A Closer Look at EIP 1559: Transforming Ethereum
Ethereum (ETH) blockchain developers recently approved significant changes to the network, collectively called EIP-1559, and is planned to take effect in late July. Under these changes, users will have to send a base fee to the network. After that, the base fee’s ETH will be burned, i.e. destroyed, which will reduce the circulating supply. Rather than reducing high transaction fees across Ethereum-based blockchains, EIP-1559 aims to lower the volatility and raise the predictability of transactions fees.
The upcoming changes will likely lead to short-term profit loss within the Ethereum miner community. Transaction fees were a huge part of miner revenues over the last year. With EIP-1559, the protocol will burn a large portion of the overall transaction fees, thereby reducing miner revenue. Many mining pools have shown their disapproval and have begun coordinating to stop the proposed change. As a result, the Ethereum Foundation is preparing to defend against a potential 51% attack on the network.
What makes EIP-1559 significant?
On the Ethereum blockchain, each transaction fee includes a gas fee that users pay to ensure their transactions are executed. The gas price depends on the demand for block space, which is capped so miners can only execute a limited number of transactions at a given time. The current block size limit is 15 million gas. The block size determines how many changes or how much information is included at one time. Generally, the sum of gas needed for pending transactions is higher than the block limit, causing miners to select which transactions they would like to include.
The current fee system follows the first-price auction model, where users submit bid prices (gas prices) representing how much they are willing to pay to get miners to process their transactions. As miners are rewarded with the transaction fees during transaction validation, they tend to prioritize transactions with higher fees to maximize their revenue. If users want miners to process their transactions quicker, they must submit a higher bid price (gas price). As a result, the system inevitably favors the users willing to pay higher gas prices to get their transactions processed ahead of other people in the queue.
But herein lies a problem, users do not know how much others are bidding. Under the current fee structure, users have to guess the gas price based on the average price paid in previous blocks. However, there is no reliable way to accurately predict the future demand for block space before submitting a transaction. If a user sets their gas price too high, they risk overpaying. If they set the gas price too low, their transaction may be filtered out, failing to go through completely.
Hence, users are under pressure to place higher gas bids, especially during network congestion to ensure inclusion into new miner blocks. This creates and promotes an inefficient system, which is skewed toward miner revenue. And this isn’t ideal, especially if the network wants to become more mainstream.
What Is EIP-1559?
EIP-1559 is an Ethereum Improvement Proposal (EIP) that Vitalik Buterin proposed in 2018 to reform the Ethereum fee market. The two main features of this proposal are the target block size mechanism and the new fee model. These two changes will hopefully remove the uncertainty and volatility associated with paying gas.
In the current system, Ethereum has a fixed maximum block size of 15 million gas. EIP-1559 will increase the maximum block size to 25 million gas. Additionally, the proposal introduces a target block size mechanism that aims to keep blocks at 50% capacity, which is 12.5 million gas. The target block size mechanism works in conjunction with the new fee model to ensure that the blocks are 50% full.
The new fee model is set to replace the variable first-price auction model currently used by Ethereum to determine transaction fees. The model involves the fee cap, which represents the most users are willing to pay to have their transactions processed. The fee cap includes two types of fees – the base fee and inclusion fee (also known as “tip”):
- Base fee: The base fee is an algorithmically computed minimum price required for each transaction. It is calculated based on the preceding block where its value increases or decreases depending on the target block size. If there is a spike in network usage and the block capacity exceeds 50%, the base fee will increase. If there is a drop in network usage and the block capacity drops below 50%, the base fee will decrease. Additionally, the base fee is burned after a transaction so miners cannot receive it as a reward.
- Tip: Users seeking to have their transactions processed quickly can include a tip on top of the base fee. Unlike the base fee, tips are directly for miners and serve as incentives for miners to prioritize transactions.
EIP-1559 and fee manipulation
Combining the features, EIP-1559 makes fees more predictable, creates deflationary pressure on ETH, and results in less fee manipulation.
- More predictable fees: The increments in base fees according to the block size capacity are constrained, thereby making the base fee across blocks easy to predict. With EIP-1559, the base fee can increase or decrease by up to 12.5% depending on the current block’s capacity relative to the preceding block’s capacity. There is an algorithm now for users to easily calculate the base fee.
