When you make a transaction on the blockchain, you have to pay transaction fees. This is not new and applies to any crypto transaction. This includes transactions with the Ethereum blockchain. Transaction fees skyrocketed with Ethereum. Because of this, it was decided to implement an update to curb the high transaction fees.
The compensation on the Ethereum network
The minimum remuneration for miners
The fee is determined by the protocol itself to ensure that miners obtain sufficient income. The amount of compensation is adjusted automatically with the number of transactions coming through the network being a key measure in the amount of compensation miners receive.
User's fee
The transaction fee (GAS) that a user must pay - which then goes to the miners as a fee - is determined by the user. If the user is not in a hurry to validate the transaction, the user can choose a lower amount of transaction fees. But if the user wants to validate the transaction as soon as possible, then the user can choose to pay more transaction fees. This will make miners pick it up and validate it sooner because the reward to the miner is higher. This is because a miner will validate transactions with higher transaction fees sooner than transactions with lower transaction fees.
How is the limit adjusted by the user?
The user can set their own maximum value for their total transaction costs. This is done very simply. The final value of Transaction Cost/Gas depends on two different parameters that can be adjusted by the user when the user wants to execute the transaction. These are the following two parameters:
The price of Gas is determined in GWei. To clarify, 1 GWei = 1 billionth of Ether. Thus, the Gas price is basically the price in Ether that the user wishes to assign to a Gas unit.
The limit of Gas represents the maximum number of units the user is willing to spend on the transaction. This is therefore the price he has already set. Thus, the user never pays more than he would like to spend in the first place.
One often compares this to the image of a gas station. The price is what is paid at the pump, while the gasoline limit is the tank capacity of the vehicle. The same apply to Gas. It is seen as the gasoline of Ethereum.
Finally, another Gas limit is encoded into the protocol by the miners' consensus algorithm. It is the maximum amount of Gas that can be included in a transaction block. Currently, it is about 16 million.
This process is more complex than Bitcoin, but it is based on exactly the same economic principles. Miners compete with each other to find blocks that they can validate, trying to earn as much Gas as possible each time. Users then offer a certain amount of Gas that they want to spend on the transaction, which depends on the desired transaction time. The faster the transaction needs to be validated, the more Gas you pay and the more the miner earns.
Problems with this model
This compensation system is based on an auction principle. Users place their bids (transactions) by setting their Gas price and Gas limit. Miners select the transactions with the highest bids in order to maximize their profits.
Although the model works well in practical terms, this model also has a number of problems that create inefficiencies:
- It is a problem that is not only with Ethereum, but is also causing problems with Bitcoin.
- The volatility of transaction costs is high and can lead to strange situations. The Gas price usually fluctuates between 2 and 200 GWei: the user fee varies by a ratio of 100, while the variation in the miner's remuneration is negligible.
- Since the Gas limit set by the protocol varies only slightly per block, users compete with each other in situations where the blockchain is overloaded where no low transaction time is guaranteed. When the Ethereum network is overloaded, the time to validate a transaction becomes longer and transaction costs increase.
How to solve this through EIP-1559
The idea behind this solution is that the base fee should be adjusted based on how busy the network is.
What is EIP-1559?
Currently, the protocol is set at about 10 million Gas. With EIP-1559, the total network capacity will increase to 16 million Gas. If the target of 10 million Gas is exceeded, the protocol will adjust it slightly higher for the next block. If this capacity is not reached, the target value will be lowered again slightly. These small steps will make fluctuations more predictable. Thus, the price fully adapts to the traffic that occurs on the network which should reduce the transaction cost and allow the network to better handle the number of transactions.
Please note that miners receive block rewards in addition to transaction fees. These should be strictly distinguished from each other. Transaction fees are costs users pay for processing a transaction. Users pay that on top of their transaction. Block rewards are rewards that miners receive in crypto and not in cash (as is the case with transaction fees). In addition, block rewards are halved every 4 years to eventually 0. In that situation, miners will then only receive transaction fees.
In the EIP-1599 update, there is a base fee for all transactions to be included in the next block and a priority fee that speeds up the processing of transactions. The base fee fluctuates according to the network congestion and is then burned. The user submits a fee higher than the base fee with the transaction. As the base fee fluctuates with the network congestion, users can put up a fee cap. After its inclusion, the users only pay the difference between the final base fee and the fee cap. These changes in the transaction fee system allow users to estimate cost better since the base fee is the minimum price for being included in the next block. Overall, this will result in fewer users overpaying for transactions.
Another significant change under EIP-1559 was that a part of the base fee is burned or removed from circulation, reducing the supply of ether and potentially boosting the asset's price. But this does not necessarily mean that Ethereum is a deflationary asset. In an interview with CNBC, Meltem Demirors, CoinShares chief strategy officer said EIP-1599 alone would not make Ethereum deflationary. "Many of these expectations are likely too optimistic in the short-term, and will become more material in the long-term," she said, adding, "the nominal amount of gas burned won't outpace network inflation." Experts are predicting that Ethereum's move from proof-of-work to proof-of-stake, branded as Ethereum 2.0, will make Ethereum completely deflationary.
The above diagram shows how the fee mechanism will work with EIP-1559. Currently, fees are paid to miners, who also receive the block reward of 2 ETH per block, plus uncle rewards. With EIP-1559, the base fee is burned, but a tip and the block reward still go to the miner.
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