Economics of Bitcoin (1): How bitcoin transaction fee is priced

Writer: James K Lee

Right now, bitcoin’s transaction fee and its pricing is somewhat overlooked. However, as block producers of Bitcoin start receiving fewer rewards, miners would have to rely mostly on transaction fees for reward. To understand and analyze long-term outlook of bitcoin, one has to understand how bitcoin mining ecosystems work, and how its economic incentive structure works.

For start, it is essential to learn how bitcoin transactions are made. Bitcoin transactions take following steps. First, a bitcoin holder determines how much bitcoin to send to which address, with how much to spend as a transaction fee. The holder signs this transaction with his/her unique, secure digital signature and announce this transaction to the bitcoin network.

The miners are working and competing through proof-of-work (PoW), and be the first one to create the next block. Each block is created every ten minutes, and around 2,000 transactions are written on each block. This is due to size limitation(1MB) of the block. The miners naturally seek to maximize their profits and likely to choose the transactions with largest fees offered per length of the transaction ledger. Miners who are successful in creating the next block will be awarded with block rewards (currently 12.5 BTC) along with collection of transaction fees offered.

This is how bitcoin transaction is made. It appears simple, trustless system, but it also has many limitations. The largest of which is TPS (transactions per second). The limitations on block size and period of new block creation puts strain on number of transactions. This problem caused bitcoin to fork into bitcoin and bitcoin cash.

Everything in the market finds its price through supply and demand. Bitcoin transaction fees are also determined by supply and demand. Demand is a demand for transferring bitcoin to other accounts, and supply is the limited TPS. If one to graph its supply and demand, supply will be completely inelastic. In such a market, the price is relatively minimal below certain demand. If a demand increases past a certain point, the price skyrockets. This is similar to controlled economy of the communist system, where people resorted to black markets (alternative market), or waiting longer in line(time) to purchase.

(Graph: Supply and demand curve for bitcoin transaction fees)

Similarly, if bitcoin transaction demand passes a certain point, the users would have to pay by waiting longer in transaction queue. In the late 2017, at the height of the bitcoin frenzy, this problem emerged. The bottleneck on limited TPS created explosions in transaction queue, and transaction fees jumped tens of times. This bottleneck happened right past 2,000 transactions per block. Bitcoin price did affect the spike in transaction fees, but the low TPS was the main driver of the transaction fee hike.

In late 2017, bitcoin transaction fee, bitcoin price, and transaction queue all spiked. At a glance, bitcoin price is the determinant of the transaction fees, but the size of the transaction queue is more strongly correlated. Bitcoin price and transaction fees have a correlation of 0.64 while the size of the transaction queue have a correlation of 0.70. This is due to previously explained demand-supply relationship explained on the graph above.

(Chart: Bitcoin average transactions per block, Bitcoin median transaction fees, Bitcoin Mempool Transaction Count(Transaction waiting queue), from www.blockchain.io )

Paradoxically, Bitcoin transaction fees are therefore fees on the inconvenience. Slower the bitcoin network, larger transaction fees will result. Even if scalability problem is tackled through increasing block size/decreasing block creation time, the transaction fees will not be moving much until a bottleneck happens. This phenomenon, in conjunction with decreasing block rewards, creates a security threat. (continued)

Disclaimer:

This report originates from and solely prepared by “Fair Square Lab”, and “Skytale investment”

The views and opinions expressed in this report may differ from the company’s opinion.