While the price of Ether is making positive headlines, hitting one all-time high after another, gas fees are reaching negative highs, uncovering Ethereum’s scalability issues once again. After a period of high and volatile gas prices during the summer DeFi hype of 2020, the beginning of 2021 has shot up prices again. While it is becoming impossible for small transactions or operations to be processed, the demand for using Ethereum is gaining momentum. However, for Ethereum to be scalable and its dApps to be widely adopted in the long-term, new solutions need to come up and lead the way forward.

Gas fees are the lifeblood of the Ethereum blockchain

Gas is paramount to the existence of Ethereum. It is the synonym for the fees paid for every transaction on the blockchain. Gas is required to conduct a transaction or execute a smart contract. Since each transaction requires computational resources to execute, payments made by users compensate for the computing energy required to process and validate transactions on Ethereum. Gas fees are paid in Ethereum's native currency, ether (ETH). They are denoted in Gwei, which itself is a denomination of ETH. Their price is determined by supply and demand between the network's miners, who can decline to process a transaction if the gas price does not meet their threshold, and users of the network who seek processing power. Therefore, the lower the user sets a gas price, the more likely the transaction will be ignored or takes a long time to process. Consequently, if a user sets the gas price high, he/she can skip the queue and the operation is verified faster.

Evolution of average gas prices on Ethereum

Source: Etherscan, February 2021

Naturally, users of Ethereum and its underlying applications prefer low fees whereas miners would like to see high gas prices for high fee payment. When during normal times gas prices tend to be low, there have been various periods throughout the past years which saw increases in gas prices because of congestion on the Ethereum blockchain. The most notable was during the summer of 2020 when Ethereum network users faced high fees on and off as a partial result of the decentralized finance (DeFi) craze, which utilized the blockchain for various lending and yield farming activities. At times, the high fees made it difficult for contributors to participate in DeFi activities.

Consequences for dApps, users, and Ethereum

Most recently, Ethereum’s gas prices have surged again. According to BitInfoCharts, the average Ethereum transaction fee has skyrocketed to an all-time high of around $23. This makes using the network totally unviable for smaller transactions which eliminates a lot of DeFi activity for the average user or investor. For applications that run on Ethereum, it is crucial that fees stay at a low level for users to interact “freely” with a dApp’s smart contract. High gas prices basically make it impossible for projects to run any microtransaction on Ethereum. This is in stark contrast to the idea of using the Ethereum network to build a (financial) ecosystem that can be used by everyone, without relying on intermediaries and with low cost. The latest spike in gas prices had a big impact on a number of DeFi projects, with some transaction fees rising above $1,000 (!). Simple swaps on major DEX like Uniswap and SushiSwap increased to levels between $40 and $75, exposing Ethereum’s scalability issues and ability to cope with rising usage. Also, centralized exchanges were affected as some were forced to halt ETH withdrawals altogether.

While looking for lower fees, DeFi users have turned to Ethereum alternatives. Data already indicates higher usage of other blockchains such as Cardano, Elrond, and Avalanche. The high gas fees are an opportunity for Ethereum competitors to grab a fair share of the market. With different types of systems, users and dApp providers have the choice and can help rival networks to challenge Ethereum as the biggest blockchain. Some of the most notable ones, such as Polkadot, share commonalities with Ethereum. While others gained prominence through their association with centralized exchanges (e.g. Binance Smart Chain, Solana). Although Ethereum is in the pole position, high gas fees clearly are a deal-breaker when it comes to small scale transactions and operations on a blockchain. Therefore, any network that can avoid surging fees will clearly be able to challenge Ethereum’s position.

Benefits of high gas prices

Surely, from the perspective of average users or investors, high gas prices can really hurt the usage of a dApp or the network in general. Daily usage is becoming impossible for the average user/trader. However, it is also a sign of high demand on the network indicating a higher adoption of decentralized systems in general. And people are willing to pay for it. It seems though that especially one group benefits more from the sharp increase in network fees than any other: big investors. Investors holding large amounts of ETH show a higher number of Ethereum transactions compared to those coming from smaller investors, correlated to an increase in fees. Since gas prices are not calculated based on the size of the transaction but rather the cost to interact with smart contracts, large investors are more likely to engage with the network during higher congestion times as a larger balance is less affected by growing transaction costs. A $200 trade and a $20,000 trade on any DEX could both cost about $50 in fees under current conditions, making it less likely that smaller investors will engage as the cost of the trade is 25% of the total value traded versus 0.25%. Therefore, a high-fee environment prices out smaller investors and just prepares another playing field for big investors.

Where to go from here?

Although the situation doesn’t look good for the network and its users, solutions might be already on their way. As innovative and fast-paced as the DeFi ecosystem is, projects tackling Ethereum’s congestion issue can be found already. Ethereum needs to scale, and Layer 2 (L2) scaling technologies might be what is most efficient here. Three L2 models gained popularity, namely State Channels, Plasma, and Rollups*:

  • State Channels can be compared to a bar tab. Two entities can generate an infinite number of transactions between each other, and once the night is over, the tab is “settled” and a single transaction is made to Ethereum. It’s possible to include multiple people in this tab, but it becomes difficult to scale State Channels to a lot of participants.
  • Plasma is an attempt to create a more flexible bar tab system, enabling many-to-many transfers, rather than just one-to-one or one-to-few. Additionally, Plasma enables more complex transaction logic, and are smart-contract enabled. Like State Channels, Plasma is completely separated from the Ethereum L1, which gives it near-limitless scalability ceilings.
  • Rollups, yet, are another form of L2 solution that offers many-to-many transactions, smart-contract capabilities, and significantly reduced total L1 blockspace requirements. The most known form is zero knowledge rollups (zkRollups) which can bundle hundreds of transfers off-chain into a single transaction via a smart contract and then providing proof to the Ethereum blockchain.

*Explanations taken and adapted from “Bankless - What’s up with Optimisitc Ethereum”

There are already some success stories of these innovative L2 technologies, speaking about Loopring (LRC), a zkRollup exchange, or Matic Network, an adapted version of Plasma with Proof-of-Stake side chains.

The long-awaited solution coming from the blockchain itself is the update to Ethereum 2.0. This upgrade is one of the most highly anticipated ones in the protocol’s history. It will see Ethereum switch from Proof-of-Work (PoW) to Proof-of-Stake (PoS). Ethereum started its upgrade journey in late 2020. And although the upgrade is expected to bring massive scaling to the network, it will likely take years to fully play out. However, DeFi users may not have to wait until Eth2 to see a reduction in gas fees on the Ethereum mainnet. There has been significant progress on the EIP-1559 testnet that was proposed by Vitalik Buterin and Eric Conner in 2019, recommending the introduction of a burn mechanism to reduce fee volatility. However, with the proposal reducing miners’ revenues to small tips sent alongside a burned base fee, EIP-1559 has been met with significant resistance from Ethereum’s mining community.


Sources:

High Gas Fees Prevent Ethereum From Being Ethereum - Coindesk ; October 14, 2020 [1]

Exchange temporarily halts Ether withdrawals as gas fees hit new highs - Cointelegraph ; February 4, 2021 [2]

Ethereum posts new highs as DeFi gas fees go through the roof - Cointelegraph ; February 4, 2021 [3]

The good news for ETH hodlers about insane gas fees - Cointelegraph ; February 5, 2021 [4]

Whales profit as high Ethereum gas fees sideline retail DeFi investors - Cointelegraph ; February 6, 2021 [5]

What’s up with Optimisitc Ethereum - Bankless ; February 3, 2021 [6]
Gas (Ethereum) - Investopia ; January 30, 2021 [7]