Ethereum EIP-1559 will be launched next month. What impact will it have on us?

Ethereum is about to undergo huge changes, we will have Eth2.0, EIP-1559, and more and more adoption of layer2 scaling solutions in the main Ethereum protocol.

The main motivation for these changes is to increase Ethereum's scalability, manage network congestion, reduce prohibitively high gas fees, and improve network efficiency. These highly anticipated changes come against the backdrop of a surge in demand for Ethereum dApps (especially DeFi and NFT dApps), which has outstripped Ethereum's capacity. This in turn has led to a surge in fees, as well as the success of Solana and BSC.

While this is what most of us focus on and look forward to, it is interesting to understand how these infrastructure developments affect Ethereum token economics (and price). This post outlines these infrastructure changes, their timelines, and potential impacts on Ethereum token economics and price in the short and long term.

Eth2.0

Eth2 can be broken down into 2 major upgrades: Proof of Stake and Sharding

1. Proof of Stake

Separated from Ethereum's mainnet, the beacon chain is the first step in the Eth2 upgrade. It introduces proof of stake (PoS) to Ethereum and lays the foundation for moving away from the current proof of work (PoW) system.

Under PoW, blockchain transactions are verified by miners who solve problems that require high computing power and cryptographic techniques. The first miner to solve the problem creates a block and is rewarded with newly minted ETH. Meanwhile, in PoS, users stake and lock up 32 ETH to become validators, creating and verifying blocks like miners under PoW. However, instead of competing to solve problems, they are randomly selected to create blocks and receive rewards. Therefore, players will receive rewards based on the amount of ETH they have invested.

This reduces the network's energy consumption, supports decentralization by reducing expensive hardware requirements and encouraging the creation of more nodes, and makes the network more secure. This solves the security and decentralization aspects of the blockchain trilemma. At the same time, Eth2's sharding solves the scalability aspect.

1. Sharding

Sharding splits large databases into smaller parts, called shards. This increases scalability because validators do not need to store data for the entire network, but only for the shard they are assigned. Currently, Eth2 is planned to have 64 shards, with the beacon chain responsible for coordinating communication between shards. There is still debate over whether shards should only provide additional data, or whether they should also have code execution capabilities.

Timeline: The Beacon Chain is launched at the end of 2020. On the roadmap for 2021 are shards, which will be introduced to the Beacon Chain until it finally merges with Ethereum’s mainnet in 2022. At that stage, the existing old Ethereum chain will be just one of many shards in the network.

Changes in Token Economics (Supply Side)

Under Eth2’s PoS, the issuance rate will be significantly lower, and is expected to be between 0.5% and 1+% based on some reasonable assumptions. It is difficult to give an exact rate because the issuance depends on many factors:

1. Amount of ETH staked / Number of validators: More validators generally lead to more ETH issuance. However, as the percentage return validators receive from staking and their willingness to stake decreases, the amount of ETH that can ultimately be staked is limited when there are more validators.

2. The degree of bad behavior of validators: If a validator goes offline or maliciously validates wrong transactions, they will be punished as the loss of Ethereum will be burned and the supply will be reduced.

Nonetheless, issuance rates are expected to decline significantly.

In general, since both PoW and PoS systems issue ETH, Eth2’s experimental phase before merging with the mainnet will result in a short-term increase in the supply rate. However, after the merger, Eth2 will cause the supply rate to drop significantly.

EIP-1559

Next month, Ethereum’s “London” hard fork will go live, and with it comes Ethereum Improvement Proposal (EIP) 1559. One of the most significant, yet controversial, changes to the Ethereum blockchain since the split between Ethereum and Ethereum Classic in 2016, EIP-1559 brings a number of changes to how fees are set and distributed on the network.

Traditionally, users include a "gas" fee in their transactions to incentivize miners to include them in a block, and the fee is set by the highest bidder. If a user sets the fee too low, other users may bid higher than the user's gas fee, and the user's transaction may linger in the pool until it expires and is canceled. This can lead to unpredictable and volatile fees during periods of high usage.

The new model will set fees based on network usage, with a variable "base fee" that will be burned or destroyed, with only an optional tip that will go to miners. The base fee, or minimum fee, is automatically set by the Ethereum protocol based on usage and demand, and is designed to achieve 50% network utilization, and it does so by moving up and down.

Considering that miners earned over $1 billion in transaction fees in May, miners and mining pools are understandably upset about this change and have been strongly opposing it over the past few months, organizing protests and even threatening to stop the network in a show of “force” against the upgrade. These actions have only caused Ethereum developers to delay their expected timeline for the migration to Eth 2.0, which will officially transform the Ethereum blockchain from proof-of-work to proof-of-stake, eliminating the role of miners in securing the blockchain based on the security of staked assets, rather than hashing power.

Because the base fee is burned when a transaction is included in a block, Ethereum has the potential for deflation. If the amount of Ethereum burned based on gas fees is higher than the amount of Ethereum given as a block reward, the total amount of Ethereum generated per block will be negative. During previous peaks of the network, this threshold could be passed, and it was thought that this would put upward pressure on the price of Ethereum as supply would be slightly reduced.

Changes in Token Economics (Supply Side)

When the network is congested, the base fee increases to reach the 50% block size target, so burning the base fee reduces the supply of ETH in proportion to the amount of activity on the Ethereum network. Estimating the size of the effect is difficult because it depends heavily on network activity. Using current transaction fees as a proxy is also not entirely accurate because we are not sure about the ratio of base fees to tips. Some estimate that EIP 1559 will reduce net issuance so much that ETH will become deflationary.

