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Ethereum Crypto mining OKEx Insights

EIP-1559’s impact — is burning gas bullish for Ethereum?

2021.03.18 Rick Delaney

OKEx Insights takes a deep dive into EIP-1559 — the Ethereum upgrade addressing network usability and ETH monetary policy. 

Ethereum Improvement Proposal 1559 was approved by core developers at the beginning of March. The upgrade to the network's fee structure looks set to improve user experience and introduce potentially massive changes to Ethereum's monetary policy. 

Among users, investors and developers, EIP-1559 is almost universally popular. There is a strong belief within the community that it will smooth out gas price spikes, reduce confirmation delays and, potentially, shrink the circulating supply of Ether (ETH).

On the other hand, the mining industry is less enthused with the proposal. To many miners, it represents an attack on their overall profitability. Chief among their concerns is the security risk of potentially driving miners away from their role of securing the Ethereum network. 

In the following OKEx Insights article, we take an in-depth look at the hugely divisive EIP-1559. We open with an explanation of its workings before looking at both its positive potential impact and the objections raised by miners. We conclude by considering the likelihood of EIP-1559 causing an Ethereum chain split and by assessing whether or not the upgrade is as bullish for ETH as its proponents contend.    

What is EIP-1559?

When an Ethereum developer has an idea that could further optimize the network, they present an Ethereum Improvement Proposal for the community to discuss. If approved, EIPs are implemented as scheduled hard forks. Scheduling such hard forks in advance gives the community time to come to a consensus over EIPs. Therefore, the risk of a hard fork splitting the chain and undermining the network's value is significantly mitigated.  

EIP-1559 is an Ethereum upgrade that would drastically change the network's fee structure and overall monetary policy. Ideas to address gas price spikes that would later become the EIP were first put forward by Ethereum co-founder Vitalik Buterin in August 2018. However, it was not until March 5, 2021, that Ethereum core developers finally agreed to implement the controversial proposal as part of the London hard fork — which is scheduled for this July. 

Often detailing subtle changes that have a negligible impact on Ethereum's end users, EIPs rarely attract attention from the wider cryptocurrency community. However, EIP-1559's potential implications for miners, investors, network users and developers have made it one of the more widely discussed proposals to date.

Putting EIP-1599 in context    

To appreciate the controversy surrounding EIP-1559, it is first important to consider the context from which it emerged. 

Largely driven by fundraising via initial coin offerings, Ethereum usage increased significantly throughout 2017. More recently, decentralized finance and an explosion of interest in nonfungible tokens have attracted new Ethereum users — creating significant demand for block space. 

The number of daily transactions on the Ethereum network increased significantly over the last year. Source: Etherscan

Every function on Ethereum carries a different cost in gas. For example, a simple ETH-to-ETH transfer requires 21,000 gas. More complex transactions — such as those interacting with DeFi protocols — demand a higher gas payment. The number of transactions a block may contain is limited by a block gas limit, which is currently 12.5 million gas. 

When the sum of gas required for pending transactions is greater than the block gas limit, miners must select which transactions to include. Since they usually attempt to maximize profit, they prioritize those willing to pay a higher price for the required gas. 

Essentially, the current fee structure demands that users guess a gas price based on the average price paid in previous blocks. However, there is no way to accurately predict future demand for block space prior to submitting a transaction. Many wallets attempt to suggest fees algorithmically, but the complexity of the task makes them unreliable at times of high volatility in gas prices. 

If a spike in network usage suddenly drives up gas prices, a user could wait a long time for a transaction to confirm, even when using the fee suggested by the wallet. This encourages users to set a higher maximum gas price, thereby increasing the probability that a miner will include their transaction. As a result, they will often end up overpaying to use the network.

Such gas price spikes also make it difficult for those building wallets and other applications to simplify Ethereum's user experience. While estimated gas prices for slow, average or fast confirmations certainly help novice users, they require at least a minimal understanding of Ethereum's fee structure. This is not ideal — particularly if the network is to become increasingly mainstream. 

Although users may choose to set gas prices manually, it is currently a stretch to expect a complete newcomer to tweak these advanced settings themselves. Even if they were confident in their ability to do so, sudden spikes in gas prices may still cause delays — not to mention their potential to invite costly mistakes. 

Gas price spikes on Ethereum have become larger and more frequent with the growth of DeFi and the NFT market. Source: Etherscan

A closer look at EIP-1559

EIP-1559 is an effort to smooth out these gas price spikes with a major overhaul of the existing fee structure. By extension, it should reduce average transaction confirmation times and improve Ethereum's overall user experience. 

