The Anatomy of a Bitcoin Transaction and Fee Mania
The 5th halving epoch has officially arrived!
This edition will cover some key basics of transacting on the Bitcoin network as well as the ludicrous transaction bids post halving.
Read on to get the rundown of how this will impact the activity of holders and miners alike.
Bitcoin Transaction Overview
A Bitcoin transaction involves a sender and a receiver. The sender will need a public address containing funds and a private key to access and move the funds. The receiver will need a public address to receive funds.
A seed phrase is where it all starts (and why it’s called “seed” phrase). A seed phrase can be generated independently (i.e. rolling dice or some other randomized process) or via a wallet.
A seed phrase (also know as the backup or recovery phrase) is technically a 128-256 bit master private key that is commonly represented in 12 to 24 words sourced from the Bitcoin Improvement Proposal(BIP) 39 list.
When a wallet generates a seed phrase, it can create 2²⁵⁶ number of private/public keys pairs.
Most wallet applications will not show the user this. That is one of the nice things about Sparrow wallet as it lets you see all your addresses.
There are a couple benefits to this:
- Simplifies backup, as users only need to secure their BIP39 recovery seed to ensure access to all their keys.
- Enhances privacy by allowing users to generate new addresses for every transaction, making tracking more difficult.
- The structure allows users to organize their funds across different accounts in a structured manner i.e. labeling (kyc vs non-kyc).
To send bitcoin you of course first need to have bitcoin.
Most wallet applications will show your bitcoins as an account balance, but underneath the hood, it actually works somewhat different.
Instead of Bitcoin operating like a digital bank account, where transactions are added or subtracted from your total balance, it behaves more like cash in your wallet.
Here is a quick example:
Any amount of bitcoin is a UTXO.
UTXO is the fancy acronym for Unspent TX(transaction) Output.
If you buy a $75 steak with $100 bill, you likely receive $20 and $5 UTXOs in change.
The $100 bill is the spent tx input, and the $20 and $5 bills are the unspent tx outputs.
Bitcoin functions in a similar manner, except the spent input gets destroyed and recreated as unspent outputs at the receiving address.
Again, most wallet applications will not show you the status of your UTXOs but a combination of them all so it appears like an account balance.
Sparrow is a wallet that does show UTXOs:
Now that we’ve briefed the components of a wallet, let’s look into how a transaction goes from creation to confirmation.
- A transaction is created from UTXOs in Bob’s wallet. Bob uses his 1 btc and 0.5 btc UTXOs to pay Sally and cover the TX fee.
This input-output would look something like this:
2. Bob signs the transaction data and broadcasts to the network.
The transaction data gets compared to the records on nodes (a node is a copy of the entire history of bitcoin blocks; this is how it knows if a transaction is fraudulent). If the transaction looks good, it gets added to the mempool (basket of transactions waiting to be confirmed).
3. Miner finds block and adds aggregated transactions to the official chain.
4. After the block containing Bob and Sally’s bitcoin transaction gets added to the chain, they will both see the bitcoin has arrived in their wallet with 1 confirmation. A confirmation is a successful block added that verifies the transaction.
Considering each block takes roughly 10min, a transaction will be 100% complete and verified after 6 blocks (60min).
You can give yourself a pat on the back, because you now understand the fundamentals of a bitcoin transaction.
Note that this example assumed Bob and Sally’s transaction would get included in the next block, when in reality that may not always be the case.
This is because miners choose the best fees offered and there is only so much space in a block. If other transactions offer a higher fee, the miners will handle those with higher priority.
Transaction Fees
Each transaction includes a fee, which is paid to the miner as a tip to incentivize them to include your transaction in the next block.
When there is a demand to move bitcoin on-chain, this leads to a competition of who can motivate miners the most.
The higher the fee a miner can earn from including a transaction, the more likely they are to add it to the next block.
This trends transaction fees higher for those moving coins on-chain as demand and the price of bitcoin increases.
Fees typically rise in tandem with the USD price of Bitcoin
This creates continual incentive for miners, as this is a revenue increase.
Hashprice is a metric revealing how much a miner can earn per unit of work(hash). As you can see, miners had a heyday over the halving.
While transaction fees are bread and butter for miners, they may present a future hindrance to network users.
Remember that 1 bitcoin = 100,000,000 satoshis.
Referring back to this image:
Sat/vB (satoshis per virtual byte) measures how much blockspace a transaction will eat up, and the level of priority a transaction will have.
1 block is limited to 1 megabyte of transaction data (1,000,000 bytes).
So if your transaction takes up 1000 byes of data, and you are in a rush to get included in the next block, then you would pay 576 sats * 1000 bytes.
(according to the image above).
That’s 576,000 sats, 0.00567 btc, $368.
So as you can see, a major contributor to the transaction fee is how much data is being sent and the current demand for block space.
What makes a transaction take up more bytes?
A common misconception is that transaction fees are a percentage of the amount sent, like the traditional financial system.
But on the Bitcoin network it could be cheaper to send $1,000,000 of btc than $50 of btc.
Here’s why:
The bytes of a transaction are determined by the type of bitcoin address used, amount of inputs(UTXOs), and witness data. Witness data is everything in the block that is not specifically transactions (Signatures, Inscriptions, etc.), and why you see block size over 1MB.
This is why it is important to not have many small UTXOs. If the fee to move a UTXO is higher than the UTXO itself, it effectively becomes un-spendable or “stranded”.
The halving was a perfect example of this.
Low priority was 962 sat/vB. Anything below that bid is not getting moved by the miners.
Transaction fees are as free market as it gets. You see a similar situation with paid parking, express theme park lines, toll roads, express shipping, VIP access events, etc.
What does this mean for holders of bitcoin UTXOs?
Consolidate UTXOs
This means combining small UTXOs that may potentially become un-spendable in the future into larger UTXOs that are more immune to high fees.
Sparrow wallet makes it very easy to do this.
All it takes is selecting all the UTXOs that you want to combine, and sending them to your own address (preferably when fees are low).
This is a good practice to ensure your bitcoin UTXOs do not become stranded during high fee environments.
It is difficult to confidently predict where transaction fees will go in the future.
Yet, as Bitcoin adoption increases and its technology provides more value to application builders, a greater demand for blockspace is inevitable.
And when blockspace is a hot commodity, transaction fee bids go higher.
That’s it! Higher fees are a blessing to miners and a consolidation warning to hodlers.
If you are currently mining with us at Simple Mining and interested in selling your older generation ASICs or upgrading to more efficient miners, please reach out to sales@simplemining.io for more information.