Ultimately, EIP-1559 is an upgrade to the blockchain that helps institutions and individuals better predict how much it will cost to complete a transaction and how long it will take to confirm the transaction. Clarity on how much and how long is extremely important for wider adoption in the larger financial markets.

L2/non-L1 extension solutions

These solutions do not change the underlying Ethereum infrastructure (layer 1), but instead reduce network congestion by processing some transactions off-chain.

We refer to them as non-L1 scaling solutions, as some solutions (e.g. sidechains) are technically not layer2 as they are not directly secured by layer1. Here is a brief overview of some scaling solutions:

• ZK rollup: Data about the previous and next states (e.g., account balances) are stored in layer 1. Smart contracts batch transactions in layer 2 and update the final state in layer 1, using cryptographic proofs called SNARKs to prove that the final state is accurate.

• Optimistic rollup: Same as ZK rollup, but instead of proving the accuracy of each state update, it is assumed that the update is accurate. Accuracy is only verified by calculation when someone challenges the state update, fraudsters will be punished, and challengers will be compensated for the challenge fee.

• State channel: A channel between parties is established to form an off-chain network in which many transactions are conducted. The final state is updated on Ethereum.

• Sidechain: A separate blockchain that uses its own consensus mechanism for transactions. Assets and data are transferred to and from Ethereum via smart contracts, which lock assets and recreate representative assets in the sidechain.

• Plasma chain: Similar to a sidechain, it operates as an independent chain with its own consensus mechanism. However, the "root" of each block is published to Ethereum, which makes the system more secure but limits its ability to perform complex operations.

Timeline: Major dapps adopt scalable solutions. Some examples:

Changes in Token Economics (Supply Side)

Scaling solutions will not actually impact ETH supply until EIP-1559 is implemented in July 2021. However, since these solutions are tied to network activity and transaction fees, interesting dynamics will emerge when EIP-1559 bridges the gap between fees and ETH supply. Here are some possible impacts:

• Suppressive Effect: Fewer on-chain activity and fewer transactions per “unit” of dApp activity results in less base fees consumed under EIP-1559, suppressing the deflationary effect of EIP-1559.

• Balancing effect: Lower fees provided by scaling solutions attract new price-sensitive users, increasing engagement in dApps. This growth can offset the effect of reduced base fees consumed per “unit” of dApp activity. Overall, the “true demand” for the Ethereum network is likely to remain roughly the same.

• New Activity Effect: It can be argued that the very nature of certain scaling solutions will make the movement of new types of economic activity on Ethereum feasible. For example, state channels can be used for small recurring payments that would otherwise be illogical given the high layer 1 fees. By introducing new types of activity to Ethereum that will ultimately still have to pay some of the fees that are burned, the supply could be further reduced.

It is difficult to determine the net effect which also varies over time. The net effect depends on:

• The extent of adoption of extended solutions

• The amount of new economic activity entering the Ethereum ecosystem

• Net impact on “real demand” for on-chain transactions on the Ethereum network

Changes in demand

These changes could lead to increased demand for ETH and fiat inflows as they attract investors through:

• Increase the attractiveness of ETH as an asset: Eth2 converts ETH into a productive asset that can generate cash flow through staking. Judging from media reports and ETH price increases before the implementation of EIP-1559 in July, the deflationary impact of EIP-1559 on ETH supply also seems to have attracted many investors.

• Raising awareness through usage: Eth2’s sharding and L2 scaling solutions improve Ethereum’s scalability and reduce transaction fees per “unit” of the network required. This makes Ethereum more accessible to retail users with smaller transaction sizes, supporting further adoption and awareness of the ecosystem’s dApps and ETH itself. This increases the pool of investors interested in buying and holding ETH.

Let’s put it together

A chart showing the impact of Ethereum infrastructure changes on ETH supply and demand. Arrows indicate expected changes over time, and box size indicates uncertainty.

Eth2

• Short term: The Eth2 pilot increases the issuance rate of ETH. It will also increase demand as investors buy ETH to earn returns

• Long term: The merger of Eth2 and Ethereum mainnet has led to a significant drop in the issuance rate. As people's awareness of Eth2 increases, the demand for ETH will also increase.

EIP-1559

• Once EIP-1559 is implemented in July 2021, it will cause the ETH net issuance rate to drop significantly due to the base fee being burned. On the demand side, it has been the main factor behind ETH's price increase and continued breakthroughs to the all-time highs in April/May 2021.

Scaling Solutions

• Short term: No impact on supply rate until EIP-1559. As some scaling solutions are implemented, it has a small positive impact on ETH demand, attracting smaller users and increasing participation with Ethereum.

• Long term: Due to the 3 effects discussed previously, the net effect on the supply rate is highly uncertain. It will be close to zero, slightly tending to reduce the supply rate in the long term due to the "new activity effect", where more innovative ideas are added to Ethereum over time and through scaling solutions. This is expected to have a significant positive impact on ETH demand, as it increases the accessibility of Ethereum, thereby increasing the number of potential investors interested in purchasing ETH.

at last

Ethereum's infrastructure changes have created a powerful tailwind for ETH prices by exerting pressure on both supply and demand. However, as ETH continues to break all-time highs, many are wondering how high ETH can go and whether these positive factors have been priced in.

• Innovation in the cryptocurrency space will disrupt multiple industries, especially the financial sector, and create and capture a lot of value in the process

• Ethereum has been the market leader in crypto innovation to date, and infrastructure changes are increasing its scalability, thereby increasing its ability to dominate the market.

• EIP-1559 ties Ethereum’s success to ETH