Bitcoin Transactions Are Slow and Costly. Let’s Explain Why.
Can Bitcoin truly replace cash if every transaction on the network is slow and costly?
Intro
Bitcoin has been in the news a lot lately — and for a lot of reasons. While many don’t believe there’s anything more to the Bitcoin craze than a bubble, Bitcoin is getting adopted by more and more institutions every day, leaving many others to wonder if Bitcoin can exist among, or even replace, fiat currencies as a legitimate means of transaction at scale.
On the surface, or at least in the mainstream news, Bitcoin sounds and looks like the future of transacting. Because it’s so new and digital, people may attach labels like efficient, fast and low cost to the concept. In fact, many initially touted Bitcoin as a superior currency due to it’s low, or even zero fee model. And while many other cryptocurrencies can truly live up to the hype of being fast and efficient , Bitcoin (BTC not BCH) does not — at least not today.
In this article I will explain why Bitcoin transactions can take much longer and cost much more than traditionally accepted means of transactions. The key to understanding how bitcoin fees and transaction times work is by understanding how the entire bitcoin network works to process transactions in blocks.
How Bitcoin Works
I wrote about the environmental effects of Bitcoin mining and transacting in this article. In a section of the article, I try my best to explain how the blockchain at a high level. For everyone who’s too lazy to follow my link to the article, I’m going to literally copy and paste the section here. Because I can. It saves me time.
Blockchain is the core protocol that helps cryptocurrencies operate and ensures that bitcoin, and other cryptocurrency transactions, can be trusted without being verified by any centralized governing body. Decentralization itself is one of the key advantages of cryptocurrencies over traditional currencies.
So how does the blockchain protocol ensure that transactions aren’t fraudulent? Each transaction on the bitcoin network is validated by a network of “miners”. In simple terms, miners use computers to crack complex mathematical problems that verify the transactions on the network. But not everyone who verifies these transactions get rewarded. Only the first miner who successfully “cracks a puzzle” to verify a “block” or group of transactions gets rewarded. Bitcoin mining is basically a competition to process transactions on the network and you earn bitcoins by contributing computing power to this competition. The more computing power you have, the better your chances to succeed in winning this race.
So the whole point of mining is to process blocks and add them to the blockchain so that you get rewarded in bitcoin for doing so. If someone is mining bitcoin, they are essentially verifying bitcoin transactions using powerful hardware for a fee.
So what can we take from this? Two things:
Miners Compete to Be the First to Solve and Verify the Next Block of Transactions
The amount of blocks that can be added in a given time is limited by the average time it takes to solve a single puzzle. The average time it takes to solve one of these puzzles is also called the “block time”, which takes on average, 10-minutes. There’s also a limit to the amount of transactions per block. Without getting into the gritty details about this limit, called the “block size”, its enough to know that these two limits determine the maximum rate of Bitcoin transactions which is approximately 7 transactions per second. To put this number in perspective, Visa allows a rate of 2000 transactions per second.
Miners Get Rewarded for Verifying Transactions
One way they get rewarded is by the block reward. With the block reward, a miner is rewarded with 12.5 bitcoins for every correctly verified block. The block reward started at 50 bitcoins per block in 2009 and is halved every 210.000 blocks. When the number of available bitcoins reaches 21 million — the limit programmed into the system — no more bitcoins will be created. But this isn’t the only way miners get rewarded.
Let me introduce: the Bitcoin transaction fee.
Bitcoin Transaction Fee
The other way that bitcoin miners are incentivized to verify transactions comes from the fees that they receive for verifying any transaction. These fees can be added to a transaction by a user when sending funds, or they can be received by a miner when confirming transactions on their node. In theory, transaction fees are voluntary fees that a sender attaches to each transaction to compensate a miner for verifying their transaction. Thus, in theory, you can bid 0 fees for your transaction if you choose to. And while this is the case if block space exceeds bids, in practice, fees have become an important consideration for the usability and convenience of bitcoin. This is for two reasons:
- Given that the Bitcoin network only allows, on average, 7 transactions per second, demand for bitcoins can greatly outpace the block space. Thus, miners have considerable discretion on what fees to accept on a particular transaction. Miners are incentivized to include any transaction with a fee greater than zero, with a preference for filling the block with the highest bids. The more congested the network becomes, the more people will be willing to pay to incentivize miners to add their transaction to the next block, thus pushing up the market price for transaction fees.