The EIP enables blocks that contain 25 million gas, which is double the current 12.5 million block gas limit. The protocol itself will adjust fees in an effort to encourage blocks that contain 12.5 million gas. The additional block space is intended only as a buffer to protect users from sudden gas spikes — rather than as a general block size increase.  

Although a simple block size increase would give Ethereum a higher overall capacity, the network would run into exactly the same gas spike issues as today when blocks eventually become full. In a post detailing EIP-1559, Buterin reasons that a larger default block size would also introduce centralization risk, issues for nodes that drop offline and additional hardware demands for node operators. 

The reformed structure put forward in EIP-1559 introduces a hybrid system of base fees — adjusted by the network itself — and an inclusion tip. The base fee represents the minimum cost to have a transaction included in a block. It will increase or decrease depending on how full the previous block is. The base fee is denominated in gwei and multiplied by the fixed cost of the intended network function listed in the Ethereum Yellow Paper. 

When the previous block contains more or less gas than the 12.5 million target, the network increases or decreases the base fee, respectively. For example, if the previous block was filled to the new maximum hard per-block cap of 25 million, it increases the base fee by 1.125x. Base fees continue to increase for as long as demand for block space in the previous block is above the long-term average target. These automatic adjustments should spread out the transaction load — and, by extension, reduce the frequency and duration of gas price spikes.  

With the required base fee growing by a factor of 10 every 20 full blocks, within around five minutes, the cost to transact would become so great that it would discourage many users from submitting transactions. When previous blocks are no longer above the target, the base fee stops increasing. If demand for block space falls below the target of 12.5 million gas, the base fee reduces to make submitting transactions more attractive again.

Burning the base fee

This variable base fee aims to ensure that most blocks have space for an extra 12.5 million gas to absorb any sudden increases in demand without immediately causing a spike in gas prices. However, if the base fee was awarded to Ethereum miners, it would incentivize them to increase their own profitability by purposefully congesting the network. 

Instead, EIP-1559 proposes that base fees are destroyed, forever removing ETH from the circulating supply. It is this feature that has made EIP-1559 incredibly popular with ETH investors — and much less so among the network's miners, who currently receive 100% of the transaction fees.  

Meanwhile, the inclusion fee — formerly known as the miner tip — is optional and set by the users themselves. Inclusion fees allow the network to revert back to a structure like the present one, if necessary. When blocks are at the 25 million gas per-block cap, the inclusion fee provides a way for those users requiring the fastest confirmations to incentivize miners to include their transaction in the next block. 

Inclusion fees should remain low at times when blocks are not full, but they would serve a similar function as the current first-price auction fee model during periods of heightened congestion. They also create an incentive for miners to include transactions, in the first place. Without them, it would be more profitable to mine empty blocks. By doing so, miners would still receive block rewards but would not need to commit computational resources to process transactions that do not financially benefit them. 

Finally, the transaction creator also sets a maximum value that they are willing to pay for both the base fee and the inclusion fee. This is known as the fee cap. The transaction will only be included if the fee cap is larger than the required base fee. The creator is also sure that their transaction will cost no more than the fee cap specified.

The following example should illustrate what comprises each transaction fee under the EIP-1559 model. 

Let us presume that the previous block was exactly at the target of 12.5 million gas and had a base fee of 100 gwei. Our transaction creator wants to make a simple ETH-to-ETH transaction, which requires 21,000 gas. They set a fee cap of 200 gwei and incentivize miners with an inclusion fee of 2 gwei. 

With the network not congested, they would pay the current base fee (100 gwei) plus the inclusion fee (2 gwei), multiplied by the transaction cost (21,000 gwei). The total paid for such a transaction would be 2,142,000 gwei — or 0.002142 ETH. Of this, the 2.1 million gwei base fee would be burned and the miner including the transaction in a block would receive 42,000 gwei. 

The potential impact of EIP-1559

A deflationary ETH

The EIP-1559 detail that has attracted the most attention from those outside of developer communities is the base-fee burn mechanism. Rather than being awarded to miners, base fees would instead be sent to a burn address — to which no one has the private key. This permanently removes them from ETH's circulating supply.

One of the main criticisms of Ethereum — particularly from BTC proponents — is that there is no limit to ETH's total supply. Unlike Bitcoin, the Ethereum network does not enforce block reward halvings that eventually reduce issuance to zero. 

The rationale behind this unlimited issuance is to continue providing a monetary incentive for miners to support the network for as long as it exists. However, this inflationary monetary policy has caused many to question ETH's viability as an investment vehicle. 

