Impact of EIP-1559 on Ethereum
Ethereum is a programmable smart contract platform, built on its own blockchain, that uses Ether as its currency to power the network.
A smart contract is a self-executing, digital contract that has the terms of the agreement between the buyer and seller written into the code. The code and the agreements contained therein exist across Ethereum’s distributed network and execute autonomously once the conditions are met. As such, Ethereum allows for the digital facilitation, verification, and enforcement of a contract without the need for third parties.
Which leads us to an important distinction: Ethereum is solving a very different problem than bitcoin. Whereas bitcoin is a digital currency and store of value, Ethereum is a tech platform on which decentralized apps can build. If bitcoin is digital gold, then Ethereum is a decentralized Amazon Web Service (AWS).
So, if Ether (ETH) isn’t money (at least not in the traditional sense), why is it the second largest cryptoasset and has grown to a market cap of nearly $400 billion in 6 years? The answer is Ethereum is decentralizing cloud computing and ETH is the fuel for the network. Every time an application runs on the Ethereum network, it must pay a “gas” fee which is denominated in ETH. Similar to how more usage of AWS results in more revenue, the more decentralized apps built on top of Ethereum and the more those apps get used, the more value accrues to ETH.
Today there are more than 3,000 decentralized applications running on Ethereum including most of the DeFi and NFT sector. In fact, the network has grown so fast in recent years that the underlying blockchain is having a hard time keeping up with demand. According to research firm Messari, in Q2 2021 Ethereum settled $2.5 trillion in transactions. This represents 1,490% year-over-year growth and puts Ethereum on pace to settle $8 trillion in 2021. The result of this explosion in demand for Ethereum’s network capabilities has led to congestion in the network and leads to slower throughput and higher transaction fees.
One of Ethereum’s biggest challenges is that throughput of the system has not been able to keep up with demand. As a result, we have seen the rise of Ethereum competitors such as Binance Smart Chain, Solana, Cardano, Cosmos, Tezos, and more looking to fill the unmet demand and offer lower transaction costs. However, Ethereum is still by far the most dominant smart contract platform on the market with over 75% of the overall economic activity happening on-chain. Other than Binance Smart Chain (BSC), no other protocol has captured even 5% of the total activity. Should Ethereum overcome its scaling issues, it is unlikely to lose that top spot. Which brings us to the core of today’s topic: Ethereum’s upgrade.
On December 1, 2020, the Ethereum community successfully initiated the launch of Ethereum 2.0 which should take roughly 2 years to complete. Without getting too technical, there are two main objectives to Ethereum’s upgrade: the change in the consensus mechanism and the change in the monetary policy of the network.
Change in Consensus Mechanism: Proof of Stake
A consensus mechanism is a fancy term for how blockchains validate transactions and make sure every node on the network agrees on the official record (aka reaches consensus). Bitcoin was the original cryptoasset and was built using a consensus mechanism called Proof of Work. Oversimplified, this method requires miners to exert significant computational power to solve complex math problems to “prove” they validated a block. The more computing power a miner has, the more likely they are to do this first and get rewarded with the underlying coin. This incentive increases the amount of computational power on the network over time which is great because the more hash power there is on the network, the more secure the network is.
The downside to Proof of Work is the same thing that makes it so secure, namely that it requires a lot of computational power which can limit the throughput of the underlying blockchain. Ethereum was originally built on a proof of work consensus mechanism and still operates on a proof of work method today. Hence, the trouble keeping up with demand.
There are two ways for a blockchain to scale. One method is to build layer 2 solutions. This is the route that Bitcoin has taken, opting to keep the security of the base layer blockchain and build networks on top that can handle greater transactional throughput. I covered this in detail previously with The Lightning Network (newsletter #10). It should be noted that there are several Layer 2 solutions for Ethereum currently in development including Polygon, Optimism, Arbitrum, Loopring, OMG, Raiden, and more.
However, the core developers for Ethereum have decided to take door number two and change the underlying consensus mechanism from Proof of Work to Proof of Stake.
Proof of Stake is a consensus mechanism that relies on users “staking” ETH rather than miners contributing computing power. Anyone can become a validator on the network by simply putting ETH up as collateral. Rather than miners competing to solve complex math problems, validators are selected at random by the network to create new blocks. They are then rewarded for proposing new blocks and for validating the ones they’ve seen.
The “stake” (aka the ETH collateral put in by the validator) works as a financial incentive for validator not to create fraudulent transactions. If the network detects a fraudulent transaction, that validator will lose a part of its stake and its right to participate in the future. As long as the stake is higher than the reward, the validator would lose more coins than it would gain if it were to attempt to create a fraudulent transaction. Thus, validators are economically incentivized to act honestly.
This change to Proof of Stake should theoretically improve Ethereum in three ways. The first is shifting the network’s reliance from computing power towards relying on capital, in the form of Ether, to secure the network. In theory, this should drastically reduce the amount of energy required to run the Ethereum blockchain. Second, by contributing to a staking pool, Ethereum users will be able to earn a passive return by locking up their Ether on the protocol layer. With the network relying more on Ether to validate transactions, this should increase demand for Ether. Third, it should increase the throughput of the base layer blockchain. With Ethereum 1.0, the network can only support around 30 transactions per second while the core developers have claimed that Ethereum 2.0 may be able to process up to 100,000 transactions per second.
Change in Monetary Policy: EIP-1559
Unlike Bitcoin’s programmatic monetary policy where supply issuance is predetermined, constant and block rewards are halved every four years, Ethereum has taken a more dynamic approach to its issuance policy. Ethereum’s monetary policy is much less predictable in that it issues just enough coins needed to adequately compensate miners. It is also important to note that Ethereum does not have a fixed supply cap like bitcoin does.
However, Ethereum’s monetary policy will see a substantial change to its supply-side economics with the introduction of Ethereum Improvement Proposal (EIP) 1559. EIP 1559 creates a new mechanism that increases the scarcity of ETH by “burning” (aka destroying) a portion of transaction fees processed by the network. If the network is processing a large enough number of transactions per day, it is entirely possible for more Ether to be burned daily than minted through native issuance. Although EIP 1559 does not impact the amount of supply issued per block, this burning mechanism lowers ETH’s net inflation rate and over time, it’s possible Ether’s net issuance per day could become negative. EIP 1559, combined with increasing demand for Ethereum, could create a great deal of upwards pressure on the price of Ether.
The reason I wanted to cover this upgrade in this newsletter is that EIP-1559 went live for the first time earlier this month. Within the first 24 hours, $12m worth of ETH had been burned reducing the amount of inflation by 36%. After the first week, $100m worth of ETH had been burned representing about half the amount of ETH that was issued to miners during this period. As of writing this, the cumulative value of burned ETH has already eclipsed $300m.
Ethereum’s success and price appreciation are by no means guaranteed. There is considerable risk moving to an unproven consensus mechanism. There is the possibility for vulnerabilities to be introduced in the transition as well as security questions of operating on a Proof of Stake model at scale given it’s never been done before. Should Ethereum falter, there is no shortage of competitors ready and willing to steal market share. However, if the core developers can successfully transition to Proof of Stake and EIP 1559 works as intended, there is incredible upside for Ethereum.
