Ethereum’s EIP 1559
Is Ethereum going deflationary after this latest monetary change
EIP-1559 has got a lot of hype around it. The bulls are saying this is going to drive the price of Ethereum upwards as ETH turns deflationary but what exactly is it?
Ethereum Improvement Proposal
First, let give a brief explanation of what an EIP is. It stands for “Ethereum Improvement Proposal” and is a method by which anyone in the community can suggest improvements to the network.
EIP’s are voted on and vigorously peer-reviewed resulting in a Darwinian survival of the fittest. Only the EIP’s that can stand up to technical scrutiny and ones the community collectively want to implement will survive.
See here for a list of EIPs that have made the cut since Ethereum started.
Ethereum Transactions Fees - Status Quo
EIP-1559 is centred on changing the Ethereum transaction fee structure. For us to understand these changes we need to understand the current state of play for the transaction fee market.
Gas Limit & Gas Price
When you make a transaction you may have seen 2 terms used, the gas limit and the gas price. All transactions break down to specific instructions (OPCODES) that miners execute. Each of these instructions has a gas cost.
See here for a list of these instructions (OPCODES) and their associated cost.
So how does gas limit and gas price relate to these?
Gas price is the amount you’re willing to pay per gas, the higher this number typically the faster your transaction will get into a block as miners will pick transactions with the highest gas fees. Think of the gas price per gallon at the gas station.
Gas limit is a protection against malicious or broken contracts, the gas limit sets a hard cap on the amount of gas you’re willing to spend on the transaction. Imagine at the gas station you could put a limit on the number of gallons from the pump and it wouldn’t let you go beyond that number to make sure you don’t overspend.
Let’s say there’s a contract that you assumed used 20 gas actually used 200,000 this would end up costing you orders of magnitude more. In this case, you could set a gas limit of 30 which would only allow your account to pay for a maximum of 30 gas. This prevents the contract call from draining your account due to the gas fees.
First Price Auction
So how do I decide on what gas price I should use?
Currently, Ethereum uses a “First Price Auction” method. This is where the price you bid is the price you pay. Let’s say a block can hold 5 transactions and the first 4 bidded 10 Gwei and you bidded 100 Gwei. You would pay 100 Gwei per gas even though you could have paid 10 Gwei and still been included in the block. An overspend of 90 Gwei per gas is not an efficient system for the end-user.
Wallets will normally decide the gas price for you and let you know roughly the expected cost in dollar terms. They predict the gas cost based on previous blocks however past performance isn’t always indicative of future price and this is evidenced by the variance we see in gas prices paid in a given block.
And where do all these fees go? They go to the miners who secure the network.
Block Gas Limit
The last thing to note is the block gas limit. This is different from the transaction gas limit we mentioned above which is set by the user. This number is coded into the network and is the limit of gas that can be used per block.
The reason there is competition for transactions to get into a block is that there is a finite amount of space available per block. Currently, this sits at 12.5 million gas per block.
Ethereum Transaction Fees - Post EIP-1559
EIP-1559 looks to change the way the transaction fees work by having a compulsory “base fee” and an optional “priority fee”.
The base fee will be algorithmically calculated and will be fixed-per-block so all transactions in a block will pay the same base fee. This base fee will be burned. The priority fee will be determined by the user and will act as a tip to miners to incentivise them to prioritise your transaction in the block.
Another change EIP-1559 implements is a dynamic block gas limit. Instead of blocks being fixed at 12.5 million gas the blocks will now target 12.5 million gas and be able to increase up to 25 million gas during periods of high load.
This dynamic block gas limit is linked to the algorithm that determines the base fee. The miner will choose the block gas limit based on demand, if that block limit is above the target limit of 12.5 million gas the base fee will be increased to suppress demand as gas prices increase. Similarly, the base fee will be decreased when the block gas limit drops below 12.5 million to increase demand.
The solidity code below shows the code that will be executed when the block gas limit is above 12.5 million gas, (see here for full code snippet)
Let’s run through this, we can see from line 8 the new base fee is being set by adding together the parent_base_fee_per_gas and the base_fee_per_gas_delta.
From line 7 we can see that the base_fee_per_gas_delta is influenced by the gas_used_delta. The higher the gas_used_delta the higher the base_fee_per_gas_delta.
From line 6 we can see that the gas_used_delta is calculated by looking at the parent_gas_used and the parent_gas_target. We know that the parent target is always 12,500,000 gas so the more we are over that number the higher the gas_used_delta will be.
This means the higher the parent block gas limit the higher the gas_used_delta which means the higher the base_fee_per_gas_delta which means the higher the new base fee will be.
This increase in base fee will continue until the block gas limit returns to its target of 12.5 million gas. This can be viewed as similar to the difficulty target that is adjusted as more hash rate comes on the network for proof of work mining.
In mining, there is a target block time and difficulty is adjusted to achieve that block time. Here there is a target block limit and the base fee is adjusted to achieve that block limit.
This predictability through the algorithm is great for wallets that can now accurately predict what the next blocks base fee will be instead of guessing based on current market conditions.
Where do the fees go?
Another change is where the fees go. Previously all fees went to the miners, EIP-1559 states that the optional priority fee will still go to the miners however the required base fee will instead be burnt.
Gas is paid in Gwei which is a denomination of Ether. Burning the base fee means removing it from circulation forever. This means for each block a certain amount of ETH is removed from the total supply.
What does this mean for Ethereum, well the first thing to note is that each block still adds an amount of ETH back into the total supply in the form of a block reward for miners, this currently sits a 2 ETH per block.
So while Ethereum will likely continue to issue more ETH than it burns, its issuance rate will decrease. This in turn will reduce some of the sell-side pressure coming from miners. Less supply on the sell-side of a market generally means prices go up.
Miners aren’t particularly happy with this development in Ethereum as ETH that used to go to them in the form of transaction fees is instead being burned.
Historically transaction fees haven’t made up a huge percentage of miners profits <5% however recently we’ve seen fees make up over 50% as the network has become congested and gas bidding wars have emerged.
The priority fee will still go to miners however this part of the fee is optional. It is likely this will be a small portion of the overall fee but we’ll have to wait and see how the ecosystem reacts to these new parameters.
Miners may not be happy but EIP-1559 is charging ahead. It’s set to be released on Mainnet with the “London Hard Fork” sometime in July 2021.
