Ethereum fee market reform: EIP-1559 as a question of fairness

1. Background

Reform of Ethereum’s fee market, and the question of how best to allocate income from transaction fees, has been discussed for a long time. Well before Ethereum’s July 2015 genesis block, founder Vitalik Buterin was sharing ideas about future changes to the the fee market, including the possibility of burning fees. The idea of fee burning in the context of ‘medium of exchange’ currencies was also included in a 2017 piece on the subject.

2. A Proposal Emerges

This was the context for Vitalik’s July 2018 article which set out in more detail a proposal for fee market reform (it was subsequently included in a wider-ranging paper on resource pricing). It described a mechanism for setting a portion of the transaction fee in-protocol called the ‘basefee’, with miners to be compensated for transaction processing with a user-set commission on top of this, now often called the ‘tip’ or ‘bribe’. The mechanism targets half-full blocks (where a full block is double the size of a current Ethereum block), and achieves this target by adjusting the basefee up and down in response to demand. Since the amount of compensation miners need for including transactions varies very little with demand, the tip would be a small amount that most users won’t need to change. Therefore, users can be presented with a simple transaction price at which they can expect their transaction to be included, rather than having to figure out how to interact in an unfamiliar market for an intangible consumable (gas). A major improvement.

  1. send the basefee to some fund (e.g. a developer fund);
  2. give the basefee to the miner of the current block;
  3. share the basefee amongst the miners of future blocks;
  4. burn the basefee.

3. Developer Scepticism

Nevertheless, if implemented, EIP-1559 would be the most dramatic change to Ethereum’s economics since genesis. It would also create significant work for wallet devs, who would need to adapt their user interfaces to the new paradigm. Accordingly, the proposal has been received with caution by experienced Ethereum developers. The most often quoted of these is Dan Finlay of Metamask, who notes that since EIP-1559 places on miners the task of fixing ‘basefee’ parameter which has the effect of diminishing their income, there appears to be a perverse incentive for miners to attempt to minimise the basefee. If miners were to succeed in doing this, EIP-1559 would effectively degenerate to the current first-price auction fee market, with users varying the tip parameter to bid for inclusion of their transactions.

4. Renewed Impetus

During 2020, demand for gas on Ethereum has continued to grow, as stablecoins, decentralised exchanges and a range of other decentralised finance (defi) applications have exploded in popularity. The result is that from June until August this year the total value of fees paid for Ethereum transactions has been greater than total Bitcoin fees on all except 8 days. Counter-intuitively, such strong fee income directed at miners may in fact cause problems for the blockchain. One group of researchers has argued that as miner income from fees overtakes the income from the block subsidy, the blockchain becomes unstable, and security is dramatically impacted as certain attack strategies become viable with much less that 51% of hashpower. Meanwhile, the extreme volatility of the gas market and corresponding UX problems remain unaddressed.

5. Who owns Ethereum’s blockspace?

So we might tentatively conclude that we probably can safely implement EIP-1559 in Ethereum. But should we? This is the question of fairness raised in this article’s title. Do miners have any right to continue to receive all income from transaction fees since they do the work of processing transactions?

6. Fair Compensation

To understand which part of the transaction fee is fair compensation for the miner’s task, and which part is unearned rent, we need to know how much transaction processing actually costs miners. As mentioned in part 1, there is a “rational minimum” transaction fee, which is the marginal cost to miners of including a transaction. This is the opportunity cost arising from the increased risk of creating a less profitable uncle block. This concept is an extension of a methodology originally applied to Bitcoin. (1)(2)

7. Allocating the Fee Surplus

The only option remaining of the 4 possibilities mentioned in part 2, is for the basefee to be burned. By burning the basefee, it is returned to Ether holders. Are they worthy recipients? For two reasons, I think the answer is yes.

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