For a system to be decentralized, it must be self-funded. In other words, there is no need for outside money to make it work. Self-funding must be incentivized to be effective.
This is the core concept of public blockchain networks, from Bitcoin to Ethereum. Every time people use these networks to transfer tokens or use dApps, they pay a transfer fee to either miners or validators. Ethereum popularized the term “gas fee,” but it all started with Bitcoin.
How Blockchain Fees Started
Without having a board of directors, a CEO, or a foundation, pseudonymous Satoshi Nakamoto released Bitcoin as an alternative to central banking. He did so by making the Bitcoin peer-to-peer (P2P) network self-sustaining:
A user installs open-source software onto their computer to turn it into a network node — miner.
Nodes link up with other nodes to validate transactions — add new data blocks — and synchronize the new state of the public ledger — Bitcoin blockchain.
When new data blocks are added, miners receive BTC block rewards, as revenue.
Moreover, to verify each data block, the node has to exert computational power to solve cryptographic equations. Satoshi placed this artificial barrier in order to eliminate spam, as a Proof of Work (PoW) obstacle. Otherwise, there would be no cost to flooding the network, and there would be no incentive to maintain nodes.
How Does Bitcoin Handle Blockchain Fees?
In the case of Bitcoin, across its 11,000 nodes, BTC senders automatically pay a fee when transferring bitcoins from wallet address A to wallet address B. In other words, the fee paid is embedded into the transaction. At its highest point in April 2021, Bitcoin fee skyrocketed to $60 per transaction.
The fee size is dependent on the network throughput, daily traffic, and BTC block size. After the SegWit (Segregated Witness) upgrade in August 2017, Bitcoin’s network throughput increased because it expanded the BTC block limit size from 1MB to 4MB.
Additionally, SegWit separated transaction data from its block signature. Because this allowed all signatures to be batched together at the end of each BTC block, it resulted in lowered BTC fee.
It is important to understand that Bitcoin miners don’t care about the monetary value of a BTC transaction, but simply its byte size. As showcased in September 2022, this means that a transaction as valuable as $100,000,000 can only cost $0.46 to send.
On average, BTC miners produce one block every ten minutes. This block represents transactions’ size in bytes, typically at 1.6M bytes, or 1.6 MB.
For BTC rewards to be distributed fairly, there is a randomness introduced with the bidding mechanism. When miners bid for which transactions to include in the new block, it is in their interest to fill it up for maximum BTC revenue. Therefore, miners set a minimum and maximum fee per block, with larger fees getting the high priority.
Low priority transactions with minimal fees can take hours to complete because Bitcoin mining pools validate high-fee transactions first. Additionally, Bitcoin’s traffic was offloaded by the Lightning Network (LN), as a Layer 2 scalability solution.
LN generates payment channels between BTC senders and receivers. The scalability trick is that only the first and last BTC blocks are processed on Bitcoin’s network, while LN handles the rest.
By removing mid-transactions between the payer and receiver, LN removes Bitcoin’s 7 tps limitation, making the cryptocurrency network infinitely scalable for daily usage with Visa-like performance. Together with SegWit, a typical LN transaction is just 1 satoshi (0.00000001 BTC), or $0.0002 USD.
Lastly, BTC block rewards are not set in stone. After four years, BTC miner rewards are halved. Meaning, as we move forward, fewer bitcoins will be generated and put into circulation. This is used as an inflation control mechanism to mitigate Bitcoin supply against its adoption.
In the year 2136, Bitcoin’s block reward will reach 0.00000001 BTC. Nevertheless, 1 sat may be worth $1M by that time, given the fact that Bitcoin’s supply is forever limited to 21M BTC.
How Does Ethereum Handle Blockchain Fees?
Ethereum’s “gas fee” has become synonymous with blockchain fees, spearheaded by Ethereum with its hundreds of dApps. This makes sense, as Ethereum holds decentralized finance (DeFi) dominance. In April 2021, Ethereum held 80% TVL market share among Proof-of-Stake (PoS) blockchain networks. In September 2022, this dropped to 57% against 146 other PoS chains.
Just like with Bitcoin’s miners, Ethereum’s validators are in charge of validating transactions, so they are added as new blocks. Every time that happens, validators receive a gas fee. After Ethereum shifted to a PoS consensus mechanism from a PoW one on Sep. 15, 2022, Ethereum gas fees go to validators instead of miners.
Just like satoshi (sat) is a denomination of Bitcoin, so are Ethereum gas fees denominated in gwei, as 10^9 of Ether (ETH), Ethereum’s native cryptocurrency. Meaning, 1 gwei = 0.000000001 ETH.
As with Bitcoin, gas fees are dependent on the network’s congestion and throughput. Even after The Merge, Ethereum’s speed hovers around 14 tps, which is likely to change after the Surge introduces sharding.
How Is Gas Fee Calculated?
Blockchain networks continue to evolve. After the London upgrade in August 2021, Ethereum received its new gas fee formula, with the EIP-1559 ETH base fee burning. It also set the block size between 15–30M gas, representing the total amount of gas used for all included transactions in a block.
Gas fee = gas units x (base fee + tip)
Gas unit is the limit set by the user on how much they are willing to pay for a transaction. Depending on the type of transaction, ranging from simple transfers to complex lending operations, there is a minimum limit for transactions to go through.
In turn, the base fee is the minimum gas needed for a transaction to be included into a new block. This depends on network congestion. The more users are plugged into Ethereum, the higher the base fee will go. If the previous block is over the 15M gas minimum, base fee increases by 12.5%.
After the transaction is validated as a new block, the base fee is burned, i.e., removed from circulation. This burning mechanic exerts a deflationary pressure on ETH, which has no maximum coin supply, unlike Bitcoin.
Akin to LN for Bitcoin, Ethereum uses multiple Layer 2 scalability solutions to reduce gas fees and speed up transaction times. The top ones are Polygon, Arbitrum, and Optimism. They exert negligible gas fees, often under one dollar.
Altogether, Ethereum gas fees follow the path of Bitcoin. Both networks use a combination of Layer 1 upgrades and Layer 2 scalability networks to make blockchain transactions affordable for everyone.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.