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Ethereum EIP 1559 explained

EIP 1559 is one of the hottest discussion topics of 2021. It is a proposal for upgrading Ethereum. EIP 1559 changes the way how transaction fees (gas fees) are calculated. It could even make Ethereum a deflationary currency! This article is an EIP 1559 guide. It explains the proposal in detail and describes the impacts on regular users and miners.

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An overview of Ethereum

Let’s start with an overview of Ethereum. If you are already familiar with the project, you can skip to the next chapter.

Ethereum is the biggest and best-known cryptocurrency after Bitcoin. It’s the leading project in the platform category. Ethereum is an operating system for smart contracts and distributed apps (Dapps). You can think of it as Android or iOS.

A Russian programmer Vitalik Buterin described the Ethereum white paper in late 2013. The project was officially launched in early 2014. The founding team also included the likes of Charles Hoskinson (the founder of Cardano) and Gavin Wood (the founder of Polkadot). Ethereum’s blockchain was launched in July 2015.

vitalik buterin

Vitalik Buterin

It was obvious from the beginning, that Ethereum 1.0 couldn’t possibly deliver Buterin’s vision of a “World Computer”. Hence, the development of Ethereum 2.0 started almost instantly after the 1.0 was launched.

It took about five years and countless upgrades until Ethereum 2.0 was launched in December 2020. This is when the Beacon Chain started running. It’s the blockchain of Ethereum 2.0. For now, only network staking is enabled. Smart contracts and other key features will be added in the coming years.

Ethereum 2.0 is expected to be fully running by 2023. Until that, the current Ethereum (1.0) will run in parallel.

The development of Ethereum 2.0 goes forward through hard forks. Previous hard forks include Berlin, Istanbul, and Constantinopole. Read more about the history of Ethereum hard forks from here.

The Homestead hard fork included the first EIPs in 2016.

What is an EIP?

EIP is an abbreviation of Ethereum Improvement Proposal. It is a standardized format for creating and handling Ethereum’s improvement. Bitcoin has a similar system in place. It’s called BIP – Bitcoin Improvement Proposal.

EIPs and BIPs are needed because cryptocurrency projects don’t run like traditional software companies. Developers are not sitting in one office, where they can pitch ideas and have meetings every day.

There are thousands of developers and volunteers all over the world. Such a group generates loads of development ideas, which need to be coordinated. EIP is a standardized process for this purpose. It’s described in detail at Ethereum.org.

eip process

Every (potential) EIP follows the same path. It starts as an idea and progresses to a draft, review, and further. There is a pre-determined template for creating EIPs. Each EIP is also given a serial number.

EIPs aren’t usually discussed outside the Ethereum community. EIP 1559 is a different case. It’s a core-level EIP, which impacts the mining & fees of the Ethereum network. EIP 1559 has been widely debated in social media by investors and developers.

Ethereum transaction fees

EIP 1559 is all about transaction fees. Hence, it’s very important to understand how they work in the Ethereum ecosystem. Roughly speaking, the system is similar to Bitcoin: those who pay the most, get their transactions through the fastest.

Ethereum is using Proof of Work consensus, which requires physical mining machines to sort out new transactions. A new block is mined every 15 seconds in the Ethereum network. This is when new ETH tokens are created. They are handed out to miners as block rewards.

Miners will also get all transaction fees. Hence, they always have an incentive to select the transactions with the highest fees. This leads to competition between the users. Higher and higher fees must be paid to have your transaction picked up first.

This concept is awfully bad for small investors. Standard transaction fees climb easily to tens of dollars when the Ethereum network is busy. This doesn’t just hurt ETH transfers but all Ethereum-based token transfers as well.

Below is an image of a GPU rig used to mine Ethereum.

ethereum mining rig

Transaction fees (usually called gas fees) are calculated by using a gas limit and a gas price. The gas price is also described with a unit called gwei.

A gas limit tells you the computation energy required to process the transaction. For example, when using DeFi applications, you communicate with smart contracts. These calculations must be processed by every Ethereum network node. The more resources the smart contract is using, the higher the gas limit.

Many readers might have heard of satoshi (sat). This is the smallest possible unit in the Bitcoin network. Gwei has a similar purpose in the Ethereum network. One ETH is 1 billion gwei, meaning one gwei is 0.000000001 ETH.

Gwei and satoshi are used to describe very small numbers. It’s more practical to say 10 sat or 350 gwei instead of using a decimal number with many zeros in it.

