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EIP1559: The Squish Chaos Edition
Retelling the story of UltraSound Money
The EIP1559 story you were told was the story that took the headline.
It was the story of EIP1559 as ultrasound money. This is the story of a deflationary asset, a decreasing supply, and a robust store of value. In all likelihood it will one day be true. I expect that after the merge to Proof of Stake (PoS), Ethereum will be deflationary. From that point on, it will functionally have a hard supply cap, and supply will reduce from that point. As a store of value, how can you beat that?
I can understand why that is the story the community chose to tell. I love the meme, and I love the message.
Unfortunately, the story as it has been told isn’t an Ethereum story. It’s a Bitcoin story. This is an EIP1559 narrative built on beating Bitcoin at its own game, improving upon the value proposition of the largest cryptocurrency in existence. It defines sound money in Bitcoin terms and responds with ultrasound.
But I would hate if the message you were left with was that EIP1559 was about one-upping Bitcoin. This isn’t so crude a game, EIP1559 is a work of art. It uniquely expresses one of the qualities that makes the Ethereum community so fantastic - the willingness to constantly search for a better way and the adaptability to implement those solutions when they’re found.
For excellent Ethereum focused EIP1559 content, check out this excellent piece by Bankless for a more general intro to the cryptoeconomic framework. In my piece, I’ll focus on EIP1559’s role in value accrual. I’ll start with the smallest changes and ramp up.
The current approach to transacting on the Ethereum network is a gas fee auction. Users check websites like gasnow.org for going rate of gas fees and take a guess at what the gas fees will be in the next block. If they’re right, their transactions go through. If they’re wrong, their transaction fails.
This stinks. It means a portion of transactions don’t go through (frustrating). It means in an effort to get transactions through, users are likely to systematically overpay for gas (frustrating), and it means users & crypto wallet providers have to spend their time taking random guesses at future gas fees - talk about a clunky user interface.
EIP1559 changes all of that. Users submit a base fee (which is more stable) and a tip, allowing users and crypto wallet providers to more easily know they’ll get into the next block. Most importantly, this will tremendously improve the ability of cryptocurrency wallet providers, or Dapps, to estimate gas fees. If the user interface is to improve in the future, the core mechanic behind gas fees needs to become more user friendly. EIP1559 does that, and it’s a big deal.
EDIT (8/5 @11:30AM)
Here’s an example of the kind of UX improvement I’m talking about.
Preventing Miner Workarounds from leaving ETH out of the loop
Another critical feature of EIP1559 is that it ties the value of the Ethereum network to Ether in a non-speculative way. It does this technically - by ensuring miners cannot be paid with any token other than ETH. It was already the case that ETH was being paid as gas during every transaction, but EIP1559 closes the door to work-arounds. There is no way around it - in every transaction, ETH must be burned one way or another.
On the economic beauty of EIP1559
A core issue I have with the UltraSound money meme as it is right now is that it’s based on Bitcoin’s approach to “sound money.” Bitcoin’s approach has strengths! But Ethereum is not Bitcoin, and one of the best untold stories of EIP1559 is how it speaks to Ethereum’s unique strengths.
The feature that makes Ethereum most different from the Bitcoin network is that….Ethereum supports an economy.
Quick primer on deflation & inflation in currencies
In a deflationary economy, currency increases in value in real terms, so individuals have a financial incentive to not spend money - they have an incentive to remove money from the economy, take less risk, and store their wealth for the future as it will have grow in value by simply doing nothing. This is great for the individual agent, who can put aside their hard earned cash at ease and expect to be able to pay their bills tomorrow. Unfortunately it’s terrible for the economy at large, which sees vast sums leave circulation, reduced economic participation, and reduced investment in innovation.
Of course the opposite isn’t great either. In an inflationary economy, currency deteriorates in value in real terms, so individuals have a financial incentive to put money into the economy to grow it in order to match the pace of inflation. Calling this an incentive is a bit misleading - it’s much worse than that. I work hard, earn some cash, and have no choice but to take on investment risk lest I take the default option of watching my money slowly erode in front of me. This is great for the economy as huge financial inflows pour into economic circulation to avoid the death knell of inflation. Economic participation increases, there is more investment in innovation. However, this is awful for individual investors - it leaves them with a default option of slowly watching their savings erode and effectively forces them to participate in economic activity as their only alternative is to let their savings wither away.
Here’s the beauty of EIP1559 - it’s adaptive.
EIP1559 makes Ethereum’s monetary policy reflexively adapt to economic activity
If there is a huge wave of investment and economic activity on the network, fees will rise and higher fee burn will make ETH a deflationary asset. Incentives will shift towards storing money in ETH and not spending it.
If there is a huge wave towards using ETH as a store of value and economic activity on the network declines, fees will decline and lower fee burn will make ETH an inflationary asset. Incentives will shift towards using ETH on chain to participate in the digital economy.