Under EIP-1559, destroyed base fees would offset the inflationary pressure on the ETH price caused by new issuance. The amount of ETH burned would be dependent on network usage. The more transactions are submitted to the network, the more ETH would be forever removed from circulation. 

This would create a feedback loop between Ethereum network usage and ETH's value. If usage is high enough that base fee burns exceed daily block reward issuance, Ethereum's monetary policy would be deflationary. The network's increasing utilization would create greater demand for a decreasing supply of ETH. In such a scenario, ETH's price rise would benefit investors — hence EIP-1559's popularity among ETH holders.

An improved user experience

Although most of the attention has been on the burn mechanism, EIP-1559's main aim is to address the sudden gas price spikes that are detrimental to Ethereum's user experience. If successfully implemented, the network's users would have a much better idea of the fee they need to pay in order for a transaction to settle without lengthy delays. 

Gas prices could still spike with sudden increases in network activity. However, any rapid growth of the required base fee should quickly bring congestion down to a point where miners once again include those transactions waiting in the mempool. Under the current fee structure, users must wait for demand to drop naturally. With EIP-1559, the protocol itself attempts to control demand by making it prohibitively expensive to transact for a short period.   

Tim Beiko, a senior product manager at ConsenSys — an Ethereum software development company — explained this principle in a series of updates on EIP-1559:

"Estimating the right price for a 1559-style transaction is trivial: set the FEE CAP high above the BASE FEE, or at one’s maximum willingness to pay for the transaction, set the TIP to an amount high enough to compensate miners for their computation cost."

Similarly, wallets and other applications would no longer need to estimate fees algorithmically in order to provide multiple options for different settlement speeds. Instead, they could offer users a much simpler single transaction fee. This would comprise a fee cap that is double the sum of the current base fee as well as a small default inclusion fee. Since users only pay the currently required base fee and an inclusion fee that they themselves can specify, they are not at risk of overpaying. 

Solidifying ETH as Ethereum's currency

An even less-talked-about impact of EIP-1559 is that it cements ETH's place as the currency of Ethereum. Although ETH is the network's native cryptocurrency, there is nothing within the protocol itself that explicitly requires users to pay for transactions with ETH.  

Obviously, the vast majority of transactions and computations on Ethereum use ETH to incentivize miners. However, transactors could equally pay with any on-chain asset. A miner could choose to accept fees paid in DAI, for example. In fact, the payment does not even need to occur on the Ethereum network. If a user somehow comes to an agreement to pay a miner in BTC, or even dollars via a wire transfer, their transaction will be equally valid. 

EIP-1559 changes this. Since the base fee is specified explicitly by the network, it must be paid in ETH. Although almost all transactions already pay the network in ETH, the upgrade would make the currency crucial to every transaction. 

While this change is unlikely to drive a sudden growth in transactions using the cryptocurrency to pay fees, it does ensure that ETH's position on the network cannot be abstracted away by users. 

Impact on miners

Since Ethereum's launch, miners have generated revenue from both block rewards and transaction fees. Under EIP-1559, the protocol burns the largest part of the overall fee — i.e., the base fee. Miners will only receive inclusion fees. Much of the documentation surrounding the upgrade concludes that these will often be less than 10 gwei, unless the network is highly congested. Therefore, such a change may significantly reduce mining revenue.

Transaction fees have been increasingly contributing to Ethereum miner revenue over the last year. Source: The Block

The counterargument to this is that any drop in revenue will likely be temporary. Increased Ethereum adoption and speculation recently pushed the ETH price back above its 2018 high

Meanwhile, Ethereum scaling solutions — like zkRollups and Optimistic Rollups — are rapidly gaining traction. Such Layer-2 protocols should reduce congestion on the base blockchain. Their impact — combined with improvements to user experience enabled by EIP-1559 — may make Ethereum more attractive to new users, driving demand for ETH. 

With EIP-1559 reducing — or perhaps reversing — ETH's growing issuance, such adoption could push the ETH price much higher. Proponents of the EIP contend that a higher ETH price would make up for any loss of revenue miners incurred prior to the eventual transition away from mining altogether with Ethereum 2.0.  

Will EIP-1559 lower fees?

EIP-1559 clearly has large implications for Ethereum's future. However, there seems to be a widely held misconception that it will radically reduce fees. 

When demand for block space is high, fees can still rise to prohibitively expensive levels with EIP-1559 active. Tim Roughgarden, a computer science professor at Columbia University, explained this in a paper exploring EIP-1559:

"No transaction fee mechanism, EIP-1559 or otherwise, is likely to substantially decrease average transaction fees; persistently high transaction fees is a scalability problem, not a mechanism design problem."

