Blockchain transaction fees: why are they important?
In 1998, the Chinese engineer Wei Dai first introduced the concept of ” cryptocurrency “. Unlike conventional currencies, digital currency only exists online. Users can trade cryptocurrencies online after purchasing tokens using “real” currencies, i.e. traditional or fiat. Cryptocurrency removes the need for a central controlling authority, such as a financial institution or government office, and instead creates a fast, easy, and efficient way for people around the world to exchange money.
About a decade after the idea of cryptocurrency was first outlined, an innovator using the pseudonym “Satoshi Nakamoto” revealed the concept behind Bitcoin . Today, Bitcoin (or BTC) is one of the most popular forms of cryptocurrencies. Although Bitcoin eliminated the need for a central authority, it did not eliminate the costs associated with the technology that underpins cryptocurrencies. Knowing how this technology works can help you better understand transaction fees and minimize transaction costs when using cryptocurrencies.
Blockchains, databases and Bitcoin
All verified Bitcoin transactions are stored via a blockchain , a type of database that stores data electronically. The main difference is that databases use tables to structure their data, while blockchains store data in blocks. When a block is filled, it is added, time-stamped and “chained” with the previous one. This creates a record with easily accessible data and an immutable timeline.
Like databases, blockchains require multiple computers to manage and store data. However, databases use servers, which are often owned by a specific person or entity, while blockchains store data on multiple computers owned by many people or entities.
The Bitcoin network includes thousands of computers called nodes, which work together to verify transactions, fill blocks, and keep the system running.
The blockchain trilemma
For a blockchain to function optimally, it must be secure, decentralized, and scalable. The blockchain trilemma, a concept introduced by programmer (and Ethereum founder) Vitalik Buterin , refers to the idea that blockchain projects strive to fulfill all three ideals.
Blockchain developers are using the trilemma concept to refine networks and create tools for optimal functionality.
Blockchains are designed to be democratic and immutable. The security of blockchains is maintained through encryption, as well as consensus algorithms that dictate the number of network nodes needed to confirm transactions before completion. Furthermore, as blockchains are made up of a series of blocks that record data in time-stamped hash functions, they have proven resistant against data tampering and hacking.
One of the tasks of the central institutions is to avoid double spending and the like. However, they are vulnerable to DDoS attacks and other security issues. The idea of a decentralized blockchain network is understood as an environment where no one needs to know anyone, as each node reflects the same information in a distributed ledger.
Decentralized systems, such as Bitcoin, are essentially invulnerable to these problems, and algorithms or consensus mechanisms provide greater system security while preventing double spending and reinforcing peer equality. If someone attempts to tamper with or corrupt the ledger, a majority of network participants must reach a consensus to do so.
During peak usage periods, bottlenecks can occur, slowing transaction processing and increasing costs for users. A scalable blockchain is essential to maintain a competitive advantage with centralized networks.
To overcome and address the blockchain trilemma, some developers recommend direct modifications to the network: first layer solutions, such as Ethereum. Others have suggested the development of secondary networks, or second layer solutions , designed to work alongside the blockchain, such as the Lightning Network on Bitcoin or Litecoin. It is 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 the early days of Bitcoin, miners worked quickly to validate transactions. As digital currencies have grown in popularity, transactions have become more numerous and more complicated. Bitcoin transaction fees were introduced to speed up the validation of Bitcoin transactions.
Fees are linked to the size of the transaction and the age of the input. In other words, a transaction that comprises more bytes that take up more block data will have higher transaction fees. The additional fees can speed up the transaction through the system by essentially placing you in a priority queue. In other words, you can pay more to have transactions validated faster.
The fees collected go to the miners, who validate and record Bitcoin transactions and help keep the system smooth and functional, as they accomplish the following:
- Support transaction processing
- Pay miners who validate transactions
- Eliminate spam transactions
In other words, Bitcoin transaction fees protect and preserve the integrity of the Bitcoin network.
How Bitcoin transaction fees work
Conceptually, Bitcoin transaction fees represent the speed with which a user wants their transaction to be validated on the blockchain. The decentralized nature of Bitcoin means that anyone can participate as a miner , which means verifying and recording the transactions that make up a block and join it on a chain. However, the process of mining Bitcoin, or BTC, is complex and expensive. Mining rigs are expensive and often consume large amounts of electricity, while block subsidy and transaction fees help offset these costs and incentivize miners each time a new block is validated.
