How do Bitcoin transaction fees work?
When you send a cryptocurrency like Bitcoin from one wallet to another, for example when you move it between two exchanges, you have to pay a fee. Sometimes this is very small, and sometimes it's very large; this guide will go through how these fees work.
How money is sent via proof-of-work & proof-of-stake
There are two common ways to achieve consensus (decide which transactions are valid) for cryptocurrencies, proof-of-work and proof-of-stake. Bitcoin for example uses proof-of-work.
For a proof-of-work coin, when you create a transaction you specify inputs and outputs (the output is where you want to send the coins to). If you specify the output value to be slightly lower than the input value, the leftover amount becomes the transaction fee. When you send this transaction to the Bitcoin network, you generally include this transaction fee in the hope that a miner will process your transaction (miners are the people doing the 'work' for a proof-of-work coin). If you didn't specify a fee, your transaction would likely not be processed. We explain this in more detail in the section below
Proof-of-stake coins have similar mechanisms, except the fee isn't paid to miners, instead it's paid to what's called a 'validator'. The goal of the fee in both cases is to incentivise people to follow the rules of the network (e.g. discourage them from breaking the rules by not rewarding them).
What factors effect fee size?
A key aspect of Bitcoin that effects the size of transaction fees is the size of a block and the amount of time it takes to generate each block (blocks are where transactions are stored). Each block takes a certain amount of time to generate, and is a finite size; these two factors combined limit Bitcoin to a maximum capacity of around 7 transactions per second.
This area is very controversial, with many people believing Bitcoin's block size should be increased to increase the maximum capacity (Bitcoin Cash was created by this group & now has a much larger block size & on-chain capacity than Bitcoin). Others believe scaling should be achieved off-chain, with technologies like Lightning Network (see this page if you're not sure what on-chain & off-chain are). This video and this video give good summaries of the situation (each biased towards one side), covering conflicts of interest & misconceptions around Lightning Network.
As the number of tranasctions being sent on Bitcoin approaches 7 per second, the network becomes very congested. This means if you want your tranasction processed fast, you need to pay a higher fee (or rather you need to pay a higher fee than everyone else on the network). This leads to a 'bidding war' type scenario, where fees become higher and higher if the network remains congested (if transactions continue to be sent the congestion gets worse and worse).
Withdrawal fee size on Exchanges
When you deposit/withdraw coins on an exchange, most exchanges will likely have wallets for that particular coin, and have an internal database keeping track of how many coins each user holds (although we are yet to find documentation on this to confirm it, alternatively an exchange might be directly involved in a blockchain's development so have a built-in mechanism for handing storage of users' funds). Assuming this is the case, this exchange will have to deal with the scenario above, where each coin has a limited capacity causing tranasaction fees for fast withdrawals to vary based on the coin's load. This raises some interesting points:
- Should exchanges allow you to specify the withdrawal fee yourself, so if say Bitcoin is under high load and you want your coins fast you can use a higher fee.
- Do exchanges take a cut of this fee? You can check the transaction on the coin's network to see if they've charged you extra! Almost all exchanges provide the withdrawal transaction ID.
Other interesting transaction fee systems
As well as proof-of-work and proof-of-stake, some coins have very different mechanisms for handling transaction fees (often allowing fees to be much lower):
- Ripple (XRP) has very low transaction fees, and they don't actually go to anyone. A fee is charged for each transaction, and this fee is destroyed (it's designed to be a deterrent to spamming the network, where as the load on the network increases the transaction fee increases). The primary incentive for running a validator on the Ripple network is to "preserve and protect" the network.
- Stellar (XLM) fees are also very low, fixed at 0.00001 XLM per operation. These fees, and also any newly minted XLM, go into a pool that's spread to users based on a voting system.
How are proof-of-work miners rewarded?
For a proof-of-work coin, in general the fees go to miners because these miners are doing 'work' in the form of mining blocks (a block is where your transaction is stored once it's added to the proof-of-work coin's blockchain). We posted a separate guide on how this mining process works if you'd like more info on that.
Some mining highlights relevant to this guide:
- Miners are incentivised by both transaction fees & a block reward when they mine a new block (called the 'coinbase', not to be confused with the exchange Coinbase).
- Miners can get try to get block rewards without validating any transactions if they want. But if they do, they both miss out on these transaction fees, and potentially reduce the value of the network in general - reducing the value of any block rewards they have/will get in the future.
- For Bitcoin, the block reward shrinks over time, eventually becoming 0. So eventually transaction fees will become the only incentive for Bitcoin miners.
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