Will EIP-1559 Upgrade Turn Ethereum Into a Deflationary Asset?

Ethereum is on course to implement a new upgrade on its blockchain network as it transitions to the next-generation Eth2.0. The network’s next upgrade, Ethereum Improvement Proposal (EIP)-1559 is tipped to change the protocol’s monetary system. The new upgrade ships with a burn mechanism that will decrease Ether’s supply and turn it into a deflationary asset.

What is a Deflationary Asset?

A deflationary crypto asset is one whose supply decreases over time. This is in sharp contrast with fiat currencies that are said to be inflationary, and as a result, suffer from inflation.

An inflationary currency is one whose supply increases. This is the case with the U.S. dollar, as it is the fate of all fiat currencies. In 2020 alone, the U.S. printed at least $3.3 trillion, which equates to anywhere between 18% and 22% of the total supply of dollars. This will inherently lead to inflation, or simply the reduction in buying power.

A deflationary asset is the opposite of this. And this applies to Ether as well.

Ether’s deflationary capabilities are bundled in the EIP-1559 upgrade. The new upgrade will enforce changes in how the protocol handles transaction fees. In the current gas fee model, network users propose — and can even analyze — the amount of gas they are willing to pay for their transactions to be confirmed. Miners will naturally choose transactions with a higher gas limit as this is economically viable for them.

However, with the new upgrade, gas fees will be more predictable. Ethereum will use standard flat fees called ‘base fees” and optional miner tips to settle transactions. The base fees, paid in Ether, are burned after every transaction. This decreases the supply of Ether, which will likely have an effect on the crypto asset’s price.

The best way to explain the impact of the burn mechanism in Ethereum is to look at bitcoin and its monetary policy. Bitcoin has a finite supply capped at 21 million, and minting new coins will cease when this figure is reached. When people forget their private keys or die without revealing their private keys, the number of bitcoins in circulation decreases. The bitcoins are lost for good. As more bitcoins exit the system, the value of bitcoins will rise. In essence, deflationary assets promote the hoarding of assets rather than spending.

Bitcoin is not the only deflationary asset, and Ether will likely join these ranks as it changes its monetary model. Besides the change it will make in the network’s economics, EIP-1559 is part of a larger upgrade to a Proof-of-Stake consensus mechanism.

The Road to Ethereum2.0

Ethereum2.0 presents the next major upgrade to Ethereum’s blockchain. The road to Eth2.0 will be done in multiple stages that will be approximately a year apart. The first step, Phase 0, went live in December 2020. Several upgrades will be implemented between each phase and the next step. EIP-1559 is one of those numerous upgrades.

Ethereum will introduce a burn mechanism through EIP-1559. Ether’s supply has no cap and this leads many to question whether Ethereum will be truly deflationary. Will Ether’s supply decrease over time or the blockchain will mint more tokens than it will ever burn?

This is a legitimate question worth addressing.

The answer to this question is not in black and white. The amount of Ether to be burned depends on network activity. If the transaction activity increases, it is possible that the network can destroy more Ether than will be issued via block rewards. This is not a guaranteed event but will likely happen if the network continues to rise in usage.

When Ethereum transitions to Eth2.0, the rate of minting new Ether tokens will decrease from around 5% to 1%. There is a high probability that the rate of burning tokens will outweigh the rate of issuance. This will make Ether a deflationary asset.

Wrapping it Up

Apart from the obvious fact that the transition to Ethereum2.0 will improve the network’s speed, there are heated debates about the proposed changes to the protocol’s monetary policy. The main bone of contention is whether the deflationary property is good for Ether or not.

A lot of stakeholders within Ethereum’s ecosystem will be affected by this change. We will start off with ERC20-based fungible tokens such as LEDU tokens that are built on top of the Ethereum network. The token holders have to pay gas fees to buy and sell their tokens. The current model in which high gas fees are required for transactions to be completed is not economically viable for the majority of token holders.

ERC20 token holders and traders have to pay a premium to buy and sell their tokens. This can force them to hold their tokens against their will. This hinders mass adoption and reduces the allure for people to buy ERC20 tokens. Thanks to EIP-1559, the reduction in gas fees could change this and lead to reasonable gas prices.

On the other hand, Ethereum miners are not impressed by the inevitable EIP-1559 update. Ethereum miners generated $830 million in January, and a record $1.37 billion in February 2021, partly due to the rising gas fees. This is the first time that Ethereum miners have generated more than $1 billion in revenue in a calendar month. And all this income is under threat from EIP-1559. Needless to say, some Ethereum miners are against the EIP-1559 update as it directly hits their pockets.

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Comments (5)

Can someone explain why deflation is good if it’s designed as a utility and not a store of value like Bitcoin? I’m not talking about your investment where less eth = higher value. I’m talking the practical aspects of it.

Deflationary should lead to hoarding and hoarding to ETH becoming a store of value. And if it’s the case, then there’s no point to ETH as a utility meaning it will collapse?

Could someone give me a rough ELI5 of how this update is going to lower gas fees and deflate ether?

The current way ethereum transaction fees work is the miners choose the transactions which have the highest gas value (how much they are willing to pay). This is inefficient because it forces everyone to try to outbid one another to get the opportunity to use the network which sends the transaction fees soaring.

The new update will make it so the amount paid to the miners is the same for everyone, and it gets automatically adjusted by the algorithm depending on demand. This means people will not need to compete against each other therefore no bidding wars to use the network, and lower fees. This new dynamic fee is also “burned”, meaning it gets destroyed during the transaction and since there is only 2 etherum generated per block, if the fees that get burned by paying the dynamic fee will cause more ether to be destroyed than generated, causing the overall supply to decrease making it deflationary

I think it’s important to note that it COULD become a deflationary asset. The amount of ETH removed every transaction is a relation to how congested the network is. Only when the network is really congested can it ever deflate and only during those times.

Additionally, this deflation is likely only to be temporary as ETH 2.0 will drastically increase the speed of transactions, thus increasing supply of the network with no change to demand.

The most likely trajectory is that this:

EIP 1559 launches. the Ethereum network stays really congested during the bull run. Ethereum becomes deflationary during the bull run.

The bull run eventually ends, the demand for ETH drops temporarily. ETH is now inflationary again.|

2.0 launches. The network is so fast for its size that the next bull run does not reach the threshold to become deflationary.

sometime way in the future, ETH is used everywhere and the demand surges high enough to stress out 2.0 protocol. ETH becomes deflationary again.

It’s better to look at it this way. ETH is, on average, inflationary. As demand is high, ETH inflates at a lower rate.

EIP 1559 has been passed, much to the chagrin of the ETH mining community. What it does is effectively makes ETH a deflationary asset, and mining ETH Will become a thing of the past as it fully implements proof of stake. Considering there is roughly 9% of all ETH already locked up in the staking contract, not to be released for afew years, combined with the fact that soon massive amounts of ETH Will be burned due to 1559, the result is an extremely bullish price scenario for ETH. Despite all the hype surrounding the “ETH killers” , ETH has a massive network effect and has a substantial most built around it. Even when fees are high, people will continue to use it, and that will just be “the cost of doing business” not to mention all of the layer 2 solutions already implemented that make transaction much cheaper. Take that, combined with the NFT movement which is JUST starting, and is native to the ETH blockchain, and you have a digital asset that is being massively accumulated by the “big boys” of finance like Greyscale. All this adds up to a very likely 6–12x from this point in price, and possibly higher depending on BTC.

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