Ethereum is currently in the middle of a multi-year upgrade to Ethereum 2.0. While this is anticipated to vastly increase the network's throughput, there is no concrete launch date for the revamped network.  

Despite the unknown timeline and current gas price issues, Buterin is confident that Layer-2 scaling efforts will enable the network to accommodate more users in the meantime. Speaking on the Tim Ferriss podcast, he stated:

"Rollups are coming very soon and we’re fully confident that by the time that we need any more scaling of that, sharding will have already been ready for a long time by then."

Objections to EIP-1559

Improvements to user experience and a harder monetary policy have made EIP-1559 extremely popular with much of the Ethereum community. However, since it may be detrimental to their profitability, Ethereum miners are divided on the upgrade. 

Many mining pools have signaled opposition to EIP-1559. Among them are major pools Ethermine, Spark Pool and Flexpool. They contend that the upgrade reduces the amount users are paying to secure Ethereum and increases the risk of attack. If mining revenue drops, miners might leave to mine a different network. This would reduce the hash rate required to attack Ethereum. It would also effectively lower the cost of renting hash power from those miners previously securing the network.

Michael D. Carter, an Ethereum miner and the host of the YouTube channel "Bits Be Trippin," is among those opposed to EIP-1559. He shared his concerns with OKEx Insights: 

"If we had a lower ETH price for whatever reason in July, when EIP-1559 goes live, and if more than 50% of the network is being propped by the higher fees, the burn of those fees puts the network at risk. Things like a fee-burn could create a large enough disincentive for large amounts of [miner] participation to drop. If that exceeds 50% of the network, then ETH is vulnerable to a 51% attack — if a would-be nefarious actor put a large enough buy order on the various brokers (NiceHash, mining rig rentals, etc.) and paid a premium for that newly kicked off hash power. While it seems like a long shot, we live in a world that pulls casual $69m bids for NFTs."

In correspondence with OKEx Insights, Ben Edgington of ConsenSys and the Teku ETH 2.0 client commented on Ethereum's current all-time high hash rate providing ample network security. He doubts that any drop in miner revenue will put the network at risk:

"Reducing the fees paid to miners will inevitably reduce the overall hash rate securing Ethereum. Hash rate, however, is at an all-time high, and the general view is that it can be substantially lowered without any risk to Ethereum's security."

Edginton believes that Ethereum's all-time high hash rate gives the network ample security, even if miners drop off following EIP-1559's activation. Source: Etherscan.

That said, the fact that some miners feel that the Ethereum community is actively hostile to them may also create a non-monetary incentive to attack the network. Writing on the StopEIP1559.org website, Flexpool stated: 

"Miners are no longer vital to Ethereum developers or big mining pools because they’ve made their money, and now miners are an embarrassment. The developers and big mining pools had forgotten where they came from and supported them when they started out. Remind them that your [sic] not a dog. Take your business elsewhere."

Miners in opposition respond

Those miners not supportive of EIP-1559 recently organized a protest to the change on April 1. The plan was for all miners rejecting the upgrade to join the Ethermine pool as a "show of force." Its goal was to pressure core developers into considering the mining industry's concerns and possibly force a compromise.

However, the planned action was called off just days after it was announced. Carter explained: 

"The April 1 show of force is being called off as the attention to the security risks has navigated the topic toward talking about 51% risk. While I absolutely agree with that, the intention was to show that it is possible to align miners. It was a pretty shortsighted display on our part to bring attention to the risks. Our intention was to bring awareness that some scenarios could put Ethereum at risk in July and nobody was listening to that concern."

Carter recently put forward a complementary EIP — EIP-3368 — that would temporarily increase block reward subsidies to compensate for any loss of miner revenue. He commented on the proposal: 

"What my proposal is asking for is a toggle (optional) deployment of an increased block reward that will naturally decay over a period of time ahead of the PoS transition. It should provide enough incentive to keep participants on Ethereum until that transition."

Edgington also commented about EIP-3368 to OKEx Insights:

"It's good to see some in the mining community engaging with the process in good faith, and I believe that the proposal is worth consideration in conjunction with EIP-1559. I expect that the community at large will view the proposal as unnecessary, but I trust the core devs to give it due consideration with respect to any impact on the security of the network."