- Miners must be compensated more than the cost to add blocks to the chain in order to maintain their infrastructure and to incentivize them to keep mining. These costs include the costs of electricity to run the mining hardware, the cost of bandwidth and as well as the cost of maintaining a competitive hash rate. The externalized cost of these transactions has been estimated to be about $10. Currently, bitcoin miners are largely incentivized to verify transactions due to the large payout of the block reward. This reward is more than enough to cover the cost of mining bitcoin. However, once all the bitcoins have been mined, the only incentive to add new blocks to the chain will come from transaction fees. Thus, transaction fees alone will have to cover this externalized cost of verifying transactions.
What Does This All Mean In Practice?
Slow Transactions
Given the relatively limited amount of transactions that can be processed in a second, the network can quickly get congested under certain conditions, such as when currency enjoys a spike in popularity and more investors start demanding Bitcoin. In times like these, Bitcoin transactions can take up to days, or even sit unfulfilled forever if the sender doesn’t attach a high enough transaction fee. This is the case for all transactions, regardless of the size. Just imagine having to wait days just to send $20 to your friend. This makes Bitcoin much less feasible as a fiat currency alternative, and it affects the user experience on Bitcoin-based businesses.
High Fees
With enough congestion on the network, fees can rise high enough to make a transaction uneconomical. To illustrate how bad this can get, we can take a look at how high transaction fees got in the crypto boom of 2017. Average Bitcoin transaction fees spiked to nearly 60 USD. As of April 15th, 2020, the average Bitcoin transaction fee sits at 21 USD which is still an order of magnitude higher than traditional payment methods.
High Fee Volatility
It is quite common to see the Bitcoin transaction fee fluctuating as much as ~10% within the same day. This makes it highly unviable for merchants to accept Bitcoin as a payment method and adds significant volatility to their business.
What’s the Solution?
Now before I start listing off potential “solutions” and changes to be made to the Bitcoin protocol, I will say this. Some people don’t think any of this is a problem at all. This problem doesn’t exist in the minds of proponents for Bitcoin as a long term store of value. These proponents compare the utility of Bitcoin to that of gold. In this scenario, Bitcoin doesn’t need to live up the expectations of being fast and efficient.
Many others, however, hope that one day Bitcoin can replace cash as a medium of exchange. The case to be made is that the usefulness of Bitcoin is inextricably linked to the expectation that transaction fees will eventually be low enough for all users. The problem for these users: Bitcoin (BTC) cannot live up to these expectations. So what are the options?
Bitcoin Cash
Bitcoin Cash (BCH) is a hard fork of Bitcoin designed to solve some of the abovementioned issues with Bitcoin. It is essentially a spin-off of Bitcoin created in 2017. In the Bitcoin cash protocol, the block size limit has been increased from 1MB to 8MB, which allows for more transactions to be processed per block.
Lightning Network
The Lightning Network is a protocol that operates on top of bitcoin. You can think of the lightning network as a second layer of payment infrastructure for bitcoin. It is primarily designed to solve the issues discussed above in the section on “Slow Transactions” and “High Fees”. As a direct result of the block size limits, many transactions can be processed off chain without having to rely on miners. However, some argue that this defeats the purpose of the blockchain which allows for decentralized and trust-less transactions with no third party authority. The Lightning Network essentially acts as a third-party authority which verifies and processes transactions off chain.
Faster Consensus Mechanisms
Faster, more efficient consensus algorithms like the proof-of-stake protocol forgoes the need for “miners”. Instead, a random pool of “validator nodes” are selected at the beginning of each block to process and verify transactions. This allows for much faster transaction processing, and in theory, much lower transaction fees. I’m going to plug my article about it again here. I go more in-depth about how it works and how it can much better for the environment than Bitcoin’s proof-of-work protocol. The Flow blockchain, the blockchain that powers popular DApps like NBA Top Shot uses proof-of-stake and can in-turn process up to 1000 transactions per second and is expected to upgrade to 10,000 transactions per second. Ethereum 2.0 is also expected to adopt this protocol.
There’s many more potential solutions to Bitcoin’s limitations, more so than can be discussed in a single post. The purpose of this article however, is to bring people’s attention to these inherent limitations. Many people speak highly of Bitcoin’s potential to be the future medium of exchange but don’t actually take into consideration those limitations. While alternative solutions like Bitcoin Cash exist, these aren’t the currencies receiving the attention and investment that Bitcoin receives.
