Ethereum is the 2nd largest cryptocurrency in terms of market capitalization, and it harbors a majority of developers in crypto on its network. These developers are mostly working on building platforms on Ethereum or improving the network to better support the platforms. Ethereum’s greatest driver of adoption in recent years has been smart contracts and the applications built with them. Smart contracts are programs that self-execute an agreement between participants when predetermined conditions are met.
Brilliant developers built a blossoming decentralized finance (DeFi) ecosystem on top of Ethereum with smart contracts. Anyone with an internet connection and some crypto can use these platforms to lend, borrow, stake for interest and much more. Because smart contracts are complex and require miners to do more computation, they can congest the network.
By the end of 2020, transaction fees had skyrocketed because so many users were interacting with smart contracts. Overpaying for these transactions transferred an enormous amount of Ether from users to miners. Ethereum core developers have proposed a few different solutions for these problems through the Ethereum Improvement Proposal (EIP) process.
EIPs present new changes, features, standards and more to Ethereum developers and the community for consideration and approval. EIPs must contain the 2 most important aspects of the proposed upgrade: its technical specifications and the rationale behind the change. Many EIPs go unnoticed by much of the Ethereum community, but EIP 1559 is different. It is an important update that should improve the experience of new users and may have a positive effect on Ethereum’s price.
Key Upgrades to Ethereum’s Network
EIP 1559 is not the only major upgrade coming to Ethereum in the short-term. A much more impactful update called Ethereum 2.0, Eth2 for short, has been in the works for years. Eth2 aims to further secure the network, lower Ethereum’s environmental impact and directly decrease transaction fees by scaling the network. Unfortunately, it won’t be completed until the end of 2021 or early 2022.
Eth2 will implement 2 major changes to the Ethereum network architecture. It will split the network into shards and change the consensus mechanism from Proof of Work (PoW) to Proof of Stake (PoS). Sharding is possibly the most awaited change because it will increase transaction throughput and lower fees. It will also lower the hardware requirements for validators by decreasing the amount of computation they need to do. This change will make the network more secure because a malicious attacker would need to control even more validators to take it over.
The move to a PoS consensus mechanism will debatably increase security as well. Bad actors can be punished more easily with PoS than PoW, but both systems have the same primary defense. It would be prohibitively expensive to take over a large PoW or PoS blockchain. PoW blockchains also use considerably more electricity, which may be generated with fossil fuels. PoS uses approximately 99.9% less electricity than PoW and can therefore be run sustainably more easily. Eth2 has the potential to solve many of the problems the network faces today. However, EIP 1559 is launching much sooner (Aug. 4) and should have a considerable impact, too.
How EIP 1559 Can Affect Ethereum’s Price
EIP 1559 will likely have a significant impact on Ethereum’s price, especially in the long term. In the short term, investors may buy up more Ether in anticipation of the change. Ethereum’s recent network congestion and high fees have been major drawbacks, leaving room for competitors to spring up and succeed. EIP 1559 will help users avoid overpaying for transactions and could lower fees overall to some degree. Users who were driven away from Ethereum to its competitors might return in droves to the network after EIP 1559 and especially Ethereum 2.0. Having more users translates to more people buying Ether for transaction fees and other use cases, resulting in a probable rise in price.
EIP 1559’s new fee model will burn a significant portion of the amount miners currently receive from transaction fees. Before EIP 1559, Ethereum is inflationary because the supply increases every time a block is mined. After the update, Ethereum can be either inflationary or deflationary, depending on fee prices and network utilization. If the network utilization is high and users aren’t including large tips for miners, more Ether will be burned than mined, decreasing the total supply of the coin. This circumstance is positive for anyone holding Ether because it should drive its value up. However, you should beware of borrowing Ether when it is deflationary for the same reason.
What Does This Upgrade Mean for Ethereum Users?
Many cryptocurrency investors falsely believe that EIP 1559 will lower transaction fees dramatically. EIP 1559 may not lower transaction fees across the board, but it will make them more predictable. Sending transactions on Ethereum will also become more user-friendly.
Ethereum’s current fee model is a first-price auction system. Users submit their transactions for miners to process, and each sets a gas price and gas limit. The gas limit is the amount of gas (for computation) the user is willing to pay for the transaction and the price dictates how much each unit of gas will cost. The final transaction fee will be the gas price multiplied by the actual amount of gas used.
