If you’ve spent any significant amount of time reading about or transferring cryptocurrencies like Bitcoin and Ethereum, then I’m sure you’ve encountered periods of “high” transaction (i.e. network) costs. A transaction cost or fee is the amount that you pay a payment processor to transfer your money from one location to another, like from one Bitcoin wallet to another or from your credit card to a business. For obvious reasons, we want transaction costs to be as low as possible so that we can keep as much of our money as we can for future use. So why do transaction costs for popular blockchains like Bitcoin and Ethereum get so high sometimes?
In order to understand why transaction costs rise and fall, it’s important to have a basic understanding of the economic law of supply and demand. Simply put, as the supply of a good and the demand for that good change relative to one another, then the price that purchasers have to pay to suppliers, or that suppliers can charge to purchasers, changes. In other words, when demand is high compared to supply, prices will be higher, while when demand is low compared to supply, prices will be lower.
For example, let’s imagine a supplier who has five bananas to sell and has five customers who each want to purchase one banana. In this case, supply and demand perfectly balance, which means that there doesn’t need to be any competition between buyers in order to get a banana. In this scenario, if the supplier raised the cost of the bananas too much, (s)he might drive away one or more of the customers if they aren’t willing to pay the higher price for the banana. If the supplier lowers the price too much, then (s)he might entice additional customers to want to buy a banana and there wouldn’t be enough bananas to go around.
Now let’s imagine that the same supplier has ten customers who each want to purchase one of the five bananas. Assume no one wants to buy part of a banana, so that means only five of the ten customers will get to buy a banana. Since demand for bananas is higher than the supply, some customers will have to be willing to pay more than others to make sure they can buy one of the bananas. This will cause the average sales price of the bananas to increase relative to the original example.
Now that we’ve learned all about banana purchases, let’s get back to talking about cryptocurrencies. In order for a cryptocurrency transaction to be processed, it has to be confirmed within a block of transactions on the blockchain. There are only so many transactions that can fit within a single block on the blockchain. In the case of Bitcoin, a single block on the blockchain is created roughly every ten minutes and contains an average of 2,000 transactions. For comparison, Visa’s network can perform over 65,000 transactions per second. So we can say that the supply of all possible Bitcoin transactions is rather small.
During periods of low demand for movement of Bitcoin, like weekends, transaction costs are relatively low because fewer people are trying to use the Bitcoin network. However, during periods of high demand for movement of Bitcoin, like the current Bitcoin bull market or the Decentralized Finance (“DeFi”) rally back in summer 2020, transaction costs can get quite high as more and more people compete to “purchase” the limited amount of transaction space on the blockchain.
Let’s use an example that’s specific to cryptocurrency. January of 2020 was a period of relatively low demand for Bitcoin. The Bitcoin price was pretty stable and the number of people wanting to have transactions processed on the Bitcoin blockchain was low. At the time, the average Bitcoin transaction fee was about $0.79. January of 2021 however, has seen significant demand for use of the Bitcoin network as the price of Bitcoin has recently increased by over 300%. The current average Bitcoin transaction fee is just over $12 USD. In other words, because only so many transactions (i.e., around 2,000) can ever be put into a single block on the Bitcoin blockchain, average transaction costs will increase as the number of people using the blockchain increases and will decrease as the number of people using the blockchain decreases.
Now, whether $0.79 or $12 per transaction is high is based on a few different things, namely, why you’re paying for the transaction and the amount of money you’d like to transfer. For example, if you’d like to buy a $2 donut from Starbucks, you probably don’t want to pay $0.79 or $12 in transaction fees and you’re much more likely to pay with cash or a credit card. However, for those of us who want to transfer thousands, millions, or even billions of dollars worth of Bitcoin, they’ll likely find the incredibly small transaction fees on the blockchain to be a great value compared to the time and cost of moving the same amounts of money through the traditional financial and banking systems.
Regardless of the amount of money you’d like to transfer, there are already solutions out there and others in the works that allow cryptocurrency to be transferred extremely cheaply or even for free without any change to the cryptocurrency’s blockchain or underlying software. As an example, various cryptocurrency exchanges, like Coinbase, allow users to transfer their cryptocurrency to other users of the exchange without charging any fees at all. In reality, the cryptocurrency in these transactions never gets transmitted over the blockchain, which is why there is no fee. The cryptocurrency exchange, which holds all of its users' cryptocurrency in its own wallets, simply increases the balance of the receiving user and decreases the balance of the sending user.
A scaling solution specific to the Bitcoin blockchain is the Lightning Network. In a nutshell, the Lightning Network allows any two participants to create a payment channel to send Bitcoin back and forth between themselves. Each transaction does not have to be broadcast to the wider Bitcoin blockchain in order to be confirmed or enforced, meaning that transactions can be executed for a tiny fraction of the cost you’d pay on the Bitcoin blockchain itself.
While Bitcoin and other cryptocurrencies are still new, it goes without saying that transaction costs will continue to change day to day as more or less people try to use the cryptocurrencies. However, regardless of the transaction cost, cryptocurrencies can have significant benefits and users will continue to come up with new and better ways to transfer cryptocurrencies more cheaply.
The links throughout this article are provided for informational purposes only. I am not an affiliate of these companies, I make no recommendation regarding the companies or their services, and I have not received any compensation for linking to their content.
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1 Prices are taken from https://ycharts.com/indicators/bitcoin_average_transaction_fee and are valid as of 1/8/2021.