Indeed, many of those first to discuss EIP-3368 seem to reject it. One commenter on the Ethereum Magicians forum stated

"Accepting this proposal would establish a precedent that Ethereum’s monetary policy is more or less arbitrary and that with sufficient social pressure issuance can be increased to benefit certain stakeholders. This would be catastrophic for Ethereum."

Mining industry divided

Not all mining pools are against EIP-1559. Supportive of the upgrade is F2Pool — currently the third-largest Ethereum mining pool by hash rate. 

In February, F2Pool released a statement to elaborate on its decision and to expound the argument laid out by the pool's co-founder, Chun Wang, at a virtual conference earlier that month. Wang's virtual presentation and F2Pool's statement implores Ethereum miners to support the proposal, acknowledging the crucial role that miners played in establishing the network while also arguing that developers and users are now the main drivers of Ethereum's activity. Thus, Wang and F2Pool contend that improving the overall user experience would help the network to accrue even greater value, which would also benefit miners.  

Furthermore, the team posits that many developers and users are already confident that EIP-1559 will be activated and has therefore already been at least somewhat priced into ETH. Reneging on the upgrade at this stage may cause the ETH price to temporarily drop — which would also reduce Ethereum mining revenue. 

They go on to argue that the recent bullish price action has already significantly increased the revenue miners earn from block rewards, and continued ETH price appreciation would likewise benefit the industry: 

"Despite block rewards dropping from 30,000 ETH daily in 2016 to 13,000 ETH daily today, on a fiat basis, miners’ block reward revenues have increased from $300,000 daily (roughly assuming $10 per ETH) to $23.4M daily (roughly assuming $1,800 per ETH)." 

Will there be an Ethereum chain split?

With miners divided on EIP-1559, it would be foolish to write off the risk of a chain split. However, the fact that those opposed to the upgrade appear to have backed down from the April 1 action suggests that they are — for now, at least — unwilling to risk undermining the network.  

In any case, following a chain split, it is likely that economic activity would go to the fork that offers the greatest user experience. For a chain split to be worth it for those miners on the non-EIP-1559 chain, it would need to attract users and investors. With the vast majority of users wholly behind the upgrade, many would likely dump any coins received on the new chain. This immediate tanking of the price would obviously hurt miners' profitability. 

Similarly, investment — itself a major driver of a coin's price — would focus on the chain with the strongest monetary policy. With EIP-1559 hardening ETH's tokenomics, the fork on which it is active would likely see greater investment. Ultimately, miners need people to buy the coins they generate. No matter how much they disagree with EIP-1559, miners would eventually revert back to the more popular — and profitable — chain in the seemingly unlikely event of a split. 

Speaking to OKEx Insights, Edgington doubted that division among miners would result in a chain split in July:

"I do not believe that there will be any significant chain split. A chain split serves nobody's interests, including the miners. To provoke a chain split would be a uniquely self-destructive move that I don't believe will happen."

Is EIP-1559 bullish for ETH?

Any upgrade to a live public blockchain network worth billions of dollars carries some risk. There may be vulnerabilities in the new code, which could damage ETH's value proposition. Similarly, since it is being included along with several other EIPs as part of a major scheduled network upgrade, a flaw in one of the other updates could also introduce vulnerabilities. 

Additionally, there is a sizable faction of miners against EIP-1559. While it might appear to make little economic sense, the risk of a chain split is still non-zero. However, given the support for EIP-1559 from the Ethereum community, any competing fork would surely struggle to represent a more economically viable proposition to miners. 

Although miners are currently seeking a compromise on the controversial EIP, it still appears that the upgrade will make it into the London hard fork, at this point. If successfully implemented, it would have a meaningful impact on both Ethereum's usability and ETH's value proposition.

Edgington is confident that EIP-1559 strengthens Ethereum. He told OKEx Insights:

"EIP-1559 undoubtedly improves Ethereum. Insofar as price and protocol are connected, the effect should be positive. The absolute impact is impossible to know."

Providing the ETH price continues to grow, Ethereum miners' revenue should not be too adversely affected. However, their margins will certainly be slimmer and, should the price tank, it is likely that some miners will become unprofitable and may drop off the network. Whether that will be enough to jeopardize Ethereum's security in any meaningful way remains to be seen. 

Although EIP-1559 looks set to improve ETH's value proposition and the network's user experience, the upgrade would not address the overall cost to transact. For now, this continues to represent one of the largest barriers to wider Ethereum adoption. However, when EIP-1559 is considered alongside the network's expanding Layer-2 ecosystem and eventual upgrade to Ethereum 2.0, it appears to represent another addition to the ever-growing bullish case for ETH.  


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Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

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