The Ultimate Guide to EIP-1559

What is EIP-1559? A guide on how EIP-1559 will change the Ethereum landscape forever

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Hey DEFI TIMES community,

Let's burn some ETH!

Ethereum currently has no supply cap like Bitcoin. In fact, Ethereum will theoretically be inflated to infinity if we don't change anything.

Luckily Ethereum developers have figured out a way to avoid this. The answer is: EIP-1559!

EIP-1559 is an Ethereum improvement proposal that Eric Conner and Vitalk Buterin co-authored.

The message is clear: we need a way to make Ether… hard money!

To this day, ETH is far away from becoming hard money. But that will change in July. A few weeks ago, Ethereum core-devs reached a consensus that EIP-1559 will go live with the London hard fork in July 2021.

In my opinion, EIP-1559 will change the Ethereum landscape forever! It will make ETH scarce again. It could reduce the inflation rate to an absolute minimum…

…or even make it negative?!

This article is a guide for you to understand the fundamental concepts of EIP-1559.

Let's dive into it!


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EIP-1559 Will Change the Ethereum Ecosystem Forever

The Problems

Currently, we determine gas fees based on an auction mechanism. This is highly inefficient because users find it challenging to know what other participants will bid. That's why most users are overpaying for every single Ethereum transaction.

This problem has been present since day one. Eric Conner, the co-creator of EIP-1559, explains it like this:

[...] the current fee system stems primarily from Ethereum's attempt to price fees using a simple auction mechanism. Known as a first price auction, this system works by having everyone submit their bid (gas price) for how much they're willing to pay to have their transaction picked up by a miner. Usually, miners select transactions ranked by the highest fees which results in many users grossly overpaying. Had they known what others were bidding, they could avoid making bids that were much higher than necessary. In many cases, we can see a large divergence of transaction fees paid by different users in a single block, suggesting that many users often overpay by more than 5x.

Miners usually pick the transactions with the highest gas fees, so participants have incentives to overbid each other, resulting in an everlasting upwards trend in gas prices. 

The problem gets even worse when front-running bots come into play. Whenever there is an arbitrage opportunity, and someone makes a transaction to take advantage of it, front-running bots do the same transaction with a higher gas fee. These bots have the sole purpose of outbidding any transaction to exploit arbitrage opportunities. As long as the profits are higher than the gas fees, they will make money.

This concept leads to front-running bots over-bidding each other - ultimately driving gas prices higher and higher.

There are many reasons why the current auction mechanism is inefficient.

Another problem Ethereum is facing is that Ether has no supply cap. Theoretically, Ether will be inflated to infinity and beyond; however, inflation is essential to secure the network. Without inflation, only the transaction fees incentivize miners/stakers to participate in establishing consensus.

We need a way to counteract inflation while also keeping the network secure.

...and that's where EIP-1559 comes in!

EIP-1559 - The Holy Grail?

By implementing EIP-1559, we essentially:

  •  vastly improve the Ethereum UX by implementing a universal gas fee

  •  establish a deflationary environment while also keeping the network secure

Let's go through each of them!

Efficient Gas Fee Estimation

EIP-1559 introduces a BASEFEE, which is the market price for transaction inclusion. If you send a transaction with BASEFEE, your transaction is almost guaranteed to be included in the next block.

Of course, this BASEFEE is variable and will change based on whether blocks are congested or not. If Ethereum is utilized more than 50%, the BASEFEE will increase. If it is utilized less than 50%, the BASEFEE will decrease.

The BASEFEE makes the current auction mechanism obsolete. Users don't need to guess what other participants are doing!

The BASEFEE guarantees block inclusion. Period. No auction necessary. The BASEFEE is also an on-chain oracle for gas prices. Before EIP-1559, we never had a native way to precisely determine gas prices on-chain. We had websites like ETH Gas Station; however, these are just third-party estimations, and tools like this cannot show whether users are overpaying.

By paying the BASEFEE, users will never overpay. The transaction will be included in the next block. Even when demand suddenly spikes, users will still be able to get their transactions through.

Variable Block Gas Limits

EIP-1559 introduces variable block gas limits, which means that when demand unexpectedly rises, the block gas limit increases while gas prices stay constant. In plain words: blocks become bigger and allow more transactions/computation to be included. By introducing flexible block gas limits, we ensure that the BASEFEE is predictable. After the gas limits increases, the next BASEFEE will rise. That's how EIP-1559 deals with short-term demand fluctuations to make gas fees predictable and stable.

However, there is one scenario we didn't think about: What happens during extreme volatility conditions or Black Swan Events like March 2020?

The block gas limit can only increase to a certain threshold. What happens when this threshold is reached? What will happen when Ethereum is massively congested?

In times of extreme market conditions, we need another way to regulate block inclusion. That's where the tip comes into play.

Gas Fee = BASEFEE + Tip

The tip is a way to prioritize your transaction. When Ethereum experiences heavy traffic, txs with the highest tip will go through quicker.

All in all, EIP-1559 will result in predictable gas fees during normal market conditions; however, during extreme market conditions, the gas fees will predominantly be determined by the tip resulting in the auction mechanism we have today.

Let's Burn Some ETH!

Okay, EIP-1559 will significantly improve UX during normal market conditions. But how does it solve the inflation problem? To recap: we need a way to counteract inflation; otherwise, ETH will inflate to infinity.

