EIP-1559 Fee Markets, Elastic Block Sizes & Deflationary Ether | Deep Dive
Review Date: March 4, 2021
Ethereum improvement proposals (EIP) serve as a governance mechanism in which developers can propose changes to the Ethereum protocol. EIP-1559 is a direct change to Ethereum’s monetary policy and how block sizes can expand and contract based on the demand of the network at any given time. EIP-1559 has the potential to make Ether a deflationary asset by burning a base fee from all transactions that will exceed the amount of annual issuance of Ether by Ethereum 2.0’s proof-of-stake consensus mechanism. There are concerns about whether miners of the network will accept this EIP as it directly affects their revenue from exorbitant transaction fees associated with current scalability limitations. Presented below is an analysis of fee markets, EIP-1559 implementation details, and changes to Ethereum’s monetary policy.
Competition for Block Space
In traditional blockchains such as Bitcoin and Ethereum, there is a concept known as a fee market in which users of the network will compete by raising transaction fees in order to get their transactions mined in the latest block. The higher the monetary incentive associated with a transaction the more likely a miner is to include it in the latest block. This is the reason many have seen Ethereum gas prices skyrocket over the past 6 months as there is limited space inside each block and ever-increasing network demand.
On the Ethereum blockchain DeFi arbitrage has become a profitable endeavor that requires transactions to be mined with priority in order to capitalize on an arbitrage trade before any other user who identifies the same trade. Arbitrage trading simply means buying an asset that is cheaper on one decentralized exchange (DEX) than another and profiting off the price difference. For example, ETH on Uniswap is at $1700 and ETH on Sushiswap is $1750, a trader will buy ETH on Uniswap and sell ETH on Sushiswap profiting $50 relatively risk-free (excluding gas fees and price fluctuations between purchase and sell).
In order to do this large transaction fees are offered to miners who will inevitably mine the transaction on the next block which in turn increases the miners’ revenue. Additionally, many firms that conduct these DeFi arbitrage trading strategies have good relationships with the miners themselves and can influence miners to re-order transactions in a block to have their transactions listed first. This means no one will front-run these transactions with higher transaction fees as miners are ordering the transactions themselves inside a block. This is commonly known as Miner extractable value (MEV).
EIP-1559 Design & Implementation
EIP-1559 has been designed to radically alter the Ethereum fee’s market and monetary policy in order to achieve the following design goals [2]:
- Better UX: Traditional price auctions (setting your transaction fee to slow, average, fast) make fees difficult to estimate. EIP- 1559 aims to provide consistent fee rates which should lead to lower transaction fees across time.
- Slack Mechanism: Network usage is variable hence why gas fees rise and fall with network demand. A slack mechanism for block size would accommodate variable network demand.
- Better Security: Blockchains that rely on transaction fees can face security problems when the block subsidy runs out (block subsidy is reward miners receive for adding a block to the blockchain). Instead of using transaction fees, a perpetual reliable block subsidy is proposed.
- Prevent Economic Abstraction: Forcing transactions to burn a specific amount of ETH instead of an ERC-20 token enforcing Ether to be the reserve asset of the Ethereum blockchain eliminating any competitors.
EIP-1559 proposes a minimum transaction fee called the BASEFEE which is burnt entirely meaning users have the ability to incentivize miners in the following ways [2]:
- GAS_PREMIUM: The fee associated with price auctions applicable in a high congestion environment. Determined entirely by the user as per the previous price auction model used by Ethereum today (slow, average, fast).
- FEECAP: The maximum a user is willing to pay to be included in a block (BASEFEE + GAS_ PREMIUM). This is necessary as the BASEFEE is a variable that will be explained below.
In layman’s terms, the BASEFEE allows for more efficient and consistent transaction fees and also serves as the foundation for an elastic block size mechanism to accommodate variable network demand.
Elastic Block Size cap
As discussed above an elastic block size (a slack mechanism) is proposed that would allow block size to become dynamic instead of static which would accommodate for variable rates of network demand. Instead of users trying to outbid each other for limited block space as per the current price auction model Ethereum uses which highly favors wealthy network participants; users will be able to access extra block space during periods of high demand. The long-term target per block is 10 million gas and the hard ceiling per block is 20m gas.
