Blockchain Transaction Fees: Why Do They Matter?
In 1998, Chinese engineer Wei Dai first introduced the concept of “cryptocurrency.” Unlike conventional currency, digital currency only exists online. Users can exchange cryptocurrency online after purchasing tokens using “real” — i.e., traditional or fiat — currency. Cryptocurrency eliminates the need for a central controlling authority, such as a financial institution or government office, and instead creates a fast, easy and effective way for people around the world to exchange money.
About a decade after the idea of cryptocurrency was first described, an innovator using the pseudonym “Satoshi Nakamoto” revealed the concept behind Bitcoin. Today, Bitcoin (or BTC) is one of the most popular forms of cryptocurrency. While Bitcoin has eliminated the need for a central authority, it hasn’t removed the costs associated with the technology underpinning cryptocurrencies. Knowing how this technology works can help you better understand transaction fees — and how to minimize your costs when using cryptocurrencies.
Blockchains, Databases and Bitcoin
All verified Bitcoin transactions are stored via blockchain, a type of database which stores data electronically. The primary difference is that databases use tables to structure their data, while blockchains store data in blocks. When a block is filled, it’s added, time-stamped and “chained” to the previous one. This creates a record with readily accessible data and an immutable timeline.
Like databases, blockchains require multiple computers to manage and store data. However, databases use servers, which tend to be owned by a specific person or entity, whereas blockchains store data on multiple computers owned by numerous people or entities.
Bitcoin’s network includes thousands of computers called nodes, all working together to verify transactions, fill blocks and keep the system functioning.
The Blockchain Trilemma
For a blockchain to function at its best, it must be secure, decentralized and scalable. The blockchain trilemma, a concept introduced by a programmer (and Ethereum founder) Vitalik Buterin, refers to the idea that blockchain projects struggle to meet all three ideals.
Blockchain developers are using the concept of the trilemma to further refine networks and create tools to achieve optimal functionality.
Blockchain is designed to be democratic and immutable. The blockchain security is maintained through coding, as well as consensus algorithms which dictate the number of network nodes required to confirm transactions before finalization. And since the blockchain is made up of a series of blocks that record the data in hash functions with timestamps, it has proven its resilience against data tampering and hacks.
One of the jobs of central institutions is to prevent double-spending and similar issues. However, they’re vulnerable to DDoS attacks and other security issues. The idea of a decentralized blockchain network is deciphered as an environment where no one needs to know anyone since each node is passed on with the same information on a distributed ledger.
Decentralized systems such as Bitcoin are essentially invulnerable to these issues, and consensus algorithms or mechanisms provide further system security while preventing double-spending and enforcing peer equality. Shall anyone attempt to alter or corrupt the ledger, the majority of network participants need to reach a consensus to do so.
During periods of heavy use, traffic jams can occur, slowing transaction processing and driving up costs for users. A scalable blockchain is essential to maintaining a competitive edge with centralized networks.
To overcome and address the blockchain trilemma, some developers recommend making direct modifications to the network — layer-1 solutions, such as Ethereum. Others have suggested developing secondary networks, or Layer 2 solutions, designed to run alongside the blockchain, such as Lightning Network on Bitcoin or Litecoin. It’s important to note that blockchain technology is still in its infancy, and as it evolves, so will potential solutions to the blockchain trilemma.
Why Are There Bitcoin Transaction Fees?
In Bitcoin’s early days, miners worked quickly to validate transactions. As the digital currency has exploded in popularity, transactions have become more numerous and complicated. The Bitcoin transaction fee was initiated to speed Bitcoin transaction validation.
Fees are tied to the size of the transaction and input age. In other words, a transaction that comprises more bytes that take up more block data will have higher transaction fees. Additional fees can speed the transaction through the system, essentially placing it in a priority queue. In other words, you can pay more to have transactions validated faster.
Collected fees go to the miners, who validate and record the Bitcoin transactions and help keep the system fluid and functional by:
- supporting transaction processing
- paying the miners who validating the transactions
- eliminating spam transactions
In other words, Bitcoin transaction fees protect and preserve the integrity of the Bitcoin network.
Understanding Bitcoin Transaction Fees
Conceptually, Bitcoin transaction fees represent the speed with which a user wants their transaction validated on the blockchain. Although the decentralized nature of Bitcoin makes it easy for anyone to participate as a miner — which means verifying and recording transactions to form a block and are joined by a chain. However, the process of mining Bitcoin, or BTC, is both complex and expensive. Mining rigs are expensive and often times consume massive amounts of electricity, while the block subsidy and transaction fees help offset these costs and incentivize miners whenever a new block has been validated.
