Understanding Crypto Network Fees: An In-Depth Look

Jul 19, 2019 10:00:00 AM Blake Ford 0 comment(s)

Finance and fees—there’s no escaping them, even in crypto! However, crypto network fees are very different from the fees familiar to mainstream finance. They might also be a little more complicated to wrap your head around.

That’s why, in this article, we’ll be breaking down crypto network fees to uncover what they’re used for, and how they’re determined.

Let’s begin with distinguishing between crypto network fees and other types of fees associated with crypto.

What’s the Difference Between Crypto Network Fees vs Other Kinds of Fees?

Crypto network fees are fees that are inherent to the underlying blockchain network of the crypto asset itself. For instance, each time you execute a transaction on the Bitcoin or Ethereum network, a fee is charged, payable in BTC or ETH. Some networks use unique assets, like ‘gas’ on the Ethereum Network, to pay the fee.

Because of this, people often interchangeably use the term crypto network fees and transaction fees (in fact the latter usage might be more common). However, we prefer the former term because it is more precise—it makes it clear that the fees are being charged by the network itself.

For instance, the term transaction fees could also refer to external fees imposed by third parties (such as fees crypto exchanges charge their users). Yet, these fees have nothing to do with the underlying crypto network. Hence, for clarity’s sake, we must separate crypto network fees (internal to the network) from transaction fees (external to the network).

Why are Network Fees Necessary?

Everybody understands why mainstream finance companies charge fees—they are a primary revenue source, pure and simple—as the fees are paid to the companies themselves. There’s no ‘underlying network’ behind the US dollar, for instance.

On the other hand, the primary purpose of crypto network fees is security. Remember, as we mentioned in our ‘What is Cryptocurrency?’ guide, the key feature is decentralization. Decentralization is its most attractive feature, but it presents a unique problem—how can you secure the network when there is no central authority?

At the basic level, crypto network security is all about preventing the ‘double spending’ problem or counterfeiting. What prevents people from spending the same Bitcoin over and over again? For physical fiat money, we have security measures like serial numbers, special ink, and such. For digital fiat money, there are trusted centralized parties (i.e. banks) to keep track of ownership.

So, the question then becomes, how can a decentralized system agree on who owns what? They need to somehow come to a consensus. The process in which they reach one is referred to as a consensus mechanism. As for fees, they cannot be separated from a crypto’s consensus mechanism.

How do Network Fees Keep Crypto Networks Secured?

There are different consensus mechanisms in cryptocurrency, but the most common (and first) is called Proof of Work (PoW). Bitcoin uses it, and so does Ethereum, Litecoin, and Bitcoin Cash—four of the five largest cryptocurrencies today.

Miners are the transaction validators in PoW mechanisms. When you send a transaction, it’s first recorded as ‘unconfirmed'. For a said transaction to be permanently added to the blockchain, a miner must first confirm or validate the transaction. To do so, they race to solve a cryptographic puzzle and are rewarded for doing so. This is the most simplistic explanation of the mining process, and it’s what allows the blockchain to keep track of all transactions and address balances, which helps avoid the double-spending problem.*

Mining rewards have two sources—inflation (the addition of new coins to the circulating supply) and network fees. Crypto network fees are used to ‘pay’ for a network’s security.

The proportional payout between the inflation and fees varies by each crypto. For instance, the block rewards for Bitcoin gradually decrease, a process known as Bitcoin halving. When it reaches its hard-capped maximum supply of 21 million, network fees will be the sole source of mining rewards.

*Important Note: The only exception is if a malicious party manages to get control of 51% or more of the entire mining computational power (known as a 51% attack). This allows them to prevent valid transactions and even reverse transactions—allowing double spending. Because of this, PoW mechanisms in small cryptocurrencies can leave them vulnerable to such attacks.

How are Crypto Network Fees Charged?

Unlike mainstream financial fees, crypto network fees are far more variable, and you can actually choose the amount of fees you want to pay! That might seem complicated, but it’s nothing more than classic supply-and-demand.

You see, miners have a choice in which transactions they want to confirm first. Obviously, they would choose the ones that offer the highest fees. This means your transaction is competing against other transactions for confirmation—set a higher fee if you want to incentivize miners to confirm your transaction ahead of the rest.

Since market principles apply, fees can also spike, especially in times of heavy network congestion. This was seen at the peak of 2017’s crypto bubble, where Bitcoin’s average network fees skyrocketed to over USD35 (as of July 4, 2019 they’re under 30 cents).

Now that you understand the role of crypto network fees in PoW consensus mechanisms, let’s briefly look at the second-most popular consensus mechanism—Proof of Stake (PoS).

Crypto Network Fees in Proof of Stake Mechanisms

There is no mining in PoS mechanism. Instead, validators are chosen based on their stake in the network. Their stake, in this context, is more than just the amount of coins they hold—they must also ‘lock in’ a certain amount of coins in the network.

So security comes down to game theory—with your assets on the line, would you still try to attack the network? A 51% attack would also only be possible with ownership of the majority of a particular crypto (in which case, is there any point in attacking the network?).

However, just like PoW cryptocurrency mechanisms, PoS mechanisms also typically incentivize validators via block rewards (inflation) or fees. Although they’re operationally different, crypto network fees play the same role in both PoW and PoS mechanisms.

Fee Structures Will Evolve Alongside Consensus Mechanisms

Consensus mechanisms exist because of crypto’s decentralized nature. Network fees are just one part of the picture and are often used as one of the primary incentives that allow these mechanisms to function.

But no consensus mechanism is perfect, and people are always thinking of how to improve upon them (though that is a topic for another article). PoW and PoS are two of the most common ones, but there are many others—Proof-of-Burn, Proof-of-Authority and more. As consensus mechanisms continue to evolve, so will their respective fee structures.