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Ethereum received its long awaited upgrade and prepares itself for the future

10 August 2021

August 5th saw the 12th long-awaited ‘London’ upgrade of the Ethereum network take place. This upgrade contained one of the most important improvements to the network of recent years that may fundamentally change the economics of the network and will drastically decrease the amount of sell pressure that ETH has historically faced.This write-up is to serve as a primer to the changes contained in the London hardfork, and will aim to roughly outline what implications these changes may have for the network.

The old ETH model

In the previous configuration of the Ethereum network, the system roughly worked as follows: users submit transactions to the network comprised of nodes at the cost of a transaction fee, these transactions are added to a queue (known as the ‘mempool’ or ‘txpool’) during which they’re validated and approved by miners. The miners then add approved transactions to a newly mined block for which they receive both a fixed subsidy in the form of a block reward and the variable fees users paid to have their transactions included in that block. These new blocks are then added to the Ethereum blockchain. 

The old economic system of Ethereum is based on a first-price auction. This means that the transactions of users that are willing to pay the highest price are mostly likely to be included first, as miners are incentivized to include transactions that pay the highest fees thus leading to users to be incentivized or even forced to pay higher fees to have their transactions processed. This bidding system has some clear downsides for users of the network, as it incentivizes users to overpay for their transaction fees to merely have their transactions included - let alone be processed in a timely manner - which can be particularly costly as transaction fees have recently surged as a result of higher activity on the network. The user also implicitly pays in a second way, as their transaction fees are passed on entirely to the miners without any value accrual to the network.

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Image: a comparison of the old fee mechanism compared to the new fee mechanism introduced by EIP-1559.
(source: https://consensys.net/blog/quorum/what-is-eip-1559-how-will-it-change-ethereum/)

The upgrade 

The main upgrade included in the London hardfork is EIP-1559, which stands for Ethereum Improvement Proposal 1559. This improvement drastically changes the way fees are structured on the network. The main goal of this improvement proposal was to improve the user experience (UX) of the Ethereum network. Moving forward, transaction fees on Ethereum will consist of a base fee, a priority fee (or tip), and a max fee. The base fee is the minimum fee a user must pay for a transaction in order to have it included in a new block, which will vary based on network demand. The priority fee can be seen as a tip that the user is willing to pay the miner in order to prioritize a transaction, and the max fee is chosen by the user to limit the amount of transaction fee a user is willing to spend. 

This new fee structure gives users a guarantee that their transactions will be included (where previously a transaction could fail if the user set its fee too low), while still maintaining the flexibility of paying for priority. Additionally, if a user were to overpay unnecessarily, the unused part of the fee is returned to the user. As a result, the new fee structure drastically improves the UX of the network. Perhaps the most important change in this new fee structure is that the base fee component is burnt, which means it reduces the rate of new ETH emissions and thus connects the users spending on the network to value accrual on the network in which they have some stake. This change in fee structure also changes the compensation received by miners, as only the variable user-paid tip and fixed protocol-paid block reward subsidy go to the miners, although experts presume the loss of mining income may be compensated by the rising value of ETH.

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Image: graph showing the cumulative amount of ETH emitted and earned by miners and burned base fees. 
At time of writing 16.500 ETH have been burned, approximately 4000 ETH per day on average. (source: https://dune.xyz/k06a/Ethereum-after-1559)

Future of ETH

Experts have long speculated that the update included in EIP-1559 may potentially make ETH deflationary, as it is theoretically possible for the amount of burned fees to exceed the amount of ETH emitted by miners. It seems unlikely that Ethereum will become deflationary during its current miner-dominated Proof-of-Work (PoW) iteration, as the rate of mined ETH emissions remains high. However, the first steps away from this PoW iteration were taken in December 2020 when the beacon chain of ‘Ethereum 2.0’ was launched. This new version of the network will move towards an environmentally-friendly miner-less Proof-of-Stake (PoS) consensus protocol (to read more about this, check this blogpost). In this new version of the network, which should be coming to Ethereum around 2022, the amount of base fee paid for each transaction is much lower due to miners being made redundant. In that future low-fee paradigm, it is very conceivable that Ethereum could become deflationary to some degree.