Miners are granted transaction fees and block subsidies as a “block reward” whenever they successfully added a block to the blockchain. The block subsidy is fixed with each Bitcoin mining and was reduced by half (Bitcoin halving) which will happen every four years or every 210,000 blocks. Looking back at 2009 a mined Bitcoin would earn you 50 BTC and in 2012, but as the years passes by, the rewards were halved, and the latest halving in 2020 set the rewards at 6.25 BTC.
The halving events cause the hashrate to fall, thus increases the computation power and energy required to mine new blocks. However, the rising transaction fees help incentivize miners to maintain network security and sanity. The transaction fees are determined based on a few factors:
- how congested the cryptocurrency network currently is
- the amount of data contained in the particular Bitcoin transaction
- the priority of the transaction
The last point is under the user’s control. If you need your Bitcoin transaction to be processed urgently, you can opt to pay a higher fee to prioritize it. If your transaction is less urgent, you can opt for a lower fee. In this case, the transaction will remain in the memory pool (or mempool) until the traffic slows.
The mempool can be thought of as a queue. When you initiate a transaction, it goes to the mempool. Transactions which are waiting remain in the mempool until a miner confirms and adds them to the block. When the mempool fills, miners choose Bitcoin transactions with higher fees first.
This system can keep transactions moving more smoothly, but it can also lead to a kind of bidding war. Many people using cryptocurrencies are willing to pay a premium to ensure their transactions are completed first. However, this tactic can backfire, especially during periods of heavy use. Some users end up overpaying fees, which forces other miners to also increase their fees.
Transaction Fees: Bitcoin vs. Ethereum
The biggest names in cryptocurrency are Bitcoin (BTC) and Ether (ETH) and understanding how fees are calculated can ensure you’re paying a fair amount to complete your transaction, without getting caught up in a bidding war or unnecessarily stagnating in the mempool.
Calculating Bitcoin Transaction Fees
To calculate bitcoin fees, you have a couple of options. With some wallets, you can automate the process, which allows you to choose how quickly you want your transaction completed and pay accordingly.
First, check the current rates and then multiply based on the size of your transaction. Bitcoins are divided into Satoshis, which are one hundred-millionth (or 0.00000001) BTC. If your transaction is 225 bytes and you choose the rate of 100 Satoshis per byte, then you can expect to pay about 22,500 Satoshis in fees, since 100 x 225 = 22,500. That currently translates to just over $14, considering 1 Satoshi is $0.00056666 or $0.00000001 BTC as of Oct. 11.
Calculating Ethereum Transaction Fees
Until 2021, everything on Ethereum’s network was based on “gas.” Gas is the unit linked to the amount of computing power necessary to complete a specific transaction. Aptly named, gas refers to the energy used to keep the Ethereum network moving.
Under this payment system, everything has been associated with gas. A simple addition problem might require just 5 gas units, while completing an actual transaction may have a cost of 20,000. To determine the transaction fee, a user would need to know the gas price, which is measured in gwei, or the equivalent of 0.000000001 (one-billionth) ETH.
To calculate, you’ll need to multiply the gas cost by the gas price. For example, you may have a transaction that will cost 20,000 gas units, and the price of gas is 100 gwei. Your total cost for that transaction will be two million gwei, because 20,000 x 100 = 2 million. That translates to just slightly above $7, assuming 1 gwei is equivalent to $0.00000359.
Users could set a “gas limit,” which referred to your spending limit, or how much gas you wanted to use for a specific transaction. Complex transactions required more work, so their gas limits would necessarily be higher than for simpler transactions.
This system proved to be cumbersome, however, and many users were underpaying, which could lead to the rejection of their transaction or the necessity of overpaying. (Think of it as putting too many stamps on an envelope you want to mail, instead of risking having the letter returned for insufficient postage.) The EIP-1559 upgrade changed the way users pay for transactions. ETH users instead would pay a base fee for specific transactions. Part of each collected fee is “burned,” which removes coins from circulation, and the rest goes to the miners. ETH users also have an option to “tip” miners, which can speed the processing and recording of their transactions.
Average Transaction Fees
Transaction fees are a necessary cost of performing financial transactions in the 21st century, and cryptocurrency transactions are no exception. Both Bitcoin and Ethereum link the cost of the transaction with its size, and users can pay more to speed the process. The average bitcoin transaction fee fluctuates from day to day, depending on the amount of traffic and other factors. The same applies to the Ethereum network.
