How will Ethereum's EIP-1559 launch affect us?

This article is reproduced from the decentralized financial community, reproduced with authorization

This article is reproduced from the decentralized financial community, reproduced with authorization

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

While this is what most of us focus on and look forward to, it's interesting to see how these infrastructure developments affect Ethereum token economics (and price). This post outlines these infrastructure changes, their timeline, and their potential impact 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

• proof of stake

proof of stake

Separated from Ethereum's main network, the setup of the beacon chain is the first step in the Eth2 upgrade. It introduces Proof of Stake (PoS) to Ethereum and lays the groundwork for a departure from the current Proof of Work (PoW) system.

This reduces the energy consumption of the network, supports decentralization by reducing expensive hardware requirements and encourages 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, the sharding of Eth2 solves the problem of scalability.

• Fragmentation

Fragmentation

Timeline: Beacon Chain launched in late 2020. There are shards on the roadmap in 2021 that will be introduced to the beacon chain until 2022 when it finally merges with Ethereum’s mainnet. At that stage, the existing old Ethereum chain would be just one of many shards in the network.

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Changes in token economics (supply side)

• Under Eth2's PoS, the issuance rate would be significantly lower, estimated between 0.5% and 1+% based on some reasonable assumptions. It is difficult to give an exact rate since issuance depends on many factors:

• Amount of ETH Staked/Number of Validators: More validators generally result in more ETH issued. However, as validators receive a lower percentage return from staking and less willingness to stake, there is a limit to the amount of ETH that ends up being staked when there are more validators.

Extent of bad behavior by validators: If a validator goes offline or maliciously validates the wrong transaction, they will be penalized as the loss of ETH will be burned and the supply reduced.

Overall, since both PoW and PoS systems issue ETH, the experimental phase of Eth2 before merging with the mainnet results in a short-term increase in the supply rate. However, after the merger, Eth2 will result in a significant decrease in the supply rate.

EIP-1559

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Next month, ethereum’s “London” hard fork will go live, bringing with it ethereum improvement proposal (EIP) 1559. EIP-1559 is one of the most important but also controversial changes to the Ethereum blockchain since the separation of Ethereum and Ethereum Classic in 2016. There are some changes in the distribution method.

Traditionally, users include a "gas" fee in their transactions to incentivize miners to include them in blocks, with the fee set by the highest bidder. If a user's fee is set too low, other users may bid higher than the user's gas cost, and the user's transaction may linger in the pool until it expires and is cancelled. This can lead to unpredictable and erratic charges 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 burned, with only an optional tip going to miners. Base or minimum fees are set automatically by the Ethereum protocol based on usage and demand, aiming for 50% network utilization, and float up and down to achieve this.

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

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Changes in token economics (supply side)

After all, EIP-1559 is an upgraded version of the blockchain, which can help institutions and individuals better predict how much it will cost to complete a transaction and how long it will take to confirm the transaction. Knowing how much and for how long is extremely important for wider adoption in the larger financial market.

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L2/Non-L1 Expansion Solution

These solutions do not change the underlying Ethereum infrastructure (layer1), but reduce network congestion by processing some transactions off-chain.

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

• ZK rollup: The data of the previous and subsequent states (for example, about the account balance) is stored in layer1. The smart contract conducts transactions in batches at layer2 and updates the final state at layer1, using a cryptographic proof called SNARK to prove that the final state is accurate.

• Optimistic rollup: Same as ZK rollup, but instead of proving the accuracy of each state update, the updates are assumed to be accurate. Accuracy is only computationally verified when someone challenges a state update, the fraudster will be penalized and the challenger will be compensated for the challenge fee.

• State channel: Establishes a channel between parties, forming an off-chain network in which many transactions take place. The final state is updated on Ethereum.

• Sidechain: Transactions are conducted in an independent blockchain using its own consensus mechanism. Assets and data are transferred with Ethereum through smart contracts, smart contracts lock assets, and recreate representative assets in the side chain.

Timeline: Major dapps have adopted scalable solutions. Some examples:

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Changes in token economics (supply side)

• The scaling solution will not really affect ETH supply until EIP-1559 is implemented in July 2021. However, since these solutions are tied to network activity and transaction fees, an interesting dynamic emerges when EIP-1559 bridges the gap between fees and ETH supply. Here are some possible effects:

• Disincentive effect: Fewer on-chain activity and transactions per "unit" of dApp activity lead to a reduction in base fees consumed under EIP-1559, dampening the deflationary effects of EIP-1559.

• Balancing effect: Lower fees offered by scaling solutions attract new price-sensitive users, increasing dApp engagement. This increase can be offset by a reduction in base fees consumed per "unit" of dApp activity. Overall, the "real demand" on the Ethereum network is likely to remain roughly the same.

New Activity Effects: Arguably, the nature of certain scaling solutions will enable the movement of new types of economic activity on Ethereum. For example, state channels can be used for small recurring payments that would otherwise be illogical with higher layer1 fees. Supply could be further reduced by introducing new types of activity into Ethereum, where some fees still end up being burned.

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

• Extent of adoption of extended solutions

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

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change in demand

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

• Raising awareness through use: Eth2's sharding and L2 scaling solutions increase Ethereum's scalability and reduce transaction fees per "unit" of network demand. 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.

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put it together

Eth2

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

• Short-term: Eth2 trials have increased the issuance rate of ETH. It also increases demand as investors buy ETH for returns

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 a major factor behind ETH's price gains and its continued breakout of April/May 2021 all-time highs.

extended solution

• extended solution

• first level title

at last

at last

• Ethereum’s infrastructure changes create a powerful boost for ETH price by putting 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 already been priced in.

• Innovation in the cryptocurrency space will disrupt several industries, especially the financial industry, creating and capturing 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