What is EIP-1559?
Introduction
EIP-1559 is the most well-known EIP in Ethereum history. It is widely understood that this EIP has introduced the burn mechanism, which will eventually cause ether’s supply to become deflationary. It was activated on August 5th, 2021, with the London hard fork. As widely known as this EIP is, many are not familiar with its specifics, nor the problems that it set out to solve. Taking a few steps back, I will introduce what an EIP is, the problems that EIP-1559 solves, how it does it, and its future impacts on ether supply after the Merge.
What is an EIP?
EIP stands for Ethereum Improvement Proposal. These proposals are written and peer-reviewed by the Ethereum community and core developers. It is the standard for upgrading the Ethereum platform, protocol specifications, client APIs, and smart contract standards. Upgrades are discussed in the Ethereum Project Management Repository, and each EIP goes through a set of phases. They start out as an idea and are then formally written into a draft form. Once drafted, an author marks the EIP as ready for review. After going through a set of reviews and edits, a last call is made, which is the final period for review. After this, the EIP is final and can only be updated to fix errors and add clarifications. There are a wide range of EIP types, each represented by a number. These can include general upgrades, ones that require a consensus fork, client API standards, ERC/application-level standards like token standards, as well as simply informational guidelines that do not propose a new feature.
EIP-1559: A Solution to an Inefficient Fee Market
At its core, EIP-1559 simplifies Ethereum’s fee market. Beforehand, gas fees were calculated via a price-first auction method. This means that users bid an amount of ETH for miners to validate their transactions, and since miners naturally act with greed, the highest bidder tends to win. While simple and effective, this system introduced massive inefficiencies. Gas fees were heavily volatile depending on how congested the network was. In combination with the gas limit (the maximum fee to be paid per transaction) in each block, users often had to wait multiple blocks before having their transaction included in a block. There was no slack in block size to optimize for block-by-block demand fluctuations. This meant that only a limited set of transactions could be included in each block, and miners would choose the highest paying transactions. It was challenging to predict what fee one would pay, and complex yet inefficient estimation algorithms were developed. Thus, it was common for users to overpay in gas, as you pay what you bid no matter what, introducing elements of instability as well.
Transaction fees were split into two parts to fix this: the base fee and the tip. The base fee is a set amount required to be included in the next block, and it adjusts algorithmically, introducing more fee predictability. Depending on block congestion, the base fee adjusts by +/-12.5%. With these constraints, users can view the fee and decide if they want to pay it or wait for the fee to go down. The tip, or the priority fee, is an additional fee that a user can include, incentivizing a miner to verify their transaction sooner during times of high congestion. The transaction’s base fee is burned. This means it is removed from the total ether supply, and the tip or priority fee is sent to the miner.
This split in fee types introduces more fee stability since base fees are constrained to +/- 12.5%. Due to this, wallets can be better at estimating gas fees. They can allow users to manually input a tip, or in the case of Metamask, simply choose between low, medium, or high priority. Additionally, a function was introduced to allow for slack in block size. This expands and contracts block sizes depending on network congestion to allow for less fluctuations in waiting time and greater fee stability. This improvement in fee stability was significant, evident by graph 2, which illustrates the lower variation in block-by-block price of gas vs time.
It is a common myth that EIP-1559, or even the Merge, would make gas fees cheaper. Neither of these assertions are true, as a great deal of users still transaction on the Ethereum layer one. This is shown by the spikes in fees during periods of high network congestion, even though fee variability is still low. After the Merge, while validating blocks will be cheaper on the validator side due to the switch from Proof of Work to Proof of Stake, transaction fees will remain the same. The only way for fees to be cheaper is to transact on a Layer 2, such as an optimistic or zk (zero-knowledge) rollup. This is consistent with Ethereum’s rollup-centric roadmap for scalability, including extremely fast settlement and low transaction fees.
EIP-1559 & The Merge
The main narrative surrounding EIP-1559 and the Merge is the burn mechanism and its role in making ether a deflationary asset. According to watchtheburn.com, during the month of August 2022, we averaged about 1,199 ETH in base fees burned per day. At the time of writing, this is akin to setting almost $1.9M on fire for a more balanced ether supply. Since EIP-1559’s inception, about 2.6M ether has been burned, 5.2M ether has been issued, and 471k ether has been tipped to miners, resulting in a net issuance over the past year or so of 2.6M ether. This EIP has solely reduced the net issuance of ether by 50.01%.
However, after Ethereum transitions to PoS via the Merge in about a week, its issuance (or new ether distributed) will decrease by about 90%. This issuance reduction, in combination with EIP-1559, means that over a certain network activity level denominated in gwei (1/1 billionth of an ETH), more ETH will be burned than is issued. Under PoW, about 13,000 ETH are being issued per day in mining rewards on mainnet. On the PoS Beacon Chain which will merge with the PoW chain, 1,600 ETH are being issued. This means that we are currently sitting at a total inflation rate of about 4.62% per year (4.13% from the PoW mainnet execution layer and 0.49% from the Beacon Chain consensus layer). After the Merge, execution layer issuance will be zero, and all that will remain is the consensus layer emissions of 1,600 ETH per day. At a gas price of about 16 gwei, 1,600 ETH will be burned per day. Thus, whenever gas is above 16 gwei, ether will be deflationary, as more ether is burned than is issued.
Overall, EIP-1559 was a significant upgrade to Ethereum and solved a great deal of problems. It is primarily known for its burn mechanism, which enables ether to be a deflationary asset and has propagated the “ultrasound money” meme. While its effect on the total ether supply is visible on graph 4 with its activation on August 5th, 2021, the burn mechanism was not its most significant effect. Without EIP-1559, the market for gas fees would be heavily volatile and unpredictable, making it much more difficult to put a transaction through on Ethereum. Wait times would be much longer, and users overpaying for gas fees would be a much more frequent occurrence. Getting rid of the price-first auction method for calculating fees in replacement for the base and priority fee mechanism improved the fee market significantly. It added predictability and allowed users to wait for fees to go down before conducting a transaction, as well as creating potential for an ultrasound money.