As discussed above the BASEFEE is variable and is adjusted to achieve the desired average block size of 10 million gas. If blocks are under the 10 million gas target the BASEFEE is lowered which incentives network demand whilst the opposite is true that the BASEFEE is increased if blocks are above the 10 million gas target.
Ethereum Miners & EIP-1559
At the present time, miners are in a unanimous decision to reject the implementation of EIP-1559 as shown by The Block data revealing 61% of Ethereum’s hash rate is voting against it [4]]. However, it has been discussed that the Ethereum application layer mainly decentralized financial protocols (DeFi) would dictate the direction of the fork. Being that DeFi requires liquidity for its financial services to function so wherever DeFi decides to migrate or remain will remain the dominant fork [5].
The fragility of DeFi will make Ethereum hard forks almost infeasible hence the miners would be fighting a losing battle. The display of hash power voting against EIP-1559 is simply nothing more than a power play to show dissatisfaction with their decreasing revenue. Additionally, an Ethereum miner is structurally long on Ether the asset of the Ethereum ecosystem as a whole, so it does not make sense to reject the collective will of the Ethereum core developers.
To understand a miner’s motivations we must understand the miner’s source of revenue. An Ethereum miner currently receives the following rewards:
- Block Subsidy: The reward a miner gets for adding a block to the Ethereum blockchain.
- Fees: Transaction fees from users bidding for block space.
- Miner Extractable Value (MEV): Value extracted for reordering transactions in a block for arbitrage bots.
Under EIP-1559 the only source of revenue that will be affected is the transaction fees which have been extremely profitable as the cryptocurrency asset class entered a bull market and DEX volume increased significantly. Miners will still collect the block subsidy and MEV.
Ethereum Monetary Policy
Ethereum’s current monetary policy is defined by the rewards issued to the miners for validating transactions on the network by issuing 2 Ether per block plus an additional 1.75 Ether per uncle block. At this present time, the network issuance of Ether is at 4.5% annually [6]. Miners are also rewarded with the transaction fees declared by users to attain access to fast transaction validation.
The transition to Ethereum 2.0 and the proof-of-stake consensus mechanism makes the maximum annual network issuance variable depending on how much Ether is staked validating the network.
After Phase 1.5 of the Ethereum 2.0 transition, the proof-of-work issuance on Ethereum 1.0 will be stopped as the state will be migrated to an Ethereum 2.0 shard [6]. Below illustrates how the annual issuance of Ether is dedicated:
EIP-1559 has the potential to make Ethereum issuance deflationary whereas Bitcoin’s Issuance is disinflationary. Disinflationary means the slowing pace of inflation (ever reducing the number of Bitcoin issued) and deflationary is the reversal of inflationary expansion (contraction in supply). Deflationary Ether comes from the amount of BASEFEE burn-in EIP-1559 exceeding the amount of Ether issued from Ethereum 2.0’s PoS consensus mechanism as illustrated above.
Summary
EIP-1559 is one of the major Ethereum improvement proposals in recent memory directly affecting Ethereum’s monetary policy and the current fee market structure. It has the potential to make Ether a deflationary asset with the BASEFEE burn, provide consistent fee rates and accommodate for high periods of network demand without increasing the transactions fee to a ridiculous level. Miners are opposed to EIP-1559 as it directly affects their source of revenue being transaction fees but it is difficult to conceive of a hard fork as it goes against core developers’ will and DeFi applications will choose the dominant fork based on the presence of liquidity. If implemented successfully then we could see an entirely new value proposition for Ether the asset being a deflationary store of value.
References
- https://etherscan.io/chart/gasprice
- https://insights.deribit.com/market-research/analysis-of-eip-1559/
- https://etherscan.io/blocks
- https://twitter.com/mhonkasalo/status/1366738731483492352
- https://medium.com/dragonfly-research/ethereum-is-now-unforkable-thanks- to-defi-9818b967738f
- https://docs.ethhub.io/ethereum-basics/monetary-policy
- https://twitter.com/drakefjustin/status/1366335946451521537
