Amy ter Haar: Why everyone in crypto is talking about the London Hard Fork

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The Ethereum network is one of the most established and probably the most used blockchains today. Its toolkit of functions has enabled it to become the home for multiple stablecoins, countless NFTs (non-fungible tokens), dapps (decentralized applications) and DeFi projects (decentralized finance projects). Moreover, its native digital asset, ETH (Ether), holds the position of second-largest cryptocurrency value by market cap. However, Ethereum’s explosive growth over the past six years has resulted in an energy intensive, expensive and inefficient blockchain that must now overcome some of these pain points. Enter, the London Hard Fork.

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On Aug. 4 at block 12,965,000, the London Hard Fork will go live on the Ethereum main network when a series of five protocol updates called EIPs (Ethereum Improvement Proposals) are deployed.

The series of EIP upgrades require miners and nodes to update their software in order to keep interacting with Ethereum’s blockchain. Since the upgrade is not backward-compatible, it is known as a ‘hard fork’ — if a node doesn’t upgrade its blockchain, it can no longer be a part of the network.

Collectively, the EIPs are designed to improve the network but the reason talk of the London Hard Fork is bubbling over from Ethereum circles into mainstream media is because it represents a big step toward an overarching upgrade of the network known as Ethereum 2.0, which will see Ethereum’s current PoW (proof-of-work) protocol replaced with a PoS (proof-of-stake) protocol.

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The difference between PoW and PoS is relatively straightforward. PoW is based on mining verification and income is derived mainly from the power of the machines involved. This is the same kind of protocol used to secure the Bitcoin blockchain. In contrast, PoS is based on users “staking” a cryptocurrency by depositing it in order to become a validator and thereafter deriving income by getting rewarded for being a good validator.

Of the five EIPs that comprise the London Hard Fork, EIP-1559 is getting the most attention because it is the core improvement in Ethereum’s attempt to generate greater bandwidth in its path migrating away from PoW toward PoS. It is anticipated that PoS will help Ethereum unlock its full potential and make it more scalable, secure and sustainable.

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EIP-1559 replaces the existing auction-based “gas fee” model of Ethereum and creates a new fee structure that splits transaction fees into “base fees” and “incentive tips” It also creates a new base-fee “burn mechanism.” In a nutshell, this means that there is a big change in the way that miners will be compensated for their work and some of them are not happy about it.

Presently, Ethereum’s transaction fees are based on a simple auction mechanism in which users submit transactions offering a certain amount of “gas” — think of it like a transaction fee — and miners choose the transactions with the highest offers. This is a simple enough system to understand but it leads to a number of inefficiencies, which the EIP-1559 aims to address by creating a different fee structure.

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From the moment of the EIP-1559 update, miners will receive payment only for including a transaction in a block (via the “incentive tip”). The remainder of the commission or “base fee”, which is proportional to the size of the transaction, will be sent to the network and destroyed, or “burned” through a new base-fee burn mechanism.

This means that the miner who used to receive 100 per cent of the transaction fees will now only pocket the optional “incentive tip” that incentivizes the miner for faster inclusion of a transaction in the blockchain.

Since the base fees are being destroyed, the effect is that some ETH is forever removed from the circulating supply and this is what has investors bullish on it. Some claim that this will create a deflationary (or at least a less inflationary) effect on ETH and that it will enhance ETH’s chances to become a preferred store-of-value asset due to its lower supply.

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It makes sense that greater scarcity of ETH could be positive for the price of ETH and admittedly, the higher the demand, the more ETH will be burned.  However, those who are bullish on EIP-1559 tend to make the following assumptions: a) that it will create a deflationary effect because the reduced supply of ETH will lead to rising prices as demand for ETH increases, and b) there will be a corresponding reduction in gas fees.

These are not facts. They are assumptions, both of them flawed or flat-out incorrect.

First, burning a base fee does not a deflationary asset make. In order for ETH to become deflationary in the monetary sense of the word, more ETH would have to be burned than issued. On its own, the burn fee mechanism is not enough to determine if the supply will increase or decrease.

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Second, EIP-1559 is not designed to reduce the high cost of gas fees. Gas is a fee required to successfully conduct a transaction on Ethereum network and it is expensive when the network is congested. But the underlying cause of high Ethereum gas fees points to a scalability problem. High fees are caused by limited network capacity to process transactions. The EIP-1559 update is designed to reduce the volatility of gas fees; it will have little (if any) bearing on how many transactions the network can actually handle.

The EIP-1559 update will enable users to speed up their transaction fees by “tipping” miners through the incentive part of the gas fee. However, if Ethereum grows as exponentially as its community expects then network congestion will get worse, not better. And if a large number of users are simultaneously willing to tip miners to speed up transactions, then we may end up in a gas-fee war worse than we’ve been already seeing.

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For example, this past year we’ve seen a surge in interest and investment in decentralized finance (DeFi). Ethereum has almost become synonymous with DeFi because users typically engage with DeFi via software called dapps, most of which currently run on the Ethereum blockchain.

The London Hard Fork will certainly help in enabling Ethereum to overcome the low bandwidth and bottlenecks that are restricting mainstream adoption.

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However, Ethereum’s vision is much grander: It wants to grow until it is powerful enough to help all of humanity reach a digital future on a global scale. The London Hard Fork is an incremental step toward this goal, but if DeFi continues its meteoric rise it won’t be enough. Ethereum will need to immediately accelerate incremental improvements necessary to realize Ethereum 2.0 or it will continue to be a victim of its own success.

Amy ter Haar is a lawyer, executive and entrepreneur who specializes in blockchain and fintech.

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