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Learning Bitcoin – About Transactions, Fees, Mining and More

May 25, 2017 10:25 am Published by

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Amid the buzz surrounding Bitcoin’s recent astronomical rise to a new all-time high of $1,856.48 — or RM8061.78 — per bitcoin on May 11 (BitcoinAverage, 2017), an oft-overlooked metric related to the use of bitcoin has likewise been setting new all-time highs: bitcoin transaction fees.

In the early years of Bitcoin’s existence, bitcoin’s transaction fees were more or less optional, i.e., they were generally considered as donations to bitcoin miners. Bitcoin users back then were thus able to have their transactions confirmed in the Bitcoin blockchain within a reasonable amount of time, without having to pay a transaction fee. However, users today would have to pay approximately 0.0008 BTC — or around RM8.20 at the current exchange rate of roughly RM10,250.00 per bitcoin — for a typical transaction to be confirmed in the Bitcoin blockchain within ten minutes. No-fee transactions today, on the other hand, may never be confirmed in the Bitcoin blockchain at all.

Before we discuss the impact of rising bitcoin transaction fees on Bitcoin as a whole and what it means for you as a user, let us first take a look at the role that transaction fees play in securing the Bitcoin network. To do that, we will first need to have a basic understanding of how bitcoin transactions work and how bitcoin transactions are confirmed in the Bitcoin blockchain via a process called mining.

Bitcoin Transactions 101

Technically, bitcoins do not exist, per se. You will not be able to find any physical object nor digital file that can be identified as a bitcoin.

Instead, a bitcoin is defined as a “chain of digital signatures”. A bitcoin transaction happens when one party “transfers the coin to the next by digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the coin” (Nakamoto, 2008, p. 2). In other words, there are only records of bitcoin transactions between bitcoin addresses, with balances that increase and decrease accordingly. And each bitcoin transaction is made up of the following three pieces of information:

  • An input. This is a record of the source of available bitcoins, i.e., which bitcoin addresses the currently available bitcoins came from.
  • An amount. This is the amount of bitcoin sent to the recipient.
  • An output. This is the recipient’s bitcoin address.

All of this is stored in a distributed ledger called the blockchain.

As an example, here is what happens when Alice sends one bitcoin to Bob:

  1. Alice uses her private key to sign a message containing the input, the amount, and the output.
  2. Alice broadcasts this message to the Bitcoin network.
  3. Bitcoin miners check if Alice’s transaction is fully compliant with all of the Bitcoin network’s consensus rules — e.g., miners check whether Alice’s bitcoins have not been spent twice. If Alice’s transaction is found to comply with all of the Bitcoin network’s consensus rules, the miners verify Alice’s transaction by adding it to the most recent block of transactions in a process called mining.
  4. Bitcoin miners broadcast the block containing Alice’s transaction, among others, to the Bitcoin network.
  5. Once the Bitcoin network accepts the block of transactions as valid, Alice’s transaction is now confirmed as a valid transaction.

Now that we have taken a look at how bitcoin transactions work, let us now explore the process by which transactions are confirmed, i.e., mining.

Bitcoin Mining 101

As mentioned earlier, all BTC transactions are stored in a distributed ledger called the blockchain. The blockchain is essentially a long, cryptographically-connected chain of blocks containing bitcoin transactions, and it is available to everyone who participates in the Bitcoin network (Nakamoto, 2008).

However, since Bitcoin was designed to operate without a trusted third party, a system was needed that would allow all participants of the Bitcoin network to agree on a single version of the blockchain. The system also had to ensure that the blockchain could not be tampered with. This is where bitcoin miners come in.

Miners are responsible for assembling new bitcoin transactions into blocks and subsequently broadcasting these blocks to the Bitcoin network. This allows every participant of the Bitcoin network to have an up-to-date copy of the history of every bitcoin transaction ever made.

Miners do this by:

  1. Collecting new transactions into a block.
  2. Finding a difficult proof-of-work for the block. The proof-of-work is essentially the digital equivalent of a wax seal. This wax seal confirms that this block, along with every block after it, is legitimate. This is because if the current block’s proof-of-work is tampered with, everyone on the network would know. In other words, once the necessary amount of computing power has been expended to satisfy the required proof-of-work, the block cannot be changed without redoing the work. And since later blocks would be built on top of the current block, “the work to change the [current] block would include redoing all the blocks after it”
  3. Broadcasting the block to the Bitcoin network when a proof-of-work is found.
    Once the Bitcoin network verifies that the broadcasted block complies with all of the network’s consensus rules, the block is accepted into the blockchain and the miner is rewarded with the block reward — currently 12.5 BTC — and the transaction fees included within the block.

Bitcoin Transaction Fees 101

Since there are only a finite number of transactions that can be added to a block — a block currently has a limit of 1 MB worth of bitcoin transactions — miners prioritise transactions according to transaction fees. This makes sense, given that miners have operational costs of their own to manage, and more transaction fees collected means more revenue to offset their costs. Ordinarily, this should not have been a problem. However, due to bitcoin’s rapidly increasing popularity and the overwhelming demand that followed, the Bitcoin network has been struggling to keep up with the surge in bitcoin transactions. In fact, on May 17 at 11:09 A.M. (UTC +8), the number of unconfirmed transactions on the Bitcoin network hit an all-time high of 175,279 unconfirmed transactions (Blockchain, 2017).

It is this congestion on the Bitcoin network that has been driving bitcoin transaction fees to all-time highs of its own (Smart, 2017). There is even a fee market now, where users bid to have miners confirm their transactions as quickly as possible (Lopp, 2016). This market has likewise spawned a mini-industry of its own, with various bitcoin wallet and service providers providing tools that dynamically calculate the most appropriate fee for users.

The Impact of Rising Bitcoin Transaction Fees

The rise in bitcoin transaction fees and the network congestion that precipitated it have set off a firestorm of debate within the Bitcoin community. After all, one of Bitcoin’s earlier main selling points was its low transaction costs, especially when compared to more traditional methods of electronic payment like credit cards and PayPal. Bitcoin’s transaction fees have now reached the point where a bitcoin transaction to buy a coffee would cost almost the same as the coffee itself — e.g., paying for an RM10.00 coffee with bitcoin today would most likely cost you around RM8.20 in transaction fees at current exchange rates, if not more.

Several bitcoin companies and service providers have also had to adapt their respective business models to cope with the rise in bitcoin transaction costs. For example, Coinbase, Bitpay, and Coinjar used to pay for customers’ bitcoin transaction fees on their behalf. As recently as March 21, however, all three companies have passed on bitcoin transaction fees to their customers.

The bottom line is until the Bitcoin community finally comes to an agreement regarding how best to scale the Bitcoin network to cope with the increasing demand, end-users are in for a rough ride. And with the continuing uptick in interest from institutional investors, expect a further rise in network congestion and transaction fees for the time being.

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