Miners receive transaction fees and block grants as a “block reward” every time they successfully add a block to the blockchain. The block subsidy is fixed with each Bitcoin mining and halved ( Bitcoin halving ), which will occur every four years or every 210,000 blocks. If we go back to 2009, a Bitcoin mined was 50 BTC and, in 2012 and over the years, the rewards were halved, and the last halving in 2020 set the rewards at 6.25 BTC.
Halving events cause the hashrate to decrease, which increases the computing power and energy needed to mine new blocks. However, increased transaction fees help incentivize miners to maintain the security and integrity of the network. Transaction fees are determined based on a few factors:
- How congested the cryptocurrency network is currently;
- the amount of data contained in the particular Bitcoin transaction;
- the priority of the transaction.
The last point is under the control of the user. If you need your Bitcoin transaction processed urgently, you can choose to pay a higher fee to give it priority. If your transaction is less urgent, you can opt for lower fees. In this case, the transaction will remain in the memory pool (or mempool) until the traffic decreases.
The mempool can be thought of as a queue. When a transaction starts, it goes into the mempool. Waiting transactions remain in the mempool until a miner validates them and adds them to the block. When the mempool fills up, miners choose Bitcoin transactions with the highest fees first.
This system can make transactions more fluid, but it can also lead to a kind of price war. Many people who use cryptocurrencies are willing to pay a premium to ensure that their transactions are completed first. However, this tactic can backfire, especially during periods of heavy use. Some users end up overpaying fees, forcing other miners to increase their fees as well.
Transaction Fees: Bitcoin vs. Ethereum
The biggest names in cryptocurrencies 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 price war or stalling unnecessarily. in the memory pool.
How to Calculate Bitcoin Transaction Fees
To calculate Bitcoin fees, you have a few options. With some wallets, you can automate the process, allowing you to choose how quickly you want the transaction to complete and pay accordingly.
First, check the current rates and then multiply based on the size of your transaction. Bitcoin is divided into Satoshis, which are one hundredth of a million (or 0.00000001) of BTC. If your transaction is 225 bytes and you choose the 100 Satoshis per byte fee, you can pay about 22,500 Satoshis in fees, since 100 x 225 = 22,500. That currently translates to just over $14, considering that 1 Satoshi is $0.00056666 or $0.00000001 BTC as of October 11.
How to calculate transaction fees on Ethereum
Until 2021, everything on the Ethereum network was based on “gas”. Gas is the unit linked to the amount of computing power needed to complete a specific transaction. Precisely, gas refers to the energy used to keep the Ethereum network moving.
With this payment system, everything has been associated with gas. A simple addition may require only 5 units of gas, while completing an actual transaction may cost 20,000. To determine transaction fees, a user would need to know the price of gas, which is measured in gwei , or the equivalent of 0.000000001 (one in a billion) ETH.
To calculate it, you will need to multiply the cost of gas by the price of gas. For example, you may have a transaction that will cost 20,000 units of gas, 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 over $7, assuming 1 gwei equals $0.00000359.
Users can set a ” gas limit “, which refers to the spending limit, or the amount of gas they want to use for a specific transaction. Complex transactions require more work, so your gas limits would necessarily be higher than for simpler transactions.
However, this system turned out to be cumbersome and many users underpaid, which could lead to their transaction being declined or the need to overpay. (Think of this as putting too many stamps on an envelope you want to mail, rather than risk the letter being returned for insufficient postage.) The EIP-1559 update changed the way users pay for transactions. Instead, ETH users pay a base fee for specific transactions. A portion of each fee collected is “burned”, which removes coins from circulation, and the rest goes to the miners. ETH users also have the option to “tip” miners, which can speed up the processing and recording of your transactions.
Average transaction fees
Transaction fees are a necessary cost of conducting financial transactions in the 21st century, and cryptocurrency transactions are no exception. Both Bitcoin and Ethereum link the cost of the transaction to its size, and users can pay more to speed up the process. Average Bitcoin transaction fees fluctuate from day to day, depending on the amount of traffic and other factors. The same goes for the Ethereum network.
