Public blockchain fee cyclicality and negative feedback loops

Invented in 1788 by James Watt, the centrifugal governor is a small, clever device that made steam engines viable in an industrial context. Effectively it takes rotational input from a steam engine and applies it to weighted balls. As they spin, the centrifugal force pushes them upwards, moving a lever connected to a valve. As they spin faster, the valve closes. In this manner the governor takes input from a steam engine and mechanically regulates the flow of steam and hence the speed of the engine.

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The Curious Case of the Cyclical Fees

As the dust cleared on the mania of 2017, I noticed that Bitcoin fees and transaction count appeared to be following a repeating pattern. Blocks would fill up, fees would spike, transactions would start to drop, and then blocks would start to fill up again. By my count, this cycle repeated itself six times in 2017.

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Chart available at Coin Metrics
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Ethereum’s 2020 ‘Fee Crisis’

This year, when Ethereum fees started to creep up and then exceed those on Bitcoin, I wondered to myself whether Ethereum would see a reprise of Bitcoin’s fee-tx count dynamics. I puzzled over whether it would have the same effect, or be more disruptive to Ethereum, since so much liquidity is “on-chain” (as opposed to primarily off chain at exchanges). I figured we’d see the same thing, with a less dramatic oscillation, since the supply of Ethereum blockspace is somewhat dynamic and can increase in response to surging usage. As it turned out, fees would end up being more disruptive than I had expected.

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Chart available at Coin Metrics
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Chart available at Coin Metrics
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Chart available at Coin Metrics
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Do High Fees Affect Liquidity?

So, we’ve established that there is a clear negative feedback loop between fees and utilization of blockchain resources, both in Bitcoin and in Ethereum. In Bitcoin we know that the cycle historically takes two months to complete; we haven’t yet seen what it will look like in Ethereum. Moreover, it’s clear that transactors have a threshold in mind for the highest tolerable fees relative to the size of the transactions they are making, and that smaller transactors defer their transactions during periods of high fees. This causes average transaction sizes for both ETH and other tokens to creep up during high fee epochs.

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Future Prospects for Ethereum Fees

We haven’t seen the full fee-chain resources cycle play out yet on Ethereum, so it’s hard to gauge the cycle length. But in the spirit of making concrete predictions I will forecast the following: I expect that we will see ongoing, positively correlated oscillations on Ethereum between fees, transactions, and crucially the liquidity and volumes of on-chain exchanges. I imagine it will look something like this:

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Dynamic blockspace supply

Unlike Bitcoin, which has only formally increased the blocksize cap once in its existence, Ethereum is more amenable to producing more blockspace if necessary, although the rate of increase is constrained. Elastic blockspace could in theory be employed to stabilize fees, but this comes at the cost of increased validation requirements, which are already fairly high for Ethereum. As Ethereum utilization has increased, miners have rewarded transactors with ever-more computational capacity.

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ETH 2.0/Sharding

When I first wrote about the prospects for Ethereum fees, Vitalik’s response to my article (in which I claimed that Ethereum would likely be saddled with high fees for an extended period, and this would affect the viability of nonfinancial applications), Vitalik clarified his stance on fees:

Rollups

The current orthodoxy in Ethereum holds that Rollups are the main path to alleviating Ethereum’s current fee woes. Rollups come in two major types — ZK and Optimistic, but they both generally involve bundling many payments together and vastly increasing the economic density of transactions, in theory preserving the assurances of base-layer transactions while massively increasing TPS. In short, transactors rely on relayers who assemble large batches of transactions and broadcast digests of these transactions.

Conclusion

The difference between a centrifugal governor and on-chain fees is that the regulating effect of fees is more of a side effect of a properly functioning system rather than a key design consideration. In public blockchains, fees exist to ensure non-frivolous consumption of network resources and to provide validators with revenue. They’re not strictly intended to put a check on the usage of the system. In practice, however, they do, and this brake tends to be a sharp rather than a gradual one.

Partner, Castle Island Ventures. Cofounder, Coinmetrics.io

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