Beyond just the meme, what consequences will the London hard fork have to investor perception of the Ethereum network?
This episode is sponsored by NYDIG.
On today’s episode of “The Breakdown,” host NLW discusses:
- Proposed amendments to the infrastructure bill
- Notable EIP 1559 changes
- “Ultra-sound” money meme explained
Amendment proposals came from a variety of political figures, including Sen. Ted Cruz’s bid to scrap the crypto provision altogether. A more realistic option, however, came from Sens. Wyden, Toomey and Lummis, who chose to insert a definition excluding non-custodial intermediaries.
In the main discussion, the London hard fork to Ethereum took place early this morning. The changes aimed to improve the user experience on the network and included the introduction of a maximum bidding tip, increased block size in times of high demand and the change to burn the base fee.
The base fee burning modification has sparked conversation about a potentially powerful side effect. In new EIP-1559 transactions, the protocol will burn the ETH used for to pay the base fee. If more ETH is burned this way than is issued, it will make ETH deflationary. If bitcoin’s fixed supply constitutes “sound money,” does ether’s declining supply “ultra-sound?”
The Breakdown is written, produced by and features NLW, with editing by Rob Mitchell and additional production support by Eleanor Pahl. Adam B. Levine is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsor is “Only in Time” by Abloom. Image credit: Zoltan Tasi/Unsplash modified by CoinDesk, modified by CoinDesk.
I think it's important to point out that sound money as a concept applied to Bitcoin really has at least two dimensions. The first is this element of fixed supply. Obviously, it's absolutely essential. But the second is that it has a programmatic money supply that is not tampered with by humans. The two key dimensions of people's belief in that inviolable monetary policy are one the true absence of a founder as a force in the protocol, and to a track record of conservatism and non interference. Welcome back to the breakdown with me and I'll w it's a daily podcast on macro Bitcoin and the big picture power shifts remaking our world. The breakdown is sponsored by nyttig and produced and distributed by CoinDesk.
What's going on guys? It is Thursday, August 5, and today we are talking about EIP 1559 and whether it turns Ethereum, ether, specifically into ultra-sound money. First, however, let's do an update on the infrastructure bill. Where we left off yesterday was that a group of Republican and Democratic Senators were coming together to author an amendment to the crypto tax reporting provision. The goal of the amendment would be to specifically exclude non-custodial actors, like miners, from the new IRS definition of broker as applied to the crypto industry. It's short, so I want to read the whole thing. But before we do, I should also note that Senator Ted Cruz also offered an amendment. His amendment would scrap the provision entirely which, while I think crypto would love to see, most didn't find it especially politically viable. Hence, us focusing on the Wyden, Toomey, Lummis amendment.
Here's the amendment as written: "Purpose: to revise the rule of construction with respect to information reporting for brokers and digital assets and for other purposes. On page 2437, strike lines nine through 21 and insert the following: definition of broker. Nothing in this section are the amendments made by this section shall be construed to create any inference that a person described in Section 6045C1D of the Internal Revenue Code of 1986, as added by this section, includes any person solely engaged in the business of a.) validating distributed ledger transactions, b.) selling hardware or software for which the sole function is to permit a person to control private keys, which are used for accessing digital assets on a distributed ledger, or c.) developing digital assets or their corresponding protocols for use by other persons, provided that such other persons are not customers of the person developing such assets or protocols."
So basically, this is explicitly excluding validators, hardware and software developers, miners, etc. Now, obviously, this is huge progress, the Blockchain Association issued a letter with more than 100 signatories, urging Majority Leader Chuck Schumer and Minority Leader Mitch McConnell to support the amendment. On top of this, there's a major campaign in the crypto industry to light up the phones of senators in support of the amendment. Just one platform helping route those calls, Fight for the Future, had logged 5,000 calls within a few short hours. Pat Toomey tweeted of the amendment quote, "While Congress works to better understand and legislate on issues surrounding the development and transaction of cryptocurrencies, it should be wary of imposing burdensome regulations that may stifle innovation. By clarifying the definition of broker, our amendment will ensure non-financial intermediaries like miners, network validators and other service providers are not subject to the reporting requirements specified in the bipartisan infrastructure package."
So, a couple interesting points of contention and political intrigue. First, there's a question about whether this specific language sufficiently excludes the Lightning Network or not. Here's the way that Neeraj from Coin Center put it last night, quote, "Lightning went from definitely included to arguably not included. The amendment gives us space to advocate for Lightning to be spelled out where previously there was none. Unfortunately, it's not going to get better than this tonight. For what it's worth, I think the odds of a Lightning node being considered a broker in practice are vanishingly small."
