Lower transaction fees and times are among the factors helping digital assets gain an edge over traditional finance while growing traction among consumers. But how are those fees determined?
The switch to cryptos as a means of sending funds within and across borders has been on the rise. Traditional banking systems are losing customers who seek a cheaper remittance option.
It is possible to send funds without a fee to recipients via exchanging private addresses to one’s wallet or through some crypto exchanges. Still, a fee is usually applied when users transact in cryptos on-chain. The fee varies from blockchain to blockchain, and how high or low those fees are related to a blockchain’s internal activity. The question then is how that activity determines transaction fees.
Briefly on Transaction Fees
As explained earlier, transaction fees are applied to transactions that occur within the blockchain. Not all blockchains charge a fee, as its application is within the chain’s consensus protocol. Nano is an example of a crypto blockchain with zero transaction fees as set by its protocol.
For those with a transaction fee, it is charged based on the validation of a transaction. Every block validated generates a fee reward for the validators. For chains that validate transactions via mining such as Bitcoin, the fee is a reward that ensures mining is profitable. For those that support staking, the fee acts as an incentive for investors to stake and validate transactions.
Link Between Activity and Transaction Fees
Crypto transaction fees are generated as a result of blockchain activities. The more investors trade, the more blocks to be validated and generated. How are transaction activities and transaction fees linked?
Demand and Supply of Miners
The key concept behind most cryptocurrencies is the relationship between demand and supply. The two market supply forces are what determine many cryptos’ market value. Some exceptions include stablecoins whose prices are pegged to other assets like gold and USD.
Transaction fees are also directly determined by the demand and supply between miners and transacting users. Using the Ethereum gas fees as a reference, the availability of both determines the prevailing price of transacting ETH on-chain. When there are too many transactions, miners can decline to process and validate transactions if the gas price is not good enough for them.
The users on the other hand need their transactions processed to meet their trading needs. Given the position set by the miners, users are obliged to raise the fee they are willing to pay for blocks to be validated.
On the other hand, transaction fees go down when transaction activities in the blockchain go down. The demand for computational power goes down, forcing a situation of too many miners validating too few transactions. Miners find themselves in a position where they have to lower the threshold they demand to validate transactions.
Transaction Data Size
The volume of activity in a blockchain is not just tied to the number of transactions. Assuming the number of transactions is the same, transactions that have a larger data size would generate more blocks than those with smaller data sizes.
Using Bitcoin as a reference, the maximum amount of data per block is 1 megabyte. Validating one block generates a block reward currently at 6.25 BTC as well as fees sent with the transactions. The daily number of transactions hovers at around 271,000.
When blocks on Bitcoin have a lot more large data transactions than smaller ones, it directly translates to fewer transactions per block. The 1MB threshold is met much faster with larger data transactions, translating to more blocks required.
With the blocks being more and having fewer transactions, the transaction fees miners charge for validating each transaction go higher. The computational power needed to generate hashes for the increased number of blocks means miners will charge higher transaction fees. Even if the fee charged per block by each miner stays stagnant, the fewer number of transactions per block means each transaction costs more.
The opposite is true where transactions are of the same volume but smaller with fewer data. More transactions are there per block sharing the same fee, translating to lower fees per transaction. Fewer blocks also put a lower demand on the computational power required to validate transactions, hence lower fees charged by miners.
Network Conditions
The condition of a blockchain’s network based on activity cycles also determines transaction fees. Congestion of the network can have an incremental effect on transaction activities.
Using Bitcoin as an example, there could be two consecutive days of 271,000 transactions each. The transactions on both days could have little data size difference, translating to a similar number of days. The number of miners on both days also stays constant.
For the first day, transactions were evenly spaced at a lower limit of 10,000 transactions per hour to a high of 13,000. There is little network congestion since activities are spread out, hence low transaction fees.
Come the second day, almost half of the transactions occur in a five-hour period, averaging 27,000 transactions per hour. During this period, network congestion due to the lumping of activities creates an artificial shortage of miners. Transaction fees during the period will be significantly higher than at any point in time of the previous day.
Ultimately a blockchain’s transaction activities are the primary determinants of transaction fees. An increase in activities results in a direct increase in the fee charged for validating transactions. A decrease in activities will also decrease fees.
Blockchain activity increments can come in the form of an increase in the number of transactions facing a static number of miners. It could also come in the form of increased data sizes of transactions, given the same number of transactions and miners as before. Activities may also rise figuratively where they are lumped in a short timeframe, causing network congestion.
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