What is EIP-1559? How Will It Change Ethereum?

It’s not everyday that mainstream financial media outlets mention specific Ethereum Improvement Proposals (EIPs). EIP-1559 bucks this trend. One of the reasons is that in addition to simplifying Ethereum’s fee market, it also changes Ethereum’s monetary policy. However, there is a lot more to EIP-1559 than its meme as making Ethereum “Ultra-Sound Money.”

In this post we answer the main questions that Ethereum holders, dapp users, and developers have about EIP-1559, which will be included in the London Hard Fork in July. The upgrade will first go live on Ropsten, at block 10499401, which is expected to happen around June 24, 2021. Tim Beiko pulled together great resources as well if you want to dive deep into the topic. 

What is EIP-1559?

EIP-1559 will change Ethereum’s fee market mechanism. Fundamentally, EIP-1559 gets rid of the first-price auction as the main gas fee calculation. In first-price auctions, people bid a set amount of money to pay for their transaction to be processed, and the highest bidder wins. With EIP-1559, there will be a discrete “base fee” for transactions to be included in the next block. For users or applications that want to prioritize their transaction, they can add a “tip,” which is called a “priority fee” to pay a miner for faster inclusion. 

As an analogy to explain the base fee and tip, imagine the experience of using a ride sharing service app on your phone (e.g. Uber, Lyft, or Didi). You want to use this app to get a ride to go from A to B. The cost to go from A to B is the same, regardless of which driver picks you up (the base fee in EIP-1559). Now, imagine if you were able to add a tip to your driver, prior to getting on the ride. If your tip is higher than what other people at that time are offering, drivers will be incentivized to pick you up over other potential passengers not offering a tip. 

This process is similar to your ETH transactions: you can set a tip for miners (the “driver” in the above example) to include your transaction in the next block (the “ride” in the above example). A higher tip means a greater chance of your transaction being included in the next block and therefore being completed.

The above diagram shows how the fee mechanism will work with EIP-1559. Currently, fees are paid to miners, who also receive the block reward of 2 ETH per block, plus uncle rewards. With EIP-1559, the base fee is burned, but a tip and the block reward still go to the miner. 

Will this make gas cheaper? 

No, this is not the intent of the EIP. As a side effect of a more predictable base fee, EIP-1559 may lead to some reduction in gas prices if we assume that fee predictability means users will overpay for gas less frequently. With EIP-1559, the base fee will increase and decrease by up to 12.5% after blocks are more than 50% full. For example, if a block is 100% full the base fee increases by 12.5%; if it is 50% full the base fee will be the same; if it is 0% full the base fee would decrease by 12.5%.

The ongoing movement of applications to rollups and Layer 2s will be what greatly reduce fees. 

How will this change the user experience when setting a transaction fee? 

The idea is to make fees based on block demand more transparent for the user. Wallets like MetaMask will be able to have better estimates, and won’t have to rely much on external oracles since the base fee is managed by the protocol itself.

Does the user need to select a transaction fee? If so, how do they determine the appropriate amount? 

Wallets will provide predefined settings based on how urgent the transaction is for the user. With MetaMask, users will still have an option to set the priority of their transaction as “low” “medium” and “high,” based on previous block’s estimated usage, and the type of transaction. 

Will typical users be selecting the “tip” amount or will that be part of an overall fee preselected for users? 

The “tip” will be included as the overall “gas fee” that users see to submit a transaction. You will also be able to “edit gas fee” to increase or decrease the “tip” which is called a “priority fee.” 

Is the user experience going to be different during times of network congestion? 

During periods of high network congestion, the base fee will adjust by 12.5% depending how much demand surpasses the ideal gas limit per block until that demand abates. Instead of a first-price auction, users will have a better sense of how congested the network is by how high the base fee is. If it is too congested, the user can either pay that price or not, like they would buy an item at a store. Or, they submit a lower fee and wait for the price to go down in the future.

Where can someone see what they paid for a tip? Will block explorers like Etherscan now show this information? 

This work is pending. Most likely yes, most tooling will be updated accordingly to show the new information related to the EIP.

Are all the client teams ready for EIP-1559? 

Yes, client specifications have been frozen. The London Hard Fork release schedule is as follows:

In order to be compatible with the London upgrade, node operators will need to upgrade the client version that they run. The versions, listed below for each client, support London across test Ethereum networks. Another release will be made by each client once the mainnet fork block has been chosen.

Will this make ETH deflationary as an asset?

Modeling exactly how deflationary EIP-1559 is difficult since you have to project variables like expected transactions, and, even harder to predict, expected network congestion. In theory, the more transactions that occur, the more deflationary pressure that the burning of the base fee will have on the overall Ethereum supply. 

After the merge to Proof of Stake, Justin Drake's model estimates as a “best guess” that 1,000 ETH will be issued per day, and 6,000 ETH would be burned. Assuming more validators join and the staking APR is 6.7%, the annual supply change will be -1.6million ETH, reducing the annual supply rate by 1.4%

Despite growing awareness of MEV and potential EIPs to bring more transparency, we can expect arbitrage opportunities to only get more sophisticated as institutional financial traders use DeFi protocols. This could mean that there may end up being way more spent on tips per block than the base fee. Zhu Su and Hasu actually predict that less than half of today's fees could be burned by EIP 1559.

Are there any potential risks for dapps on Ethereum?

All change is risky, but the Ethereum community has a track record of strong software development and coordination. There are some potential risks EIP-1559 presents to network actors that are sensitive to timing, such as oracles. Oracles usually provide the pricing information needed to support various actors in the DeFi ecosystem. For example, Compound needs to know the valuation (i.e. price x number of assets) of a user's collateral in order to determine if their position needs to be liquidated or not. The valuation of these assets have to be constantly updated, and Compound relies on oracles to update this information. 

Yet oracles might run into issues under EIP-1559 during periods of high congestion. In EIP-1559, when blocks are constantly full or close to being full at the larger block size, the base fee exponentially increases and won't stop exponentially increasing until the blocks are no longer as full. This exponential increase happens based on a predetermined algorithm and is not based on an auction. Thus, if demand does not abate, the base fee can reach exorbitant levels fairly quickly. Network actors such as oracles, which are time sensitive since they need to provide the pricing information for nearly all of DeFi, might end up paying incredibly high fees in order to ensure the pricing information reaches the DeFi application in a timely manner. In fact, many oracle networks might have to change how often they provide pricing information, which would alter how many DeFi applications interact with oracles.