When using the popular DEX Uniswap, you often see gas limits around 250,000. Gas price has been historically between 10 and 100 gwei, but the DeFi boom has increased gas prices to 200-500 gwei.

Let’s have an example calculation of a Uniswap trade with a gas limit of 250,000 and a gas price of 50 gwei. The transaction cost is calculated by multiplying the gas limit with a gas price; 250,000 * 50 = 12.5 million gwei.

When we multiply 12.5 million by 0.000000001 ETH we get 0.0125 ETH. The current ETH price is about $3000. Hence, the transaction would cost $3000 * 0.0125 = $37.5.

Popular Ethereum wallets like Metamask allow users to adjust the transaction cost (gas fee) up or down. This way you can also pay more than the estimated amount.

EIP 1559 explained

Now you should understand EIPs and Ethereum transaction fees. Hence, we can finally dive into the EIP 1559. This is a proposal published by Vitalik Buterin in early 2019. It is all about the transaction fees and also known as “the fee-burning proposal”.

EIP 1559 presents the following new features: base fee, miner tip, and the gas limit increase. See the video below for an excellent EIP 1559 guide.

The problem with the current system is that it’s very difficult to estimate gas prices due to high volatility. EIP 1559 changes this by using a base fee. This is the floor of gas costs and it is determined by the base fee of the previous block. The significant thing is that the base fee can only grow by 15% per block.

There is also a change in the gas capacity. In each Ethereum block, there is a limit of how much gas fees they can include. It’s like the block size limit of Bitcoin. EIP 1559 makes it possible to double this capacity when the network is busy. It means that miners can create bigger blocks.

The third feature is called miner tip. It is exactly what it sounds like. It is an extra payment user can do to make sure the transaction gets in front of the line. This feature alone prevents gas fees from going too low during high-traffic periods. There are always whales, who will overpay for fast transactions.

The purpose of EIP 1559 is to bring predictability to gas fees. When the base fee can only grow 15% per block, it’ll be easier for users and wallet software to determine how much one should pay for a transaction.

After EIP 1559, it’s also possible to set a fee cap for your transaction. It means your transaction will wait until the base fee drops to the desired level.

The impact of EIP 1559 for miners

You have probably understood by now, that miners are the ones suffering the biggest impact of EIP 1559. A random user moving Etherum-based tokens from an exchange to a wallet might not even notice anything. Active users enjoy the increased predictability of gas fees.

The key feature we haven’t mentioned yet is fee burning. The base fee of each Ethereum block will be burned after the EIP 1559 is implemented! Burning means that fees are destroyed. No one will receive them.

coin burn

Miners are currently cashing in block rewards and transaction fees (gas fees). The DeFi boom has made gas fees worth even more than block rewards! This has never been the case before. EIP 1559 is going to change all this. Hence, it’s no wonder miners have been against the proposal.

The current fee model is lucrative for miners because whales (heavy users) are overpaying so much. They are running arbitrage bots and yield farming tools, where it’s very important that transactions go through as quickly as possible.

Now it’s difficult to estimate the correct gas fee due to high volatility. If you are making a large transaction, you can afford to overpay quite a lot to be on the safe side. Investors are now using services like the ETH Gas Station to guess the needed gas fee. This system is highly ineffective.

After EIP 1559, miners will only get the tip. Even if there will be overpaying in the future as well, it’s difficult to say how much the miner income is exactly impacted. It will go down, that’s for sure. The block reward stays the same, though.

The impact of EIP 1559 in the bigger picture

Is EIP 1559 going to solve the scalability issues of Ethereum? Does it make Ethereum-based DeFi applications like Uniswap cheap enough for small investors? The answer to both questions is no.

EIP 1559 is not going to change the fact that the current Ethereum cannot handle the traffic caused by DeFi and NFT applications. The system will be properly scaled with Ethereum 2.0. There are also promising Layer-2 solutions like Polygon, which seem to be helping quite a lot.

It’s likely that Ethereum’s transaction fees remain too high for small investors even after EIP 1559. Increased predictability helps mainly active users and software developers.

Burning the base fee is an interesting concept. This means that Ethereum might become a deflationary currency during peak hours. Once base fees become higher than block rewards, it means more ETH is burned than created. This has been the major discussion topic in 2021.

EIP 1559 will be officially launched in July 2021 with the London hard fork.

You should also check the video below, which explains Ethereum’s gas for beginners. This article has useful information about Ethereum’s monetary policy.

Image by Flickr / Techcrunch, Image by Лечение Наркомании from Pixabay, Image by Hebi B. from Pixabay, Flickr / Marco Verch

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