- Deflationary pressure on ETH: EIP-1559 proposes an ETH burn mechanism where the base fee of each transaction is burned. The burning mechanism reduces the total supply of ETH and raises its value by increasing scarcity, causing a deflationary effect.
- Less manipulation of fees: Gas prices in the current system is exploitable where miners can include dummy transactions with very high or very low fees that will go to themselves to manipulate the transaction fees. With EIP-1559, miners have to pay higher costs to manipulate the base fee as the base fees of dummy transactions are burned, rather than go to them.
What will happen After EIP-1559?
A study analyzed the new system’s possible behaviors in different states of congestion:
- State of no congestion: When blocks have a capacity below the maximum block size, users looking to complete their transfers do not necessarily need to include tips. For urgent transfers, users can still include tips, but there is no need to increase the tips above the minimum value. Suppose the block capacity is under the target block size. In this scenario, users can even set their fee cap lower than the current base fee so that their transactions are included in the later block. As the block capacity is under 50%, the base fee will drop in the next block, and users can save some money.
- State of occasional congestion: The base fee will increase when the block capacity is above the target block size. If the next block’s capacity is equal to the preceding block’s gas, the base fee remains the same. If the next block’s gas is lower than the preceding block’s gas, the base fee decreases. However, if the successive blocks are constantly above 50% capacity, the base fee will keep rising. In this scenario, users with urgent transactions will opt to pay more tips to have miners prioritize their transactions and the system falls back to the existing first-price auction model.
- State of extended congestion: The base fee becomes very expensive after extended periods of network congestion and will outgrow the transaction demand. Hence, a typical pattern would be a series of blocks with near-maximum capacity followed by a series of blocks of under 50% capacity as users wait for the base fee to go down.
What Are the Possible Problems with EIP-1559?
The proposal has met resistance from various mining pools. In the current system, miners have earned more than $1 billion for five consecutive months. Almost 50% of miner revenue in four of those five months comes from transaction fees, as seen in the figure below. With EIP-1559, the base fee is burned, causing miners to lose a large portion of their revenue. Though there are tips that will directly go to miners, users can choose not to include the fee.
Many Ethereum mining pools have taken a public stance against EIP-1559. For example, two of Ethereum’s three largest mining pools, Sparkpool (24% hashrate) and Bitfly (20% hashrate), announced they were against EIP-1559. Together with other smaller mining pools, those against EIP-1559 currently have a combined hashrate of above 50%. On the other side, F2Pool, the third-largest Ethereum pool with an 11% hashrate expressed support for EIP-1559. However, the combined hashrate of the supporting side is currently much lower than that of the opposing side.
Once EIP-1559 passes, those who rejected the proposed changes will remain on the old fork, while supporters switch to the EIP-1559 fork. It is unclear how this would affect the Ethereum network but both forks may continue to run in a similar manner to Ethereum and Ethereum Classic (ETC). Then, users will have to decide which one they prefer.
Monthly miner revenue on the Ethereum network. (Source: The Block)
Another possible issue is that miners can still manipulate the base fee. Miners may want to maintain the base fee at a very low value that is almost minuscule so that they can take the entire bid without any burning. They do this by selectively accepting transactions to not exceed the target block capacity, thereby maintaining the base fee at a specific value. Fortunately, this form of base fee manipulation is difficult to achieve as at least 50% of the hashrate must pledge to ignore blocks larger than the target block capacity. Moreover, miners can break off from the coalition and choose to include more transactions anyways.
There is no doubt that EIP-1559 is a key turning point for the Ethereum ecosystem. This is because it will considerably simplify and improve the user experience. Also, it will replace a fee mechanism that is no longer appropriate for a growing network. The new fee model simplifies fee calculation, reduces fee manipulation, and creates a deflationary effect on ETH. However, many mining pools have expressed their dissatisfaction regarding the proposal and announced their decision not to support EIP-1559. The opposing side already has a combined hashrate of more than 51%, and it is unclear how this will affect the Ethereum network. Nonetheless, EIP-1559 is set to deploy on the Ethereum mainnet in late July 2021.