The solution: EIP-1559 will burn the BASEFEE.

Ethereum secures the network with inflation, while Bitcoin depends on transaction fees. By burning the BASEFEE, Ethereum can keep inflating ETH for security reasons without sacrificing the currency's scarcity. As long as the burned BASEFEEs equal the amount of issuance, there is no inflation.

That's how Ethereum plans to build a secure and sustainable security mechanism. 

Besides, burning the BASEFEE has positive externalities. The BASEFEE can only be paid in Ether, strengthening ETH's money status. Whenever you make a transaction, you need to hold ETH.

David Hoffman describes it in his famous piece about EIP-1559:

[...]It also 'locks-in' Ether as the native currency of Ethereum, as it should be. No other currency on Ethereum can be used to pay for transactions. This is comparable to a nation-state demanding that only their native currency be legal tender.

EIP-1559: Ethereum's Taxation System

There is no way to pay your taxes in another currency other than the one accepted in your country. You cannot pay taxes in Euro if you are based in the US. 

Similarly, you have to pay transaction fees in ETH. ETH is legal tender in the Ethereum nation-state.

EIP-1559 will ensure that you pay taxes in ETH. And burning the BASEFEE is essentially a tax. By burning the fees, every single ETH holder benefits. It adds to the scarcity of ETH, ultimately making ETH more valuable.

Governments use taxes to provide goods and services for their citizens, which should positively impact society. Ethereum doesn't use the BASEFEE to produce goods and services; there is no way to do so. Instead, we have found another way to impact society positively: By burning the BASEFEE, Ethereum's legal tender becomes more valuable. Because every Ethereum citizen holds ETH, the Ethereum society profits immensely in the long run - EIP-1559 is Ethereum's taxation system.

How Will Miners Pay Their Bills?

Miners need to find another way to pay their bills. Now that most of the transaction fee is burned, how are miners compensated for securing the network?

Miner Revenue = Inflation Rewards + Tip

Miners will still receive freshly minted ETH and the Tip. This won't change when we finally switch to Proof of Stake. In that case, validators will receive inflation rewards and Tips.

But will the Tips even be relevant? I explained earlier that the BASEFEE ensures transactions will be included in the next block. Why should people even pay a tip when the BASEFEE is sufficient?

That's a major problem for miners/validators because most transaction fees will fall away - and currently, tx costs make up almost 50% of the miner revenue.

The question is: are transaction fees relevant for the security of the network? Or is the inflation reward sufficient?

The Ethereum community decided that the inflation reward is enough - and it is! In early 2020, transaction fees were negligible for miners. Just as DeFi summer occurred, transaction fees became noticeable.

With EIP-1559, we decided that these transaction fees are better used to make ETH more scarce.

ETH Is Hard Money

If I had to describe EIP-1559 in a single sentence, it would be this: 

EIP-1559 makes ETH the hardest money on earth.

As long as transaction fees exceed issuance, Ether will decrease in supply.

Transaction Fees > ETH Issuance → Deflation

ETH will be harder money than Bitcoin. Bitcoin's supply is hardcoded, never to exceed 21 million coins. While ETH doesn't have that kind of supply restriction, it is almost indisputable that ETH will have a negative emittance after EIP-1559.

Negative issuance is not the only advantage ETH will have over Bitcoin: Bitcoin relies on transaction fees to secure the network after the last bitcoin has been mined. From that point, miners will depend on transaction fees to pay their electricity bills. Today, we can only guess whether it will work out.

Ethereum does not depend on transaction fees because it can secure the network indefinitely by constantly issuing new coins while also not sacrificing the currency's hardness.

That's the beauty of EIP-1559 -  it is one of the best economic schemes we have ever come up with!

Conclusion

Let's summarize what we just learned in very simple terms:

  • Gas Fee Estimation: The BASEFEE will be the standard gas fee ensuring block inclusion. No waiting, no stuck transactions - you make your transaction and press "send," and your transaction goes through. This will vastly enhance UX, especially for newcomers.

  • Inherent Taxation System: After paying the BASEFEE, Ethereum will burn it. We can compare it with a nation-state taxing the economy. By burning the BASEFEE, the Ethereum nation-state profits collectively. Ethereum citizens hold ETH, which will appreciate because it becomes more scarce.

  • Long Term Security: Ethereum doesn't depend on transaction fees to secure the network - we can keep inflating the currency without increasing supply. That's how we can achieve long-term sustainability. Network security and economic soundness go hand in hand.

  • Hard Money: EIP-1559 makes ETH hard money. ETH is scarce and deflationary. People will see ETH as a store of value because they can be sure that it will be burned as long as people use Ethereum.

EIP-1559 probably is one of the most critical upgrades in crypto history. It ensures the network's long-term sustainability. While EIP-1559 lowers the miners' margins, it only brings value to all other parties involved.

The UX will become significantly better; ETH will be harder money, no long-term security trade-offs, and an inherent taxation system turns Ethereum into a nation-state-like system.

EIP-1559 turns ETH into hard money, and it will convert Ethereum into the most remarkable economic system the world has ever seen.


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All information presented above is meant for informational purposes only and should not be treated as financial, legal, or tax advice. This article's content solely reflects the opinion of the writer, who is not a financial advisor.

Do your own research before you purchase cryptocurrencies. Any cryptocurrency can go down in value. Holding cryptocurrencies is risky.