Still, I think it's a concern enough that it's worth keeping an eye on, but here's something even more intriguing that has to do with the politics behind this whole thing. Politico this morning has a piece on the amendment called "Cryptocurrency Tax Changes Spark Clash Between White House and a Key Democratic Senator," which of course they're referring to Senator Ron Wyden, the Senate Finance chair, in discussing the Toomey, Lummis, Wyden amendment, Politico writes: "Echoing concerns from the cryptocurrency industry, these senators say the legislation's definition of who counts as a broker, and therefore subject to the new rules, is overly broad and will sweep in too many unintended targets. They want to amend the legislation to specifically exclude people like software developers, but the administration, which has advised the larger bipartisan group of lawmakers who put together the infrastructure plan, calls that bunk. It believes the industry is using scare tactics to try to water down the requirements, an senior administration official said, speaking on condition of anonymity, and the administration believes the proposed changes are significant enough to put a dent in the $28 billion budget forecasters anticipate the provisions raising for the $550 billion infrastructure plan."
So according to this piece, the administration is taking the same weird line that Rob Portman, the Republican author of the provision took, which is that of course they don't have the intent of going after those actors. But let us write it really broadly. Here's another quote from the piece. "The administration worked behind the scenes with lawmakers on the provision in question. It says people like miners are minor players in the cryptocurrency economy, the official said it has no intention of pressing people for information they could not possibly have. The amendment will needlessly tie Treasury's hands when it comes time to develop regulation spelling out the details of how the rules would work, the person said."
This to me is so, so suspect. This morning, the Joint Committee on Taxation said that the revenue would be reduced by $5.17 billion if the amendment passed. So, here's the big f**king question. If for days, Rob Portman has said these miners, devs and validators weren't the intended target, a position that this scoffing anonymous White House source reiterate, but now we have an amendment, that's only purpose is to say officially, these are not the targets of this plan, how could there possibly be a $5 billion gap? Sounds to me like the Joint Committee on Taxation was intending to include these actors to the tune of $5 billion, which is shady. As always, I will continue to share this story as it develops. And wow, what an interesting dimension to it.
Now, let's flip to the big crypto industry happening of the day: Ethereum's London upgrade, which includes the implementation of EIP 1559. I think where this intersects with the interest of the average "Breakdown" listener is about the macro narrative, and if and how this changes where Ethereum fits in that macro narrative and to large scale institutional investors. That said, I think it's also important to cover at least some of the basics and the technical specifics, so a big shout out to Anthony Sassano's Daily Gwei and 0xNader who I cribbed much of this from.
EIP 1559 was first proposed in April 2019, and is now going live with Ethereum's London upgrade. The changes made by EIP 1559 are largely about the user experience of the Ethereum network; it changes how transaction fees are determined as well as how the network operates in times of high demand. Ethereum currently uses a first-price auction model, in other words, users that bid more are more likely to have their transactions included first, this creates an incentive to over-bid to ward off fluctuations in demand. In this current model, there is a base fee, which is a minimum fee set by the protocol and the priority for your tip. Currently, if a user overpays, that overpayment goes to miners.
In the new EIP 1559 model, there is still a base fee. That's the portion set by the protocol. But then users also set a max fee, and the priority fee or tip. If the max fee exceeds what is needed for the transaction to be processed by the market, they pay only the base fee and their tip, but get refunded the difference between that and their max fee. So imagine if you were trying to buy a ticket aboard Jeff Bezos' spaceship and the minimum bid was $10k. Your priority bid was $5k over that for a total of $15k. But you were willing to pay up to $25k. Now let's say that the price necessary to secure a spot was $20k. More than the $15k you wanted to pay but less than the $25k you are willing to pay. In this new model, you'd be refunded the difference between the winning bid of $20k and the max bid of $25k. Effectively, the key thing to know here is that the overpayment goes back to the bidder, to the user, rather than to the miners. This is meant to better align the incentives of miners with the rest of the community.
Now, there's another dimension to EIP 1559, which is an approach to temporarily increasing block size in times of high demand. The goal again is to improve the user experience by smoothing out transaction prices. Now that's sort of out of the technical scope for this podcast, but I wanted to at least mention it.
Still, the change that has created the most chatter is the burning of the base fee. As mentioned above, in an EIP 1559 transaction there's a base fee, a priority fee or tip and a max fee, the base fee again set by the protocol. And the logic of having it burned rather than go to the miners is that if the base fee did go to the miners, it would create an incentive for them to keep that fee high. Now, here's the thing that has a lot of people chattering about this. What happens if the ETH burned as part of the base fee are greater than the issuance of ETH? ETH would then, by definition, become deflationary. Right? And this is where the ultra-sound money meme was born. The idea behind that meme is that if bitcoin's issuance reduction, leading ultimately to a fixed total supply, is "sound" money, ETH's overall supply reduction over time leading to a supply that is declining, would make it even sounder money, or so the argument goes.
So, let's discuss this specifically and then let's discuss ETH in the macro context more broadly. First, a lot of the Ethereum community that I most respect, even those who are excited about these deflationary changes, are quick to point out that one, the fee burns do not necessarily mean that more ETH will be burned than is issued right away. Folks have created models to show what the average base fee would have to be both in the current proof of work design, and in the anticipated ETH 2.0 proof-of-stake design for the burn to be higher than issuance. The reason to reinforce that is to point out that the core of the proposal is really intended to improve the experience of paying for transactions with this burn being a side effect. That said, as many on Twitter pointed out this morning, at Ethereum block 12,965,263, more ETH was burned than was issued, as many put it, the first deflationary block in history.