Because miners earn the transaction fees from all transactions in the blocks they process, they are strongly incentivized to pick the ones with the highest gas prices. A transaction submitted with a low gas price might take a long time when the network is congested. Imagine you sent some Ether to another wallet with a low or average gas price right before a spike in network activity. You might have to wait for hours until the miners finally get to your transaction. EIP 1559 should mostly eliminate this problem.
The new fee model after EIP 1559 will double the capacity of each block and introduce a discrete base fee. The greater block capacity will allow more transactions to be processed at once, and the base fee helps reduce network congestion. The base fee is altered incrementally based on the current utilization of the network. When utilization is above 50%, the base fee will increase. When it is below 50%, it will decrease. The base fee can only change by up to 12.5% per block, flattening fee spikes seen in the current fee model. To prevent miners from artificially driving up fees with their own transactions, the entire base fee is burned.
EIP 1559 will simplify the process of sending a transaction. As of right now, users have to set the gas price manually based on estimations. After the change, wallets will be able to accurately predict the gas price so users don’t worry about paying too much or paying too little and waiting forever. Some advanced traders fear that the new fee model will make arbitrage trades that need to be processed as quickly as possible, but EIP 1559 has a solution for that too. Users can include a tip for the miners to incentivize them to add the transaction to the next block first. EIP 1559 is a comprehensive update that should improve everyone’s overall experience using the Ethereum network, except for miners.
Will EIP 1559 Affect Ethereum Mining?
Yes, it will absolutely affect Ethereum mining. In the current state of Ethereum, miners earn both the Ether reward for each block mined and all the gas fees. The recent congestion in the network has driven up gas fees tremendously and miners made a killing from it. After EIP 1559, miners will only receive the Ether block reward and any miner tips. They will still profit off of congestion from competitive miner tips, but it will likely be significantly less than the current system. It's impossible to know exactly how their earnings will be affected, but in all likelihood, they will be diminished.
Where to Buy Ethereum Today
Because EIP 1559 will launch on Aug. 4, you should know how and where to buy Ethereum. Luckily, Ethereum is available for purchase on nearly every cryptocurrency exchange out there and even a few stock brokerage apps. Some of the best trading platforms that support Ethereum are Coinbase (NASDAQ: COIN), Gemini, Binance, Robinhood, Crypto.com and Webull. You will need to set up an account on an exchange and verify your identity before you can trade any crypto. In the U.S., verifying your identity requires you to provide your address, Social Security number and a picture of your driver’s license or other valid ID. As soon as you’re done with the verification, you can fund your account with fiat currency or cryptocurrencies and buy Ethereum.
Cryptocurrency Price Movements
The cryptocurrency market is still reeling from a major crash that started in May. Ethereum fell from its all-time high of about $4,150 to $2,100 in less than 2 weeks. Bitcoin suffered a similar move from its all-time high of almost $64,000 to $34,000 in a little more than a month. Both cryptos rose in price soon after but have continued to bleed value since the crash. Recently, the 2 largest cryptos have hovered near vital support levels and could break out in either direction soon. Cryptocurrency investors are still debating whether Bitcoin and Ethereum can still recover in the short term. The awe-inspiring 2020-2021 bull market might have ended months ago with a resounding crash or it may just be on hiatus.
Long-Term Effects of EIP 1559 on Ethereum
In the long term, a majority of Ethereum users seem to believe that EIP 1559 will be a positive upgrade. It brings 4 major factors that could have important implications on the cryptocurrency: consistent gas prices, user-friendliness, possible deflation and lower earnings for miners. The new simplicity and consistency of sending transactions on the network may attract more users that didn’t like or understand the current system. If the network utilization stays high most of the time, deflation could increase the price of Ethereum significantly over time. It's difficult to predict EIP 1559’s effect on miners, but if too many stop mining, Ethereum would be less secure and easier to take over.
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About Henry Stater
Henry is an expert in all things crypto. He stays up to date with all the latest coins, platforms and technologies in the field. He has particular expertise in the burgeoning decentralized finance ecosystem and loves trying out all the new platforms. He also always follows major events in other financial markets and geopolitics as a whole, especially when an event’s effects ripple through the crypto market.