Ultimately, the core economic innovation of EIP1559 is that it creates harmony between the need for a core incentive towards increasing economic participation and investment in innovation and the need for the core economic unit to be an effective store of value, protecting economic participants from the deterioration of their hard-earned labor.
This is economic beauty. Ether is reflexively deflationary when it is most able to be, and inflationary when economic activity is most necessary. It is a monetary policy that is built to last - one that adaptively shifts to protect the economy from the most dire risks of the present, whether those risks are inflationary or deflationary extremes.
Aside: As a gift to myself with my first full time salary check, I decided to purchase a limited edition EIP1559 supporter NFT! One of the coolest aspects of NFT art collecting is that it makes explicit an idea that art collectors have always known - works of art have always been about the ideas they represent, not the materials from which they’re made. If there is a side to NFT collecting that is about the collection of beautiful ideas, I love to think that I started my collection with EIP1559.
Tying Ether to Ethereum
I mentioned earlier that one of the key aspects of EIP1559 is that it technically forces Ether to be burned in every transaction. The economic effects of this answer a crucial question: If Ethereum the network is valuable, what necessarily makes Ether the asset valuable?
Typically, investors have answered with the gas fees, but it’s not that simple. Gas fees before EIP1559 didn’t accrue very well to Ether the asset. If gas fees that I pay just go to miners, and they sell those ETH for USD, then the value of the network doesn’t accrue to ETH holders - it just accrues to miners. Moreover, it does so at a cost! When miners dump ETH for USD, they suppress the price of Ether - an effect I discussed at length in my Triple Halving report.
Before EIP1559, when I bought ETH to use as gas, I would apply upwards pressure upon price. Then when I use the ETH as gas, miners would sell it and apply downwards pressure upon price. No value added.
The fee burn changes that. Going forward, a portion of the fees are removed from supply and cannot be sold by miners. This means that from the moment EIP1559 is passed, there will be a 30% decline in sell pressure (discussed at length in my EIP1559 report). It also means that from this moment onwards, activity on the Ethereum network has a net positive effect on price. If I buy 1 ETH and use it as gas, miners can only sell 0.7ETH to take profits. 30% of the fees in every transaction transformed into an effective share repurchase.
I want to make 2 points here:
Most of the attention is being paid to whether the fees offset new issuance. I want to focus your attention instead on the mechanism of the tailwind. In the history of Ethereum’s price action, there was no direct connection between increased network activity and increased price. The price always rose purely as a result of the same investor activity as on the Bitcoin network, and so Ether has had a very high degree of correlation to Bitcoin. From this point on, however, if the Ethereum network’s activity is uncorrelated with Bitcoin’s price, we should begin to see Ethereum’s long term correlation with Bitcoin deteriorate as ETH price is no longer tossed around by the winds of speculation but grounded instead in its own network’s value creation
Look at the effect on circulating supply, not total supply. If I discover a large amount of inaccessible oil, oil prices wouldn’t tank. It’s the jump in circulating supply that drops prices. Viewed this way, Bitcoin is actually inflationary - with an increasing circulating supply. Every halving event represents a 50% reduction in the inflation rate of its circulating supply, which creates a jump in price. EIP1559 will reduce Ether’s circulating supply by 30% - and we should expect a significant increase in price to result. More importantly, this should put the goal of deflation into context. If fees burned after the merge can even fully neutralize issuance, so that Ether supply is no longer inflationary, ETH prices will rocket upwards even without deflation. What makes me so confident? The fact that prices are rising under this much inflationary selling pressure is a strong signal for the degree of demand that is underlying price. When the inflation is removed after the merge, this demand will finally effect price.
Bitcoin doesn’t have EIP1559…so how does it benefit from its own network adoption? The answer is HODL culture and its something I’ve really underestimated. Here’s one final section on how Bitcoin accrues value and how EIP1559 fundamentally alters that dynamic.
Ether accrues value differently under EIP1559
I detail the miner sell pressure angle in my triple halving report, but I made only a minor comment on HODL culture and diamond hands as an element that exacerbates the demand from the halving. I now believe it has at least an equal role to play. I’ll do a deeper dive later, but for now here’s a quick model for how Bitcoin’s price action works and how Ethereum’s will be different now and going forward.
Explaining Ethereum’s future price action through Bitcoin: A simple model
In the years before the halving, Bitcoin investors gradually accumulate a significant portion of liquid supply. I’ll measure liquid supply here in dollar terms (ie. if there is 1 bitcoin available to buy, and it costs $10,000, I’ll say there is $10,000 of liquid supply left of bitcoin).
As they accumulate, the liquid supply of Bitcoin becomes scarce in dollar terms (in this example, there might be only 0.1 bitcoin left. At $10,000 that only leaves $1000 of liquid supply of bitcoin).
