Updated: Jul 4
Ethereum is going through some major network alterations in 2021 as it moves from its Proof-of-Work (PoW) to Proof-of-Stake (PoS) consensus mechanism in order to improve its underlying architecture. One of the most prominent upgrades this year is the London Hard Fork, which continues the progression towards Ethereum 2.0. The London update will make significant changes to Ethereum’s transaction fee system, which has long been a contentious subject due to the congestion on the network that has hosted the vast majority of decentralized finance (DeFi) and non-fungible token (NFT) projects.
In this context, the two issues of network congestion and high transaction fees (also known as gas fees) have impeded Ethereum’s adoption even as it remains the highest-utilized blockchain across the stablecoin and decentralized finance (DeFi) sector.
The London hard fork will thus introduce new Ethereum Improvement Proposals (EIPs), which are set to make the blockchain more competitively priced as well as user-friendly. The core proposal, known as EIP-1559, will lower Ethereum’s gas fees while moderating the volatility of the network’s transaction fees. EIP-1559 also brings in the so-called scarcity feature to the Ethereum ecosystem, which is currently the primary bullish factor in the Bitcoin (BTC) markets thanks to its limited supply cap of 21 million units, a feature which allows Bitcoin to function as an effective hedge against inflation. Ethereum however does not have a supply limit, which makes it less appealing as a store-of-value asset against fiat currencies.
Of the Ethereum Improvement Proposals, one of the most significant is Ethereum Improvement Proposal (EIP) 1559, which was first suggested by Vitalik Buterin in 2018. EIP 1559 sets out to fix numerous issues with Ethereum’s user experience and brings the following key changes:
Exclusion of 'single fee
Ethereum has one 'single fee' estimated through the 'first price auction' model. EIP-1559 proposes that instead of a single fee, there will be two fees; base fee (which will be fixed per block depending upon the block size) and inclusion fee (an optional fee (a tip) that will go directly to the miners).
Elastic block size
Block sizes are now dynamic and will increase or decrease depending on the state of the network congestion. The maximum gas limit per block will now be 25 million, which is 2x the current gas limit per block of 12.5 million.
Investors and traders alike should take heed of the fact that the base fee will be burnt permanently, which could put deflationary pressure on Ethereum over the long run. In this regard, it is important to note that the issuance rate of Ethereum stands at 4.5% per year and according to estimates this will decrease to 0.5 - 1%. Consequently, the potentially infinite supply of Ethereum will be limited and this could act as a bullish catalyst for Ethereum prices in the near-to-medium term.
Ethereum Average Transaction Fee measures the average fee in USD when an Ethereum transaction is processed by a miner and confirmed. Average Ethereum transaction fees can spike during periods of congestion on the network.
Ethereum Layer-2 Scaling Solutions
Network congestion and high transaction fees are two of the major impediments to Ethereum’s scalability. In this context, transaction speeds tend to suffer when the network gets busier and this ruins the user experience for various decentralized applications (DApps). Additionally, as the network gets busier, gas prices increase as senders aim to outbid each other. To solve these issues, Layer-2 scaling solutions bring ultra-fast and low-cost transactions to the Ethereum network.
Layer-2 solutions also go beyond the limitations of the underlying platform and provide different services that are not possible otherwise on Layer-1 such as cross-chain transfers between Ethereum's main chain and any Layer-1 or Layer-2 platform quickly and securely. Layer-2 is the shared term for solutions designed to help scale DApps managing transactions off of the Ethereum mainnet, which are in this case the layer-1, while leveraging it’s decentralized model.
The London Hard Fork may not be able to match the scalability and flexibility offered by the Layer-2 scaling solutions, but it helps set the right foundation to improve the transaction fee mechanism. Moreover, Layer-2 scaling solutions can help people to run their businesses and applications on Ethereum and this could pave the way for decentralized economies and open finance.
Effect On Miners
The London Hard Fork may be detrimental for miners earning high revenue each month from transaction fees. As a consequence of this, big mining pools are in dispute as to the merits of EIP-1559 and the date of the London Hard Fork in July is thus tentative due to the concerns raised by the miners. Specifically, EIP-1559 proposes a fixed fee with an optional tip to miners instead of regular gas fees, which will harm mining revenues.
The London Hard Fork may improve the Ethereum network’s user experience, yet the network may as of yet be unable to match the scalability and flexibility offered by Layer-2 scaling solutions. It is important to note though that the London Hard Fork brings a deflationary pressure on Ethereum while also lowering the fees to transact on the network and going forward these combined changes may act as bullish catalysts for Ethereum prices in the near-to-medium term.