Currently, average Bitcoin fees range from $2 to $5, which translates to between 3,700 and 9,170 Satoshis. The average ETH transaction fee is between $2 and $7, that is, between 0.00056 and 0.002 ETH.
Average transactions per day
The BTC and ETH networks are growing, with countless transactions being completed and verified every day. On the Bitcoin network, there are between 200,000 and 300,000 transactions per day. Ethereum, for its part, makes more than a million transactions a day.
Completing transactions on a low-traffic day can lower your transaction rate without forcing you to compromise on verification speed.
High Bitcoin transaction fees are attractive to miners, but might not be as popular with users. The fee structure may be such that some users are paying the equivalent of their transaction amount in fees, especially for small transactions.
Transaction fees are not the only issue plaguing Bitcoin. Scalability is also proving to be something of an Achilles’ heel. The Bitcoin protocol clearly defines the size and generation of blocks, which restricts Bitcoin to about seven transactions per second, or TPS. This caused Bitcoin to branch out into other forks, such as Bitcoin Gold (BTG) and Bitcoin Cash (BCH). Ethereum on the other hand has larger blockchains and can process around 20 TPS and ETH 2.0 is paving the way for a more scalable solution.
To change the Bitcoin protocol, its users must agree and choose a specific software. The Lightning Network offers an alternative that is designed as a second-layer payment protocol, meaning that it overlays the blockchain. With the Lightning Network, you can complete numerous transactions before closing the payment channel and settling the final transaction on the blockchain.
The Lightning Network is an off-chain solution that sits on top of a blockchain not exclusively on the Bitcoin network. Mainly, it helps to process blockchain payments quickly and securely without potentially long block confirmation times. It even allows users to complete cross-chain atomic swaps instantly without relying on third parties.
One of the highlights of the Lightning Network is its ability to allow small payments, even less than one Satoshi. The process is more private, allowing multiple individual transactions to occur without being broadcast through the blockchain. As its name suggests, the Lightning Network is also fast, with virtually no TPS limits. Settlement times are equally fast, with the average transaction settling in a minute or less. Also, the rates are lower.
For those looking for privacy, speed, and affordability, the Lightning Network offers a great alternative.
A more scalable consensus mechanism
A consensus mechanism or algorithm refers to a specific protocol designed to ensure that computer networks can work together efficiently, thereby maintaining security. The algorithm is often used to ensure that the cryptocurrency network can function effectively and prevent certain types of system attacks.
If Bitcoin’s main weakness is its scalability, a more scalable consensus mechanism could help reduce costs. Bitcoin currently operates 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 and the data is entered into the blockchain.
The proof of stake (PoS) protocol is more scalable and sustainable than PoW. PoS links mining power to staking participation. Miners do not need to expend energy to solve mathematical problems, but are limited to mining a specific number of transactions linked to their participation in staking. A miner with a one percent stake could then 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 a network’s digital currencies to launch an attack on the system, which would be detrimental to his or her interests.
Ultimately, a PoS system is more scalable, energy efficient and secure than PoW systems.
Line up and wait for less traffic
Just as a traffic jam causes congestion, more transactions waiting on a network leads to slower flow and higher fees. Because of this, rates tend to increase at peak usage times.
If your Bitcoin transaction is not urgent, you can “stand in line” and wait for a spot, just as you can choose to leave a little later in the day to avoid rush hour traffic. The blockchain tends to have predictable highs and lows, due to companies completing larger transactions. Waiting until the weekend to complete yours could mean less traffic, faster settlement transactions, and smaller fees. That is one of the advantages of markets that never close.
Although custom fees are possible, miners prioritize and process transactions based on several factors, including the amount of fees. Your larger transactions may take a bit longer to complete, but they will be added to the blockchain, usually when traffic slows down.
Higher or lower fees can significantly reduce your profits and affect your capital gains and losses. Although these fees are a necessary part of digital asset transactions, you can take steps to lower your overall costs and reduce the risk of overpaying, either by opting for an alternative system for smaller transactions, such as the Lightning Network, or waiting until the ideal time to process your transactions. Researching your options and finding the one that best suits your needs can help you save on both your transaction prices and the cost of doing business.
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