What EIP-1559 means for Ethereum and can it actually make it deflationary?
If you are an owner of ETH or any Ethereum based project you most likely have heard something about the upcoming “EIP-1559”, otherwise known as Ethereum Improvement Proposal 1559. The majority of EIP’s mainly focus on technical improvements to Ethereum and are not widely discussed outside of the core Ethereum developer community. However, the changes proposed in 1559 could present major implications for the Ethereum monetary network and Ethereum based projects. EIP-1559 suggests changes to the Ethereum fee model and was proposed back in 2019 by one it’s creators, Vitalik Buterin. To understand the significance of these changes it’s best to recap Ethereum’s current fee model.
Ethereum’s Current Fee Model
The current fee model is based on an auction mechanism known as “first price auction.” In this mechanism, the users looking to have their transaction picked up by a miner and placed in a block must essentially “bid” for it by submitting a gas price that they are willing to pay to have their transaction fulfilled. The miners are incentivised to fulfill the highest price transactions first. This process can be inefficient and usually results in users overpaying for their transactions.
Where EIP-1559 comes in to play
EIP-1559 aims to achieve the following:
- Make transaction fees more predictable
- Reduce the delays in transaction confirmation
- Automate fee bidding system
- Create a positive feedback loop between network activity and the ETH supply
EIP-1559 Fee Model
EIP-1559 first introduces the concept of a base fee which will be the minimum fee to have a transaction included within a block. The base fee can be adjusted to be higher or lower depending on how congested the network is. The proposal also aims to increase the network capacity by doubling the block size from 12.5 million to 25 million. The goal is to achieve equilibrium by raising the base fee when the network capacity is above 50% and lowering it when the base fee is above 50%. Essentially, what the developers aim to do is lessen the volatility of gas fees by substituting in higher volatility in block size. EIP-1559 also introduces a “miner tip”, which would allow users to offer to pay more to have their transaction filled faster.
The big differences in the two models are how miners are compensated. Under the current fee model miners receive both the block reward and the entire gas fee. Under EIP-1559, the miners only receive the block reward and the miner tip. The base fee is, however, is burned.
Base Fee Burning.
The base fee burning has potentially massive implications on the ETH supply, which is why EIP-1559 is heavily discussed among ETH investors. Burning the base fee creates an interesting feedback loop between network activity and the ETH supply. More network activity would mean more ETH burned. This could cause less ETH to be available to be sold on the market by miners, making the existing ETH more valuable. This concept rewards the existing users by making their ETH more scarce instead of over paying miners.
So Can ETH Become Deflationary?
This would be the case when the block reward plus miner tip is less than the base fee burned. It can happen in instances when the network is under constant heavy utilization, similar to the way it has been during the recent DeFi craze.
If EIP-1559 is implemented, ETH will sometimes be deflationary and sometimes be inflationary. However, as DeFi and the Ethereum ecosystem continues to evolve, the instances when ETH is deflationary may outnumber the instances when it is inflationary. This, coupled with the already imposed inflationary cap of 2%, is great news for investors.