The halving event reduces the issuance rate, decreasing Bitcoin miner sell pressure and creates a temporary supply/demand dislocation. This creates initial price momentum. As money flows in to chase this momentum, it acts on a scarce liquid supply, so price undergoes high upside volatility.
After price has risen sufficiently high, liquid supply is again abundant in dollar terms (in this example, if bitcoin’s price rises 10x to $100,000, that remaining 0.1 bitcoin in liquid supply now represents the entire original $10,000 of liquid supply).
Bitcoin now enters another bear market where investors begin the process of accumulating again. While price is higher, and market cap is higher, liquid supply is actually only $10,000 just like it was before. Bitcoin only has to find the same amount of capital to invest as before to get the same degree of price increase going forward. This looks petty - the investors in the last cycle bought 0.9 bitcoin to HODL, but these investors are only buying 0.09 bitcoin to HODL. However, it reduces circulating supply the same amount, and when the halving event occurs, it will cause price to rise just as powerfully.
I think the mistake people make is that 1) they look at total supply instead of circulating supply, and 2) they look at supply in Bitcoin terms instead of dollar terms (the marginal investor is adding funds in dollar terms, so that’s what counts for measuring inflows). When you do this, you can see why market cap is a misleading way to look at Bitcoin valuations if huge chunks of supply never move (the market value reflects circulating supply which is dwindling from HODLing despite the new issuance).
The Ethereum Value Accrual Model
Ethereum has the same dynamic as Bitcoin but accentuated.
Proof of Stake & HODL culture: Ethereum has the same mechanism as Bitcoin as supply is increasingly removed from circulating supply via HODLing. However, HODL culture is about to become economically enforced as investors will be paid a yield to keep their ETH out of circulating supply. This has the effect of bringing in a much larger pool of possible investors into ETH HODLing as there is a yield incentive to do so. I go into much further detail in my Triple Halving Addendum on why staking derivatives will lead to dramatic drops in circulating supply.
EIP1559: Unlike Bitcoin, which sees price rise from punctuated halving events creating supply/demand dislocations in the context of an inflationary circulating supply, Ethereum will have a deflationary monetary policy - creating a more smoothed supply and demand mismatch that will be directly associated with the degree of network activity. Most importantly, as I detail in this thread, it’s the impact of EIP1559 on the supply of unstaked ETH rather than staked ETH which will most impact price.
Triple Halving (EIP1559 & PoS = 90% reduction in sell pressure): While Bitcoin has a punctuated halving event every 4 years, Ethereum is getting the last 3 Bitcoin halvings worth of supply/demand mismatch in 2 events. When applied to a dwindling supply, price should rise substantially on minimal incremental investment.
EIP1559 breaks Raoul Pal’s Metcalfe Law Thesis
Here’s the original twitter thread:
Here’s a link to his most recent reference of the argument:
Raoul’s argument goes like this:
Metcalfe’s law says the value of a network is proportional to the square of the number of connected users
If you regress Bitcoin’s active addresses against price or market cap, you see what looks like a strong relationship
If you model Ethereum’s active addresses to this, Ethereum is on the path of Bitcoin’s previous cycle
By looking at Bitcoin’s previous cycle and applying the Bitcoin regression to ETH prices, you get a price target of ~$20,000.
The logic here makes some sense - the value of any network would be expected to be proportional to the number of users…but the value extraction per user is a key variable. I remember clearly when Facebook finally cracked the mobile advertising code. The company’s value skyrocketed - not because estimated user growth had changed - but because the value per user had changed. A metcalfe’s law model on past prices, which assumes the value accrual per user during those historical prices, would misrepresent future prices. EIP1559 ties the value of Ether more tightly to the Ethereum network. It allows more value to be harvested to Ether per user than ever before. As a result, the past is not a good model for the future. ETH prices will break out beyond what this relationship based on historical prices would expect. If historical prices modeled ETH 20k, and we’re breaking above that…my base case of $30-50k with a 150k speculative peak starts to appear within reach.
We’ll let the market decide, but I have a feeling Raoul will be happy if he’s wrong on this one.
Congratulations to ETH investors - EIP1559 is a huge milestone. Cheers to many more!
Apologies if there are typos in this piece. I’m tired, had a long day, and wanted to get this out before EIP1559 tomorrow, so there very well may be mistakes. I figured on an exciting day like this it would be more fun to get something out, even with some mistakes, then hold out for perfectionism. Thanks for being patient with me.
EIP1559 Bulls Panel!
I’ll be on an ETH panel tomorrow - check it out:
This does not constitute investment advice. I am not an investment professional. Do your own due diligence before investing your money.
I know, I know - this is just another Bitcoin comparison. I need something to anchor in readers’ minds and it’s hard to find good comparisons. Suffice to say that Ethereum has an entirely different model for value accrual than Bitcoin. These are good analogies, but Ethereum isn’t trying to be a better Bitcoin - it’s playing an entirely different game.