Footprint Analytics: Will the London Upgrade Deflate ETH?
Ethereum remained the top blockchain in 2021, but its market share continued to erode, dropping from nearly 100% at the beginning of the year to 65%.
Its main problem is the PoW (Proof of Work Mechanism), which causes transactions to be slow and expensive.
Ethereum devs have realized new L1s are providing faster, more convenient networks and pushed toward the Ethereum 2.0 upgrade with four hard forks in 2021 in preparation for the replacement of PoW with PoS (Proof of Stake).
These forks were:
- April: Berlin upgrade
- August: London upgrade
- October: Beacon Chain Altair upgrade
- December: Arrow Glacier upgrade
Of the four, the London upgrade has received the most attention, mainly because it affects everyone—users, holders, miners, and developers.
Footprint Analytics analyzed this upgrade in Who benefits from EIP-1559? in August. Besides smoothing out gas fee changes by allowing variable block sizes, splitting the gas fee into Base Fee and Priority Fee, and burning out the base fee, the London Upgrade will likely enable ETH to continue increasing in value by making it deflationary, among other benefits.
Changes From the London Upgrade
The main effects of this upgrade are:
- More stable and predictable gas fees: With base fee price based on previous block usage, it can vary between blocks by up to 12.5%, which makes it easier for users to accurately predict the amount of gas they will spend. Note that this doesn’t necessarily mean lower gas fees.
- Miners will lose revenue: After the upgrade, miners will no longer reap the entire gas fee as before, but only part of the priority fee. Future income will also rely mainly on block rewards.
- The ecosystem will start burning ETH: Ethereum has launched a burn mechanism that makes the inflation rapidly slowing down. This change will likely tie the value of ETH to the value of the use of the network.
As of Dec. 31, five months after the burn mechanism was launched, 1,317,700 ETH have been burned, with about 6.22 ETH being burned every minute, and 1.43 ETH per block.
The number of users who choose EIP-1559 as their transaction type is also gradually increasing, from 50% at the beginning to 70%, and on average about 10,000 ETH will be burned every day.
While the London upgrade does not overhaul the network experience and cut down fees, it sets the stage for Ethereum 2.0. By delaying the difficulty bomb—a mechanism to force PoW to stop producing blocks—it ensures miners can still earn revenue without going “on strike” under the PoW mechanism until the Beacon chain is ready to implement PoS.
How Does the London Upgrade Make ETH Deflationary?
The London upgrade was the first step to make ETH deflationary, and the Ethereum 2.0 and Layer 2 expansion will continue this effort. The Ethereum mainnet will complete the merger with the Beacon chain in 2022. After the upgrade, PoW will turn into the PoS mechanism, while the block structure will shift from single chain to multi-chain fragmentation.
The PoS mechanism allows for better energy efficiency and increased capacity. TPS on Ethereum 2.0 could reach 2,000 to 3,000, and eventually 100,000 TPS, solving the current congestion problem.
The PoW mechanism will be removed, meaning that mining—as done up to that point—will become a thing of the past and new incremental issues will only be issued through the PoS mechanism of 400,000 to 700,000 per year. After the London upgrade, at the current burning rate of about 10,000 ETH per day, about 3.65 million ETH will be burned each year, far more than the number of incremental issues.
In 2021, we saw the price of ETH rise from $738 at the beginning of the year to $4,182 in May. After a big drop in the price of the cryptocurrency, the price of ETH gradually heated up, reaching a high of $4,826 for the year in November. While this was boosted by the growth of the projects during the summer of DeFi, the reduced rate of inflation after the London upgrade also played a role.
After the launch of Ethereum 2.0 in December 2020, the mining rewards were gradually reduced. Tim Beiko, the Ethereum developer, expects the merger of Ethereum 1.0 and 2.0 in April or May 2022, after which Ethereum 1.0 will probably fade away and eventually become abandoned. With the arrival of the PoS mechanism, the PoW mechanism of Ethereum 1.0 will become history and the deflation of ETH will come soon. For those who are bullish on Ethereum, 2022 may be an “ETH Summer” to look forward to.