Still, I think it's important to point out that sound money as a concept applied to Bitcoin really has at least two dimensions. The first is this element of fixed supply. Obviously, it's absolutely essential. But the second is that it has a programmatic money supply that is not tampered with by humans. The two key dimensions of people's belief in that inviolable monetary policy are one, the true absence of a founder as a force in the protocol, and two, a track record of conservatism and non-interference
To the extent, then, that one wants to entertain the meme of ultra-sound money, even if you give ETH high marks around a new deflationary supply, or at least to supply trending that way, I think many people will have questions around the second part, its monetary policy was never prioritized to be inviolable in the same way that Bitcoin's was. This is what has allowed it to change. But the change itself in some ways undermines the confidence that it won't change again. On the leadership front, I will note that I strongly believe that Vitalik exerts less influence now in Ethereum than at basically any point in the past. However, even his intentional withdrawal points to how fundamentally unique Satoshi's vanishing was, at any point Vitalik could decide to try to exert more influence. Over time, his ability to do so would of course diminish, but there likely would always be a pretty big block, pun intended, ready to support him.
So, what's the point of pointing all this out? Is it to crap all over the ultra-sound money meme as just some cringe Twitter artifact? No, I will let you make your own judgments about memes. It is instead to try to draw contrast about what might make macro players care about one crypto asset versus another. I have felt and continued to feel that the credibility of Bitcoin as an antidote to human monetary policy remains unlike anything before or since. And to be clear, I think that the 21 million hard cap is the great expression of that inviolability. But what matters is the contrast between human made monetary policy and math made monetary policy. The people who care about such things as their chief and primary concern will continue to prioritize Bitcoin. There is also the whole other dimension of things that people prioritize around Bitcoin, i.e. censorship resistance and what true decentralization looks like. But I'm not even going into that now, just focusing on the sound money side of the argument.
However, now let's ask a different question. Will a deflationary ETH supply make ETH more appealing to some parts of the market? And the answer here is almost certainly Yes. There are many people who currently interact with Ethereum for reasons other than its monetary policy, who will still find this new deflationary supply pressure even more of an inducement to hold ETH. My argument is that this set will likely not be folks who poke their heads into crypto looking for the hardest asset. Instead, it will be people who have come to Ethereum for other reasons. For example, the dynamism of its developer community, which VCs always call out, or those focused on NFTs for which ETH functions in many cases as a unit of account, or those that interacted with Ethereum powered DeFi applications. These folks already have different interests in different weightings of trade offs, but by simple laws of supply and demand, the overall supply of the base asset decreasing over time, is likely to make it more appealing.
Now, there are counter arguments to all of this. There are many who argue that a restricted supply makes a currency ill-suited to be the base of a complete financial ecosystem like Ethereum is trying to build. These are the same folks, however, that argue vociferously for the contemporary Fiat based system in the macro world, so their arguments are unlikely to hold much water with the crypto crowd. Ultimately, my perspective in this industry has always been that maybe the most important thing any person needs to align themselves around is objectives and trade offs, is creating the soundest money possible the objective? Is censorship resistance the objective? Is creating the building blocks for developers to reimagine old systems the objective, is it speed? Is it security? Is it durability? There are no right answers a priori, there are right answers based on what one is trying to achieve.
I will also say this, though, the cool thing, also a challenging thing, about decentralized protocols is that the answer to what one is trying to achieve can be fiercely different among different groups, even those who are focused on the same asset. The arguments around objectives and trade offs often represent some of the most important forging moments in the life of protocols. See, for example, the block size wars in Bitcoin. So is ETH now ultrasound money? Simply put, I have a hard time believing that the folks who prioritize sound money, hard money, are going to abandon Bitcoin for ETH because of these changes, the burden of proof on human involvement in monetary policy is too high. And the ICO that launched ETH is to them an original sin that can't be expunged.
The flip side is that for people who are already invested in or interested in the Ethereum ecosystem for other reasons, this could certainly increase the appeal of holding that base asset. On top of that, I do think it's worth exploring the potential impact among institutional investors. There are some institutional investors that have a highly ideological thesis, but there are far more who like making money. I think for that set, it is totally plausible that we'll start to see more arguments for sound money baskets, and other such Wall Street Style instruments that group these things together. Their argument might be that it's sound enough relative to engorged government balance sheets, plus it has some other things going on. So why not? Either way, so far the market likes it, EIP 1559 is trending on Twitter, ETH is up 6% in the last 24 hours, although I do think that the short term impact of big changes like this tends to be overestimated, but either way, there you have it. Apologies to the partisans on both sides for a sort of a validly apolitical take, but now let me know what you think. Hit me up on Twitter, on YouTube. I appreciate you listening as always and until tomorrow, be safe and take care of each other. Peace!