Valid Points: Why EIP 1559 Matters to Eth 2.0 Validators

ETH prices took a tumble this week, dropping over 30% between last Tuesday and today. In the wake of stricter crackdowns on cryptocurrencies by the People’s Bank of China, other top coins such as bitcoin and XRP also declined in value.

While the week-to-week volatility of the crypto markets is as unpredictable as ever, the total value managed by smart contracts on Ethereum has been consistently on the rise since Jan. 1. In this week’s Pulse Check, we discuss what that suggests about the long-term value drivers for ETH.

Also, we explore the implications of an upcoming code change to Ethereum’s fee market to Ethereum 2.0 validators.

This article originally appeared in Valid Points, CoinDesk's weekly newsletter breaking down Ethereum 2.0 and its sweeping impact on crypto markets. Subscribe to Valid Points here.

Pulse check: ETH held in smart contracts rises

Read more: Ethereum 2.0 Explained in 4 Easy Metrics

Since January, the amount of ether

held in smart contracts has increased over 50% to an all-time high of 26.7 million ETH, worth roughly $50 billion. Meanwhile, the amount of ETH held on cryptocurrency exchanges fell to a two-year low of 13 million ETH.

As background, smart contracts are accounts on Ethereum that are controlled by self-executing code as opposed to a user. These accounts can be engineered to trigger transactions according to a set of predefined rules and conditions. As of June 2021, close to one quarter of total ETH supply is held and managed by smart contract accounts.

The most popular smart contracts on Ethereum, according to analysis by Anthony Sassano, co-founder of the “EthHub” podcast, are finance-focused and enable users to earn attractive yields on their ETH. Of the 26 million ETH held in smart contracts, roughly 8.5 million is used within decentralized finance (DeFi) apps such as MakerDAO, Aave, Compound and Uniswap.

After DeFi apps, the Ethereum 2.0 deposit contract, which is the smart contract that creates validators on the Eth 2.0 Beacon Chain, is the second-most popular by total value locked, holding around 5.8 million ETH.

Increasing value in these smart contracts suggests the use case for ether as a speculative asset to trade on exchanges is growing weaker while the asset’s narrative as an interest-bearing crypto asset to be used within the decentralized application (dapp) ecosystem of Ethereum is taking off.

“It’s all about what the ETH is actually being used for and if the utility of Ethereum is driving demand for more ETH. I believe that it clearly is,” Sassano wrote in his newsletter, The Daily Gwei.

New frontiers: The impact of EIP 1559

Ethereum Improvement Proposal (EIP) 1559 is one of five code changes that will be activated on the main Ethereum network some time this summer. It introduces a new pricing mechanism for transactions based on a minimum fee called the “base fee” that is automatically calculated by the protocol, instead of being set by the user.

The following is an edited excerpt from CoinDesk Research's latest report about EIP 1559 and its impact on miners and Eth 2.0 validators.

Goodbye transaction fees, hello inclusion fees

Miner revenue consists of two main sources, a block subsidy and transaction fees. EIP 1559 removes transaction fees as an income source for miners and replaces it with the inclusion fee. Because the inclusion fee is both optional and an additional fee on top of the base fee that users must pay for their transactions, it is likely the income earned from the inclusion fee will be less than what miners would have earned under Ethereum’s auction-style fee market.

It is difficult to estimate exactly how much miners can expect to lose in revenue given the variability of the inclusion fee and the difficult-to-quantify revenue that miners can also receive by reordering or censoring transactions on the network. This third, lesser-known revenue stream, known as miner extractable value (MEV), is becoming increasingly widespread with the growth of decentralized exchanges (DEXs) on Ethereum.

Miners have the ability to earn more rewards from DEX traders who value the speed and order in which their transactions are executed on the blockchain more than the average user does. They can also take advantage of arbitrage opportunities on DEXs themselves by executing lucrative cryptocurrency trades that front-run DEX traders.

Once proof-of-stake (PoS) is activated on Ethereum sometime early next year, Eth 2.0 validators will take over the responsibility of ordering transactions from miners and begin pocketing two additional revenue streams, user inclusion fees and MEV, on top of the rewards they currently receive as interest on their staked ether.

Warming up for the merge

Like the upcoming merge to PoS, EIP 1559 will get activated on Ethereum through a backward-incompatible upgrade or “hard fork.”

There is the potential with any hard fork activation to see a chain split in the network, with some portion of miners, validators or users running outdated client software. Usually, these chain splits are temporary as the majority of miners will eventually congregate to one version of the chain to produce blocks and earn rewards. The minority chain in these cases fizzles out due to a lack of computational energy to move it forward beyond a few blocks. Since its launch in 2015, Ethereum has been through 10 hard forks and disruptive chain splits have been extremely rare.

Hard forks require coordination from all network stakeholders, which is why they become progressively more difficult to execute the larger and more decentralized Ethereum becomes. It’s one of the reasons why developers for the Bitcoin protocol have arguably never released a planned hard fork upgrade. The norm for code changes on Bitcoin are “soft” forks, which maintain backward compatibility with older client versions.

In order to avoid an unintentional chain split, Ethereum developers are leading community initiatives to spread awareness and support for the “London” hard fork, leading up to its activation date. These initiatives include public community calls, one-on-one outreach to large businesses operating on Ethereum and online guides for network stakeholders. Similar initiatives will be needed to ensure a smooth transition to PoS once research and development for the merge is complete.

For more information about the status of EIP 1559 and its investment implications to the long-term value of Ethereum, click here to read the full CoinDesk Research report about the upgrade.

Validated takes

• 4 common misperceptions about Ethereum’s EIP 1559 upgrade (Article, CoinDesk)
• A look at four projects that exemplify a new innovative phase of “weird DeFi” (Article, CoinDesk)
• The London hard fork upgrade is ready for deployment on Ethereum test networks Ropsten, Goerli and Rinkeby (Blog post, Ethereum Foundation)
• The history of the DAO and lessons learned (Blog post, slock.it)
• 23% of ETH supply is deposited into smart contracts, here’s a breakdown of which ones (Newsletter post, The Daily Gwei)
• 2 ideas to solving Ethereum’s state size problem and a proposal to implement both ideas at the same time (Blog post, Vitalik Buterin)
• 100 Eth 2.0 validators staked 64 ETH each by accident, here’s how it happened and why it was a mistake (Newsletter post, What’s New in Eth2)

Factoid of the week

Open Comms

Valid Points incorporates information and data directly from CoinDesk’s own Eth 2.0 validator node in weekly analysis. All profits made from this staking venture will be donated to a charity of our choosing once transfers are enabled on the network. For a full overview of the project, check out our announcement post.

You can verify the activity of the CoinDesk Eth 2.0 validator in real time through our public validator key, which is:

0xad7fef3b2350d220de3ae360c70d7f488926b6117e5f785a8995487c46d323ddad0f574fdcc50eeefec34ed9d2039ecb.

Search for it on any Eth 2.0 block explorer site.

New episodes of “Mapping Out Eth 2.0.” with Christine Kim and Consensys’ Ben Edgington air every Thursday. Listen and subscribe through the CoinDesk podcast feed on Apple Podcasts, Spotify, Pocketcasts, Google Podcasts, Castbox, Stitcher, RadioPublica, IHeartRadio or RSS.