Who Pays to Keep Bitcoin Running?
When you hand someone a dollar bill, gold coin, or bushel of wheat, the transaction doesn’t require much effort to execute. The seller holds a physical object, and apart from counterfeiting, knows that he or she has been paid. When you pay someone by credit card, money must be digitally transferred between accounts, but this is all done by a centralized company and requires only a trivial amount of computing power. But when you pay someone with a cryptocurrency such as Bitcoin, computers in a decentralized network around the world must verify the transfer from one Bitcoin wallet to another. Executing the transaction therefore requires significant real resources—energy needed to run computers. Those who spend the time, energy and computing power to execute payments need to be compensated.
This compensation comes in two forms. The more well-known form of compensation is newly created bitcoins—this is the reason we call those running the software miners. Miners currently earn 12.5 bitcoins for each “block” of transactions (about 1MB in size) verified, over $30,000 at today’s prices. But the code behind Bitcoin is designed so that this reward is cut in half when the all-time number of transactions hit certain milestones (the reward was originally 50 bitcoins). This causes the number of new coins to slow down as they reach the predetermined limit of 21 million bitcoins. The limit isn’t projected to be reached for 100 years, but this form of compensation for running the system will inevitably decline in importance.
Miners are also compensated by transaction fees in the form of small fractions of a bitcoin every time you or I make a transaction. Many people don’t know about these fees—widely used wallet services like Coinbase have an algorithm to determine how much you pay. Like most things about Bitcoin, the transaction fee system is decentralized, market based, and a little hard for the beginner to understand. You choose the size of the transaction fee you will pay (or no fee at all), and miners decide based on that amount whether or not to include you in a verified block. Transactions with lower fees therefore risk taking a longer time for the system to verify.
Average transaction fees have increased at a staggering pace this year, from 35 cents on January 1 to almost $4.50 today. That works out to a little more than $10,000 on average per verified block. Much of this increase is due to competition as the system becomes more crowded with transactions. But over a longer time frame, this incentive will become more important as fewer new coins are mined. Predicting the future level of these fees is difficult and depends on variables such as future computing speed, energy costs, and the value of a bitcoin. But they will be essential to provide incentives to keep the system running.
Could high transaction fees provide an open door for a competitor to disrupt Bitcoin? Bitcoin makes the verification process even more difficult and energy consuming than it needs to be in order to get the economic incentives right and keep a lid on the number of new Bitcoins. If someone designed a digital currency that solved those problems while making verification more efficient, it could presumably save consumers millions in transaction fees. Such a scenario is yet another reason why hard and fast predictions about the future of Bitcoin are a fool’s errand.
Max Gulker
Max Gulker is a former Senior Research Fellow at the American Institute for Economic Research. He is currently a Senior Fellow with the Reason Foundation. At AIER his research focused on two main areas: policy and technology. On the policy side, Gulker looked at how issues like poverty and access to education can be addressed with voluntary, decentralized approaches that don’t interfere with free markets. On technology, Gulker was interested in emerging fields like blockchain and cryptocurrencies, competitive issues raised by tech giants such as Facebook and Google, and the sharing economy.
Gulker frequently appears at conferences, on podcasts, and on television. Gulker holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Prior to AIER, Max spent time in the private sector, consulting with large technology and financial firms on antitrust and other litigation. Follow @maxg_econ.
