Based on the underlying principles of EIP-1559, how much ETH will be burned?

Source: Bankless

Compiled by: DeepCryptoFlow

Original title: "How much ETH will EIP-1559 burn?"

In the words of UFC host BAFO: It's time.

EIP-1559 is finally live, two and a half years after it was initially proposed! Activated as part of a hard fork, EIP-1559 marks a critically important protocol change in Ethereum’s history, overhauling the fee market and improving the user experience of paying for the network’s precious block space.

Importantly, EIP-1559 also introduces a destruction mechanism whereby a portion of transaction fees paid to miners or validators are permanently removed from circulation.

Every time the Ethereum network is used, ETH tokens are destroyed - which means that every time someone trades on Uniswap, or users rush to imitate the latest NFT, ETH holders essentially gain through this destruction mechanism.

Fee burning, combined with a significant reduction in block reward issuance from the merger to proof-of-stake, could lead to a deflationary supply of ETH and fulfill rumors of ultra-sound money.

While we are still some time away from experiencing its final form, it is possible that a large number of ETH tokens will be destroyed in the meantime.

This raises a series of questions. How many tokens are destroyed? What is the impact on issuance? Is ETH expected to become a deflationary currency?

This is the answer we will be looking for.

The underlying principle of EIP-1559

Before we look at how many ETH tokens will be destroyed, let’s take a moment to explore the underlying principles of EIP-1559.

EIP-1559 redesigns Ethereum’s fee market. Currently, the mining fees that users pay on the network are determined through what is known as a “first-price auction.” In this system, multiple users bid for block space, and the transactions with the highest fees are included in a block.

This system can lead to a frustrating user experience. We may have experienced this firsthand - mining fees can spike while a transaction is being sent to the memory pool or when it is confirmed, leaving users stuck waiting for their transactions to be confirmed because they paid too little. Being stuck is very frustrating for users because it often means that they need to manually enter a higher mining fee.

EIP-1559 alleviates this problem in several ways. First, by introducing a new mechanism to temporarily expand the size of blocks during periods of high network usage to accommodate higher demand for block space. Second, it replaces the "first-price auction model that is free for all" and changes the composition of fees, which is also the focus of this article.

Instead of paying a single fee, mining fees today consist of two parts. The first part is the so-called "base fee," which is determined algorithmically and varies on a per-block basis depending on its utilization.

The second part is the “priority fee”, which is a tip determined by the user to incentivize miners to participate in transactions.

Smart users can also set a maximum fee, which is the maximum mining fee they are willing to pay in order to include their transaction in a block. If the sum of the base fee and the priority fee exceeds the maximum fee, the difference will be refunded.

The base fee is the portion of the transaction that is destroyed. We can easily infer from this that during periods of high network activity (i.e. when mining fees are rising and block space is scarce), more ETH tokens will be removed from circulation (and vice versa).

Beyond that, we can see that the value of ETH holders is directly related to the demand for using Ethereum.

Fee destruction rate

Now that we understand the mechanics of EIP-1559, let’s look at the impact of fee burning on ETH supply and issuance.

When making these estimates, it’s important to keep in mind that basefees fluctuate on a block-by-block basis. Developer Tim Beiko, who played a leading role in the implementation of EIP-1559, has stated that basefees are expected to account for 25-75% of total transaction fees.

Since it is extremely difficult to manually determine the historical base fee for each block, we will use his predicted destruction ratios of 25%, 50%, and 75% as the worst-case, base-case, and best-case total transaction fees, respectively.

Therefore, these estimates may not be completely accurate.

Cumulative ETH destroyed

Let’s first look at how much ETH would be destroyed if EIP-1559 had been adopted since the inception of Ethereum.

Currently, the total supply of ETH is approximately 116.9 million.

If EIP-1559 was implemented when the Ethereum mainnet was launched in August 2015, the cumulative destruction would be 2.9 million, 1.9 million, and 99.4 ETH tokens, respectively, based on the basic fee rates of 75%, 50%, and 25%.

This means that the theoretical supply of ETH will be between 114 million and 115.9 million.

While this number may not seem that large, it is still a meaningful reduction relative to total issuance - as the supply of ETH will decrease by 0.85%, 1.70%, and 2.55% respectively.

