What is EIP 1559 and what will it mean for DeFi?

This week will see the long-anticipated introduction of a major upgrade to the Ethereum network dubbed the “London hard fork”. Expected to launch on Aug 4 between 13:00 UTC and 17:00 UTC, with block 12,965,000, the upgrade will see five Ethereum Improvement Proposals (EIPs) implemented.

Arguably the most controversial of those is EIP 1559, which has split market opinion amid threats of an Ether miner revolt. Marking a radical change to how transaction fees are set, EIP 1559 could see miners lose up to 35% of their normal fees, according to CoinDesk research, so it is no wonder a mutiny is brewing. Others, however, see huge opportunities in the latest update, which could see the value of Ethereum sky-rocket and promises of a raft of benefits for users.

In essence, EIP 1559 will make fees on Ethereum more predictable and less volatile. Instead of determining transaction fees through a blind auction-like process, the network will now automatically calculate a fee based on demand for block space. This will result in a “base fee”, that all users will have to pay, and instead of being paid to miners directly this fee is going to be “burned” — earning this upgrade the name “The Fee Burn Proposal”.

READ: EIP-1559, the Ethereum miner revolt and what it all means for DeFi

The hope is that this will reduce the wait times for transactions, make fees more predictable, and therefore ultimately make Ethereum more attractive for users, especially increasing its applicability to decentralized applications (dapps).

Already, Ethereum is the blockchain of choice for decentralized finance (DeFi). The amount of Ether (ETH) held in smart contracts has increased by 50% since January, hitting an all-time high of around 26 million ETH, according to CoinDesk, with some 8.5 million ETH of this used in DeFi. Meanwhile, the amount of ETH held on cryptocurrency exchanges is down to a two-year low of 13 million ETH.

ETH held in smart contracts has hit an all-time high of $26 million

Source: https://www.coindesk.com/

It is certainly possible that EIP 1559 will increase the attractiveness of Ethereum for DeFi, as users no longer have to contend with long waiting times and a lack of transparency on the fees they are paying. The bad news, however, is that the hope of lower transaction (or “gas”) fees resulting from this change has unequivocally been exposed as a myth.

Today, Ethereum happens to be the most expensive blockchain to use in the world, with users paying more than $9 million a day for transaction fees compared to $392,000 for Bitcoin (Source: https://cryptofees.info/ Aug 2). Since EIP 1559 was first announced, some have been harboring hopes that the update will cut transaction fees on the network.

Historically, transaction fees have been all over the place on Ethereum. EIP 1559 will make fees more predictable and less volatile, and therefore easier to budget for. Sadly, though, it will not lead to a drop in gas fees, since the efficiencies it will introduce to the network won’t make it more scalable.

Developers are, however, working on other solutions that could achieve this, such as the “sharding” that will come with the long-awaited Ethereum 2.0. This will see the blockchain split into multiple mini-blockchains (“shards”) that can process transactions in parallel. Rumour is this could boost the scalability of the Ethereum network by over 64 times, but that code is nowhere near ready yet.

The other key feature of EIP 1559 is the burn mechanism, which will see the ETH used to pay for transactions burned rather than paid to miners as part of their fee. This is, of course, why the mining community is so upset. However, ETH investors could benefit from this feature, since it will take coins out of circulation over time. One long-standing criticism of Ether has been the unlimited supply of the coin, unlike Bitcoin, which means users’ holdings are becoming diluted over time.

Simulations of EIP 1559 by Dune Analytics as of June 8 suggest the activation of EIP 1559 over the trailing 365 days would have burned a total of 2,967,937 ETH, resulting in a net reduction in the coin’s supply of 76% over that time period.

EIP-1559 could lead to a 76% net reduction in ETH supply annually

This could potentially lead to a huge jump in the price of Ether. Some analysts are predicting ETH could hit $4,500 by the end of the year (from the current level of $2,575).

This could be great news for those invested in the cryptocurrency (though not so much for DeFi users, who pay in ETH for transactions on-blockchain). But this is all simulation, and the true impact of EIP 1559 on the price of ETH is hard to predict, as it depends very much on the demand for block space. If demand suddenly falls, the move could have far less impact.

Which takes us to the last, but very pressing, question: will Ethereum survive as the blockchain of choice for DeFi? If EIP 1559 fails to meet the hefty expectations of market participants, Ethereum’s competitors such as Binance Smart Chain and Cardano could step in to close the gap.

READ: Can Ethereum be replaced as the blockchain for DeFi?

There is undoubtedly a lot riding on this upgrade and only a few days left before we get to see in practice how it will affect the status quo in the crypto market. It may take a while until the implications are clear, though, and there may well be some stumbling blocks along the way.

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