The 11th of May 2020 at 19:23 GMT, block 630 000 was mined and the long awaited third halving took place. Bitcoin’s block reward got reduced by half, if you want to learn more about the halving and its importance, you can take a look at this other article in BTSE’s Academy. Searches for the event are through the roof and folks around the world are all rushing to understand this phenomenon. This is a crucial historic moment for Bitcoin because it proves the value proposition of its programmable supply emission schedule and its digital scarcity.
However, given miners are incentivized by the block reward to provide hashing power to the network, how can we rest assured that Bitcoin security will prevail in an environment with only half the rewards? That’s where Bitcoin transaction fees come into play. We will explore what they are, how they will become the main driver of the network’s security financing and what other benefits they provide. Finally, we will explore the history of transaction fees up until now and what you can do to pay less fees on your transactions.
What are Bitcoin Transaction Fees?
If you’re executing a BTC trade on BTSE, you will have to pay the trading fee that the platform charges. However, even if your balance changes, no Bitcoin will have moved on-chain since this is all happening inside BTSE’s system. If you want to deposit extra BTC funds or to withdraw them from the platform into your wallet, a transaction on the Bitcoin network will take place.
It is common to see news articles covering tremendous Bitcoin transactions for millions (or billions) of dollars only cost a few cents to a few dollars in transaction fees. This is often touted as a great example of how Bitcoin compares to the traditional banking system. Sending these amounts of money traditionally would cost orders of magnitude more. The reason this is true is because Bitcoin transaction fees aren’t proportional to the dollar amount being sent, but rather to the amount of data consumed on the blockchain.
When you’re making a transaction from a personally held wallet, you will often be presented with transaction speeds to choose from. Fast, Average or Economical are common nomenclature representing fees to be paid. This is simply a way to provide an improved user experience, while under the hood transaction fees are calculated in an amount of satoshis per byte or vbyte. For each byte (used to encode a character such as a letter or number represented by 0s and 1s) your transaction consumes, you agree to pay an amount of satoshis. The size of your transaction varies depending on the amount of inputs (coins you’re spending) and outputs (where you’re sending those coins) you include.
Once a transaction is composed, the fee is reflected in the difference between the inputs and the outputs. For example, if I’m spending 0.1 BTC and I’m sending 0.05 BTC to a digital store, while sending myself back 0.049 to a change address, the difference will be 0.001. This is the fee of my transaction. This transaction can be broadcast to the network, where it will wait await confirmation.
The mempool is a place where transactions are propagating throughout the network of peer to peer nodes, but haven’t been included in a block yet, thus they have 0 confirmations. They eventually get included in a block by being selected by a miner, who might select it before others if it’s more economically interesting (offers a higher fee).
Why are transaction fees important?
The mempool acts as a market where participants compete to be included in the next block and where whoever has the highest fee most often wins. This is crucial to Bitcoin since the process of selecting transactions by a miner becomes a pure economic choice, thus disincentivizing them to discriminate against transactions on any other basis than the transaction fee. Censorship and exclusion of a transaction by a miner is highly unlikely, since there are multiple parties mining on the Bitcoin network and any attempt at censorship will likely be viewed in the eyes of competing miners as an attractive additional source of revenue.
The main use case of Bitcoin transaction fees is the title of this article: the financing of Bitcoin's network security. Mining is one of the core components of Bitcoin, it provides security to the entirety of the network by leveraging the Proof-Of-Work consensus mechanism. Bitcoin’s peer to peer network is resistant to DDoS (Denial-of-Service) attacks because nodes will only accept a mined block if it contains proof a miner has put forth the computation effort required to "solve" it.
Due to proof of work, Bitcoin’s history can’t easily be rewritten. This consensus mechanism ensures double spending coins and erasing transactions is almost impossible. If an attacker wants to reverse a transaction that took place 5 blocks ago, he has to redo the mining process for not only that block, but all subsequent blocks to the current moment. Not only that, the miner must also providing a longest valid chain by outpacing other miners on the network and having them build atop his version of history, abandoning the previous chain. In this example, one must mine the next block plus the previous five in a shorter amount of time than the whole network combined has to mine just the next block, which is all but an impossible feat. Why attack the network with such a high likelihood of failure when you can simply participate in the next block and have a chance at winning the reward?
This is the incentive system underpinning Bitcoin and keeping miners honest. However over 18 million of a total 21 million bitcoins have already been issued. Future incentives for miners will increasingly rely on the transaction fees. In a few years, these miner fees will become the majority of the block subsidy. The ratio will continue to increase until the year 2140 when the Bitcoin network will no longer issue any new coins.
Outside of the subsidy, transaction fees are still important even at a very low cost. This is because they function as a spam prevention system. Altcoin networks which pride themselves in having no fees ultimately open themselves up to being attacked by a user who maliciously broadcasts transactions back and forth to crash network nodes. Bitcoin transaction fees protect the whole network from suffering a similar attack.
History of Transaction Fees
Transactions were ridiculously cheap at the beginning of Bitcoin since there were almost no participants in the network. Over the years these have increased as users have began competing to get included into the next block. Paying a higher bid for the scarce block space ensures quicker settlement in times of network congestion. Although there were some spikes of bitcoin activity leading in gradually rising fees even in the early years. The nominal fees paid in USD also rose gradually as Bitcoin grew tremendously in dollar terms.
We can observe that fees continue to grow as Bitcoin adoption increases and becomes mainstream. There are visible spikes in the average fees paid in USD in mid 2011 and late 2013, coinciding with tremendous Bitcoin bull markets.
However, nothing to date has surpassed the huge deviation in average transaction fees paid during the bull run that led Bitcoin from the $1000 mark to $20,000 in late 2017. In attracting a massive influx of new market participants, the mempool became clogged and brought the average fee to over $50. Some individual transactions were recorded with a $1000 fee, suggesting that some people were either in a real hurry, or just didn't understand how to properly anticipate the required satoshis per byte. (According to bitinfocharts)
Following the 2017 explosion of fees, large market participants like exchanges and wallets started adopting more efficient ways to manage scarce block space. These included things like Segwit and transaction batching. These efficiencies meant more transactions could fit inside a singular block, increasing throughput and contributing to downward pressure on the fee market. Secondly, the initial mania that led to an abrupt influx of users cooled off in 2018. The average transaction fee has yet to return to the highs of 2017, even though we've similar instances of on-chain activity.
Though it may seem counterintuitive, rising transaction fees are a desirable phenomenon if we want them to eventually replace the block subsidy. Miners need to get compensated for their work done on the Bitcoin network. Since the mining subsidy trends to zero, fees will probably rise significantly in the upcoming years in order to keep Bitcoin network participants' financial incentives healthy. As pointed out by Dan Held in his article Bitcoin security is fine, it is estimated that over 50% of the block reward in 2030 will be coming from transaction fees paid by users.
We've explained why bitcoin transaction fees are an essential part of the Bitcoin ecosystem. They form a perfectly competitive market ensuring that users wanting to transact faster than others have to outbid other market participants in order to get included by miners in the next block. In the meantime, this constantly rising part of miner’s revenue in a block reward will guarantee a gradual transition of miners being supported entirely by transaction fees over the decreasing block subsidy periods.
There are numerous ways in which you can save on fees. Using different techniques and tools, you can make sure you’re always paying the lowest price. Stay tuned for next week's article to learn everything on how to effectively reduce your transactions fees. This advice will be particularly prudent for the next Bitcoin bull run, so you can keep more sats to yourself instead of handing them out unnecessarily to miners.
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