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Understanding DeFi: Ethereum’s EIP-1559 update explained

EIP-1559 is one of Ethereum’s most widely discussed updates of recent years. First authored by Vitalik Buterin in 2018, the “ETH buyback” proposal has drawn the attention of Ethereum developers, miners, community members and major crypto media outlets alike over the last few months. The discussions reached a climax in March, when Ethereum’s core developers agreed to implement EIP-1559 in the protocol’s London hardfork. The crucial update involves burning a portion of the gas fee with every transaction on Ethereum. As the community prepares to see ETH become more scarce, many are eagerly anticipating the update. However, it’s also met some resistance from miners. In this guide, we detail how it works, and what it could mean for Ethereum in the long term.

EIP-1559 is an “Ethereum Improvement Proposal” that involves burning a portion of the gas fees on Ethereum transactions.

It was first introduced by Vitalik Buterin in 2018, who noted the “tragedy of the commons” problem that arises from miners processing transactions on a blockchain network. While transactions benefit the sender, they also have a social cost to the network as every node must process every transaction.

Every Ethereum user faces a cost in the form of gas, measured in Ethereum’s ETH currency. While gas fees help secure the network, there are issues associated with the original fee system. This idea was further detailed by key Ethereum evangelist Eric Conner in 2019, who wrote a paper titled “Fixing the Ethereum Fee Market”.

When you pay for a transaction on Ethereum, you effectively submit a bid to the miner, indicating the price you’d be willing to pay for your transaction to be confirmed in the next block. For users, it can be difficult to estimate the optimal fee to submit. Miners are incentivised to choose the highest bids, which results in users overpaying for transactions. But if the fee is too low, the user can experience long delays in getting their transaction confirmed.

EIP-1559 proposes a solution to the issue by setting a base fee, which is the minimum fee a transaction needs to pay to be included in a block. This base fee is also adjusted by the protocol depending on the level of network congestion: the fee increases when the network is at greater capacity, and decreases when the network is at lower capacity.

The proposal also adds a tip to go to miners, which can be adjusted if the sender wants to process the transaction faster. If not, they can set a maximum fee and wait for the transaction to be confirmed when the base fee drops below their fee.

A crucial change with EIP-1559 is that the miners only keep the tip from the transaction, while the base fee gets burned. This creates what EIP-1559 coordinator Tim Beiko refers to as an “ETH buyback” mechanism, where ETH is paid back to the protocol and the supply gets reduced.

EIP-1559 should help users avoid overpaying for gas fees. It also prevents miners from artificially inflating the fee. Moreover, EIP-1559 hardens ETH’s monetary policy, while adding to the security of the network. As Bankless host David Hoffmann wrote in a Medium post discussing EIP-1559, “by adding to the scarcity of Ethereum today, Ethereum’s security tomorrow is secured.”

A common misconception of EIP-1559 is that it will reduce gas fees on Ethereum. While it’s true that it will make prices more predictable, it won’t stop the costs from reaching highs when the network is congested. Layer 2 solutions and the eventual launch of sharding as part of Proof-of-Stake are expected to have a much bigger impact on reducing gas fees.

Burning the majority of the gas fee will make ETH more scarce. If there are enough transactions on the network, it will make ETH a deflationary asset. Reducing the supply essentially pays back ETH holders, as increasing the scarcity should also increase the value of the asset.

Although many have praised the potential benefits EIP-1559 could bring to Ethereum, the proposal has faced some criticism.

EIP-1559 will affect miners’ revenue, and many have vocally opposed the update. “We are sad to see many people only care about price now,” key mining pool Sparkpool wrote.

Though some miners have supported the update, a few have argued that EIP-1559 threatens the security of the network, as a group of miners could collude to carry out a 51% attack. A 51% attack refers to a scenario where a group of miners takes control of 51% of a blockchain’s hash rate to attack the network. Although difficult to achieve with a decentralized blockchain like Ethereum, it would be a critical threat to the future of the network. Despite the concerns raised of a potential attack, an analysis from Tim Roughgarden concluded that EIP-1559 wouldn’t make an attack any easier.

In a “show of force” in opposition to EIP-1559, a group of miners arranged to move their hash rate to the mining pool Ethermine for 51 hours on 1st April. Ethereum miner Michael Carter said the intention of the protest was “not attacking the network, what it is showing though is miners can coordinate” on his YouTube channel.

In response to the rising tensions surrounding EIP-1559, some miners shared a “counter proposal”, EIP-3368, which suggested raising block rewards to 3 ETH, with an eventual reduction to 1 ETH. However, the proposal was met with a tepid response. On 19th March, Tim Beiko confirmed that it would not be added to London.

In summary, despite the pushback from some miners, EIP-1559 is arguably Ethereum’s most anticipated update since the launch of Ethereum 2.0. There’s a good reason for this: the update should improve the user experience of the network by eliminating fee estimates. But it will also likely turn ETH into a deflationary asset, effectively redistributing the protocol’s earnings to the wider Ethereum community. In reducing the supply of Ethereum’s reserve asset, EIP-1559 should also benefit the security of the network. Ethereum’s core developers have added the proposal to the London hardfork, the next major update following Berlin. It’s scheduled to ship on 4th August.

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