If measured in US dollars, the aforementioned cumulative destruction will look even more amazing. Assuming the same interest rate, ETH worth $1.16 billion to $3.5 billion will be destroyed over the life of Ethereum. From another perspective, the lowest value of this destruction is equivalent to destroying the entire market value of SushiSwap, and the highest value exceeds the total value of Yearn and Compound.

From the chart above we can also see that the amount of ETH destroyed has skyrocketed since the second half of 2020.

This makes sense. The start of DeFi summer led directly to an explosion in demand for Ethereum, which also triggered an era of high mining fees that has not yet subsided.

ETH destroyed in 2021

Let’s take a closer look at fees generated so far in 2021. 2021 is an important year because it likely paints the most accurate picture of network utilization levels and future burning fees.

From this we can see that the past year spanned the DeFi summer of 2020, the bull markets in the fall, winter and spring of 2021, and the NFT craze this summer. Ethereum has been operating at peak capacity throughout the year.

If you are a Bankless reader, you probably hope that this situation will continue for the foreseeable future, as it means that the fees generated this year help to reasonably anticipate future levels of destruction.

Using the same 75%, 50%, and 25% burn rates, if EIP-1559 had gone into effect, more than 1.4 million, 93,000, and 467,000 ETH would have been destroyed so far in 2021. Extrapolating these numbers on an annual basis, it is estimated that 800,000 to 2.4 million ETH will be destroyed in 2021.

From this data, we can see the impact of high network utilization on fee destruction, as ETH destruction in the first seven months of this year has exceeded 48%.

In USD terms, assuming the same base fee rate, this means between $959 million and $2.8 billion worth of ETH was destroyed.

On an annualized basis, the value of ETH destroyed is between $160 million and $4.8 billion. These are staggering numbers. To put it in perspective, the value of ETH we destroyed this year has exceeded the market value of MakerDAO's MKR. Going further, in the best-case scenario for annual prices, the value of ETH destroyed would make it a top 25 crypto asset by market value.

However, it is important to remember that ETH destruction in USD terms can sometimes be misleading because it depends on the price of Ether. This helps explain the difference between the 2021 value denominated in ETH and the percentage of total value denominated in USD.

As we discussed above, the former is 48%, while the latter is over 80%.

The impact of EIP-1559 on the issuance of ETH

Now that we have seen how much ETH has been destroyed this year, the question arises: is there deflation in Ethereum? To confirm this, we need to look at the total issuance of Ethereum in 2021 and then subtract the assumed fee consumption.

As shown in the figure, a total of 2.24 million ETH were issued in the first seven months of 2021, equivalent to an average of 10,418 ETH issued per day. If calculated on an annual basis, the supply of ETH increased by 3.8 million, or 3.33%, from 114.09 million to 117.89 million.

Using the above data, if 1559 takes effect, based on the basic fee rates of 75%, 50% and 25% respectively, the ETH destroyed will be 1.4 million, 935,000 and 467,000 respectively, which is equivalent to selling 6,511, 4,348 and 2,172 ETH per day.

From this, we can know that for 1559, the daily net issuance of ETH ranged from 3907 to 8246, a decrease of 20% to 62%. If calculated on an annual basis, the new net issuance range is between 1.44 and 3.04 million, which means that the net inflation rate of ETH is 1.26% to 2.66%.

Although deflation has not yet occurred, the supply entering the market has been greatly reduced. ETH's inflation rate is lower than before the merger. Then, just like in the case of Bitcoin, ETH's selling pressure will be reduced by half.

Miners in the system have to sell coins because they need to pay a lot of electricity and hardware costs, 1559 turning selling pressure into buying pressure, transferring value from miners to ETH holders.

Ways to use ETH as a better currency

The 1559 supply shock points ETH in the right direction to be treated as a better currency after the merger.

The POS network greatly reduces the issuance required for network security. According to data from ETH Hub, even if 100 million ETH are pledged (which is indeed economically not feasible), the maximum issuance of 1.81 million is only 52%, which is still lower than the expected increase in 2021.

Based on the current supply and the destruction data in 2021 (these two numbers will change and can only be used as rough parameters), ETH is very likely to experience deflation after the transition to POS. Through the destruction rate, we can know that Ethereum's inflation rate may drop to -1.05%.

No, this is not a drill.

ETH really could be a better currency.