Why do we pay fees?

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Since the start of Bitcoin, no or low transaction costs have been one of the often mentioned advantages of Bitcoin over other payment systems. Over time, this has changed: some support the development towards higher fees and others think it does not belong to Bitcoin. In this article we will discuss the functions that fees have, how fees work and what the “right” fee is to choose.

Why do we pay transaction fees?

During the early days of Bitcoin, there were virtually no users. This made it possible to make transactions in which no fee was paid, without this causing usability problems. As the use of Bitcoin increased, transactions began to compete with each other and the payment of a fee became necessary to ensure that a transaction was confirmed in a timely manner.

Antispam / Denial of Service ( DoS )

One of the functions of fees is to prevent spam transactions and denial-of-service attacks. Giving priority to a transaction based on the fee given ensures that someone with bad intentions for the network has to pay higher fees than normal users in order to be successful.

For fees to work effectively as anti-spam protection, they must be high enough to discourage an attack. Exactly how high this is depends on an attacker’s motivation, but the cost of an attack should outweigh the potential benefits. There are two types of DoS attacks that fees protect against:

  1. Attacking the network by sending large amounts of transactions to the nodes, causing them to get stuck processing all transactions and prevent normal transaction processing.
  2. Attacking the blockchain by filling up the blocks, so that other users can no longer use the available space in a block and therefore have more difficulty confirming their transactions.

In both cases, the transactions use limited available space: 1) the available RAM at nodes for maintaining the mempool and 2) the available capacity for transactions in blocks. By making users pay fees, an attacker cannot continue an attack indefinitely.

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Reward for the miners

The Bitcoin network is secured by proof-of-work . This is the process by which miners expend computing power and electricity in the hope of finding a block, rewarded with the bitcoins from the block reward.

In addition to the reward from the block reward, the fees from users’ transactions also go to the miners. How many fees these are, depends on how much the network is used. The demand for space in a block creates competition to be included in a block: miners will prefer transactions with higher fees or not include transactions with too little fee in a block.

The block reward and the fees from transactions serve as an incentive for the miners to act fairly: the most profitable choice for a miner should always be the fair choice.

When a block is mined, the miner receives a basic reward: the block reward. These are new bitcoins that are created as a reward for the work the miner has done. When Bitcoin started in 2009, this reward was 50 bitcoins per block mined, but the reward halves every four years on a set schedule. On November 28, 2012, the reward halved to 25 bitcoins and on June 9, 2016, it halved again to 12.5 bitcoins. This halving ensures that a maximum of 21 million bitcoins will ultimately be created (this number is expected to be reached in 2140).

Because the block reward halves every four years, the reward that the miners receive from fees will become increasingly important. After all, when there is no more block reward, fees will be needed to ensure that the miners remain honest. With the current average fees and 1 MB block size, each block contains approximately 1 Bitcoin in fees on top of the reward of 12.5 Bitcoins. The fees currently represent approximately 8% of the remuneration.

This percentage was lower in the past and is expected to grow in the future.

There is limited space available in blocks

It is getting busier on the Bitcoin network and the blocks are therefore increasingly full. As a result, a fee market is emerging: there are more transactions queued for confirmation than can fit in a block, so users must determine how much they are willing to pay to have their transaction included in a block. block. If there are too many other users willing to pay higher fees, a transaction may never be included in a block.

Fees are calculated per byte of available space

We have already mentioned that the space in a block is limited, while the potential demand for space is unlimited. Most miners therefore use a price per byte that a transaction takes. Due to the way Bitcoin transactions are put together, the size of a transaction can vary quite a bit. For example, multisignature transactions require more space than a normal transaction and a transaction with many inputs also takes up more space, so it needs more fee.

The latter is sometimes a bit confusing: if you have received many small payments to your wallet, for example 0.003 bitcoin daily for a small share in mining, and you want to spend these, all these small payments will have to be combined into one big transaction. For example, to send 0.5 bitcoin, 166 small payments of 0.003 bitcoins must be issued. A digital signature is required for each payment that is processed in the transaction, which means that more bytes are required in the transaction for the digital signatures and the transaction will therefore cost more.

Why do the fees keep rising?

The first time we really saw the fees increase was when an unknown group of people performed a “stress test” on the Bitcoin network. They delivered a constant flow of transactions whose volume exceeded the space in the blocks. At this time, the amount of fee you added to a transaction for the first time affected how quickly it was confirmed, before that just about every transaction was mined anyway.

In recent years there has been a continued increase in actual transaction volume (no spam or stress tests). As a result, we have now reached the point where the blocks are regularly full. As a result, it has now become very important to set the “right” amount of fee when making a transaction to ensure that the transaction will be confirmed by a miner.

This is the market for fees we talked about earlier: with fees you bid on the available space in a block. The highest bidder wins and gets their transaction included in a block.

What is the “right” fairy?

For a long time, the standard fee was 0.0001 bitcoin, mainly because in the past there was not much pressure to choose the right fee. In addition, the price of a bitcoin was much lower at that time, so it was not necessary to “optimize” the fee and choose the “right” fee. This changed when the blocks started to fill up and it became clear that 0.0001 bitcoin fee was not the right choice.

There are two methods used to choose the right fee:

  1. Look at the current transactions in the mempool and use that to determine the right fee to get a transaction confirmed.

This is often done by users who manually try to estimate the correct fee. They look at the statistics of the transactions currently in the mempool and choose a fee that brings them to the first 1,000,000 bytes (the space available for the next block). This gives a good chance of a quick confirmation.

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The disadvantage of this way of choosing a fee is that after each block there is a dip in the chart. After all, there are fewer transactions in the queue. This makes it difficult to choose exactly the right fee 100% of the time.

  1. Look at the last X blocks and determine what the right fee was to be included in one of those blocks.

This looks at the transactions included in the last few blocks and how long those transactions have waited for confirmation. Then we look at the transaction with the lowest fee that still had a chance of more than 80% to be included in the next block after sending the transaction.

Will the fees continue to rise?

In four years the block reward will be halved again. We will have to work towards ensuring that the miners are compensated enough via fees during the next halving to ensure that they continue to act fairly and benevolently.

In addition, the limited block size and rising adoption will likely result in users willing to pay higher fees making it more expensive and difficult to use Bitcoin for unwilling users and services that rely on low fees.

On the other hand, there are also a few things on that horizon that are likely to have a positive effect on fees.

  • An enhancement to the Bitcoin protocol called Segregated Witness will hopefully be activated this year. Activating Segregated Witness will result in 50 to 100 percent more transactions fitting in a block.
  • An increase in block size will also lead to less pressure on the market for fees – however, such a change to Bitcoin is not yet planned.
  • The Lightning Network is a layer on top of Bitcoin that allows Bitcoin to potentially scale many orders of magnitude without changing the block size itself and with the same trustless security as regular transactions. Transactions then go over the Lightning Network, instead of directly on the Bitcoin blockchain. This makes lightning transactions cheaper and non-lightning transactions rarer and more expensive. Non-lightning transactions then serve as settlement once in a while.

Many still hope and work on a simple enlargement of the blocks and it is not unlikely that this will happen in the future. An enlargement of the blocks will initially relieve the pressure on transaction fees, but with time the limit will be reached again and the fees will come under pressure again.

This article was previously posted on blog.btc.com – courtesy of Thomas Kerin.

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