of setting transaction fees. The duty would be assumed by wallet providers such as CoolWallet and miners will not pocket gas fees. After collection, the transaction fees are burned. This decreases the amount of Ether in circulation. Ether’s scarcity is predicted to propel the currency’s price in the future.

Tips also play an important role in transaction fees. The Ethereum network will allow network users to add tips on top of base fees as a way of asking miners to prioritize their transactions. Tips are kept by miners, unlike base fees that will be burned after collection. This will likely push miners to prioritize transactions that offer tips. Blocks would be about 50% full, making it easy for miners to accept tips and process prioritized transactions.

In times of lower network usage, a small tip would be enough for users to have their transactions prioritized by miners.

Pros and Cons of EIP-1559 for miners and users

The rise in transaction fees is a dagger in the pockets of ordinary network users, and a cash cow for Ethereum miners who are smiling all the way to the bank. Ethereum mining is a very lucrative business. Miners raked in $1.59 billion in April, and a month earlier, they generated $1.3 billion. A decent portion of miners’ revenue comes from transaction fees. It comes as no surprise that miners are not amused by the upgrade, which according to some estimates, would slash transaction fees by 90%.

On the flip side, some stakeholders stand to gain from the upgrade. DeFi projects will have to pay less for transactions on Ethereum, which could have run the risk of crumbling under the weight of its growth. 

Token holders are also excited at the prospects of Ether being a deflationary asset, just like Bitcoin. The asset’s value will likely increase in the future, and this alone is appealing to those who buy and hold Ether for speculative purposes.

Final thoughts on EIP-1559

The contentious EIP-1559 was proposed by Ethereum co-founder Vitalik Buterin in 2018. It is now set to make wholesale changes to Ethereum’s gas fee model, which could hit the pockets of miners very hard. A number of mining pools – Flexpool, Ethermine, and SparkPool among others – have all condemned the imminent upgrade.

However, some argue that the upgrade is necessary as Ethereum evolves into a more scalable blockchain network. But doing so at the expense of miners could raise questions of whose toes Ethereum will step on to meet its growth targets. The blockchain network is nowhere near where it wants to be, but a collection of hard forks and upgrades – including the successful launch of the Beacon Chain in December 2020 – will eventually push Ethereum to reach its final destination.

Until then, token holders and network users have a reason to smile.