Average Transactions per Day
BTC and ETH networks are flourishing, with myriad transactions being completed and verified every day. On the Bitcoin network, about 200,000 to 300,000 transactions are completed daily. Ethereum, on the other hand, completes over 1 million transactions each day.
Completing your transactions on a day when traffic is light can lower your transaction rate without forcing you to compromise on verification speed.
Hefty Bitcoin transaction fees are attractive to miners, but might not be as popular with users. The fee structure can be such that some users are paying the equivalent of their transaction amount in fees, particularly when it comes to smaller transactions.
Transaction fees aren’t the only issue dogging Bitcoin. Scalability is also proving to be something of an Achilles’ heel. The Bitcoin protocol clearly defines the block size and generation, which restricts Bitcoin to about seven transactions per second, or TPS. This has led to Bitcoin branching off into additional forks, such as Bitcoin Gold (BTG) and Bitcoin Cash (BCH). Ethereum, on the other hand, has larger blockchains and can process about 20 TPS and the ETH 2.0 is paying the way for a more scalable solution.
To change the Bitcoin protocol, its users must all agree on and choose a specific software. Lightning Network offers an alternative that’s designed as a Layer 2 payment protocol, which means it‘s layered on top of the blockchain. With Lightning Network, you can complete numerous transactions before closing the payment channel and settling the final transaction with the blockchain.
The Lightning Network is an off-chain solution that sits on top of a blockchain not exclusively on Bitcoin’s network primarily helps to process blockchain payments quickly and securely without potentially lengthy block confirmation times. It even allows users to complete cross-chain atomic swaps instantly without relying on third parties.
One of the key highlights of the Lightning Network includes its ability to allow for small payments, even less than a Satoshi. The process is more private, allowing for multiple individual transactions to occur without being broadcast via the blockchain. As its name suggests, the Lightning Network is fast too, with virtually no limits on TPS. Settlement times are equally fast, with the average transaction settling in about a minute or less. Fees are lower as well.
For those in search of privacy, speed and affordability, Lightning Network offers an excellent alternative.
A More Scalable Consensus Mechanism
A consensus mechanism or algorithm refers to a specific protocol designed to ensure that networks of computers can work together efficiently while maintaining security. The algorithm is often used to ensure the crypto network can function effectively and prevent certain types of system attacks.
If Bitcoin’s primary weakness is its scalability, a more scalable consensus mechanism may help lower costs. Currently, Bitcoin runs on a proof of work (PoW) consensus, which requires each node to solve complex mathematical problems to validate a transaction. The first to complete the problem can add the next block to the chain. The block is then verified, with the data entered into the blockchain.
The proof of stake (PoS) protocol is both more scalable and sustainable than PoW. PoS links mining power to ownership stake. Miners don’t need to expend energy solving mathematical problems but are instead limited to mining a specific number of transactions linked to their ownership stake. A miner with a one percent ownership stake would then be able to mine one percent of the blocks.
PoS systems are also less vulnerable to a certain type of economic attack. A miner would have to own more than half of the digital coins on a network to launch a system attack, which would be disadvantageous to their interests.
Ultimately, a PoS system is more scalable, energy-efficient and secure than PoW systems.
Camp Out for Less Congestion
Much as a traffic jam causes congestion, a greater number of transactions waiting on a network results in slower movement and higher fees. Ergo, fees tend to increase during times of peak use.
If your Bitcoin transaction isn’t urgent, you can “camp out” and wait for an opening, much as you might choose to leave a little later in the day to avoid rush-hour traffic. The blockchain tends to have predictable peaks and valleys, due to businesses completing larger transactions. Waiting until the weekend to complete yours could mean less traffic, faster clearing transactions and smaller fees. That’s one of the advantages of markets that never close.
While custom fees are possible, still, miners prioritize and process transactions based on several factors, including the size of the fee. Your larger transactions might take a little longer to complete, but they will be added to the blockchain, usually when the traffic slows.
The Bottom Line
Higher or lower fees can significantly cut your profits and affect your capital gains and losses. While these fees are a necessary part of transacting in a digital asset, you can take steps to lower your overall costs and reduce the risk of overpaying, whether that means opting for an alternative system for smaller transactions, such as Lightning Network, or waiting until the ideal time to process your transactions. Researching your options and finding the best one for your needs can help you save on both the prices of your transactions and the cost of doing business.