The main difference between a product and a service is that products are only paid for once while services demand periodic payments. Whether they be subscriptions, monthly bills, or fees, all require recurring payments.
On a fundamental level, blockchain networks are nothing more than services. They provide the opportunity to transfer money in a secure, anonymous, and decentralized way. Being decentralized, which means that no one truly controls them, blockchains have to be supported in one way or another.
A blockchain network like Bitcoin is not a magical box on the internet that takes and then distributes money on its own. Blockchains are merely the infrastructure that enables users to facilitate such actions.
A great analogy would be: if roads are blockchain networks, then cars are the users creating transactions.
But who maintains the road? This is the question that will help us answer what transaction fees are and why they are necessary.
Transaction fees are the fees that we pay for when issuing a blockchain transaction or sending a crypto payment. Any action that includes some form of wealth transfer charges fees. Examples include depositing, withdrawing, and sending cryptocurrencies.
Blockchain fees are generally considerably smaller compared to fees charged by traditional financial services like banks. However, they are prone to increasing numerous times their average size in the event of network congestion.
Network congestion occurs when the level of demand for transactions is higher than the level of available network power. If a wave of new crypto users joins the market and there is not a significant shift in miners, blockchains will experience congestion, and fees will increase.
For the past few years, fees on the Bitcoin network have averaged between one to six dollars. During the ongoing bull market, fees went as high as $62 but have averaged between $12 to $20 most of the time.
Blockchains are decentralized, and no one truly owns them, so where does our money go to and why? The answer is simpler than you think.
The first purpose of transaction fees is to financially incentivize miners to confirm transactions. Without fees, miners would have to do their ‘job’ for free, or they would not issue any confirmations in the first place. Naturally, the second option is far likely.
Most blockchains use the Proof of Work consensus model, which requires competitive computing power and electricity. Since electric bills can go high when mining farms consume thousands of watts, the network must reward users who verify transactions. Therefore, the fees that we pay go towards verifiers.
Security is the second purpose of transaction fees. Without fees, malicious users can spam blockchain networks with worthless transactions and thus prevent them from functioning normally. Any rival project or interest group would be incentivized to do so if given a chance. By charging fees, blockchains prevent spam attacks, at least to the degree of them being more expensive to conduct.
Therefore, if fees are distributed to verifiers for blockchains to work in the first place, their other reason for implementation is to keep decentralized networks healthy and normal.
Fees do not function in the same way, nor are they calculated the same on all blockchains. For example, the leading smart contract ecosystem Ethereum named its fees ‘gas,’ and they have another entire layer of utility. Nevertheless, most projects use the same fee structure set in stone by Bitcoin.
As previously mentioned, Bitcoin works on the basis of Proof of Work which means that transaction fees are needed to:
It is important to note that different transactions have different fees. Transactions with higher fees have better rewards, so they are prioritized by miners. Inversely, transactions with poor rewards are left last or are even ignored in some cases.
Transaction fees depend on one factor: transaction size.
A transaction worth $1,000 is larger in size compared to a transaction worth $1. If Bob sends a 900-byte transaction and the average fee costs 120 satoshi per byte, he then has to pay 108,000 satoshis.
Note that transaction blocks have a block size limit of 1MB, which means that they can only include so many transactions. If Bitcoin experiences network congestion, likely as a result of increased market demand, transaction fees will surge in value.
Changing block sizes was the first idea thought of by blockchain developers but it soon fell apart after the community could not reach a consensus (which eventually resulted in hard forks like Bitcoin Cash and Bitcoin Satoshi Vision). The existing scalability feature for Bitcoin is the Lightning Network, which is gaining popularity among miners and users alike.
Transaction fees are not paid without a strong reason. They represent a core feature of blockchain networks. As we have learned, decentralized platforms would not work at all if it were not for fees.
The only problem with fees is that they reach absurd amounts during network congestion. To eliminate this issue, we have to solve scalability first, and truth be told, we are far from scaling at current levels of demand.
For Bitcoin, the major solution is the Lightning Network. For Ethereum, the most accepted solution is the switch to a Proof of Stake consensus mechanism. Both will likely finalize and reach peak development in the near future. Until then, users are forced to pay enormous fees during bull markets.