High transaction fees on bitcoin

One of the common criticisms bitcoin has received throughout the years is about the high transaction fees. People claim they will keep bitcoin from being widely adopted as a currency. These beginners are missing a few things, and as it turns out high fees are actually good for bitcoin. Let me explain.

Why are fees high?

Transactions fees are high on bitcoin because it is designed in a very specific way, with very specific goals. High fees are not the result of an oversight by the developers or because it is technologically difficult to do. Anyone can build a simple program which sends thousands of transactions per second (tps). The technologically difficult task, in regards to a decentralized currency, is to design a network that can stay decentralized long-term.

An autonomous decentralized network must have a limit on the number of transactions it can process. If it did not, and its currency had any significant market use, the network would quickly be overwhelmed with spam. This is because of Parkinson's law, "the demand upon a resource tends to expand to match the supply of the resource."

Adapted to bitcoin, "demand" is the number and size in bytes of transactions, and the "resource" is storage and bandwidth of nodes. We could restate Parkinson's law as follows: the number and size in bytes of transactions will expand to the storage and bandwidth limitations of nodes. This will restrict the number of nodes on the lower end of these resource scales, centralizing bitcoin to fewer nodes which are more expensive to operate and easier to attack.

Therefore, in order to maintain a high level of decentralization and even grow more decentralized with time instead of less, a network must have strict limits on its maximum resource requirements. Bitcoin does this with the block size limit, also known as the block weight limit. Every 10 minutes on average a new block of transactions is confirmed on the bitcoin network, ordering these transactions in the history of the network. Each block can only be 1 MB (though modern node software counts the bytes of some transaction types differently, allowing a theoretical maximum of 4 MB per block).

Transactions consist of data and have a size in bytes. Only a certain number of transactions can fit within the 1 MB limit (roughly 2,500 - 3,000). As the demand for transactions increases, miners who order these transactions into blocks, will naturally prioritize transactions with higher fees. As demand goes up, fees go up.

The result of high fees, layers

High fees are a natural market phenomenon in a decentralized network, but instead of discouraging usage of bitcoin, high fees incentivize innovation. This innovation leads to new products and services creating more demand for bitcoin and bitcoin transactions, incentivizing more innovation, in a virtuous cycle.

The main way people mitigate fees is with, what we call, a Layer 2 protocol. You are probably familiar with layered protocols and don't even know it. Http and https are layers on top of the core Internetworking Protocol (TCP/IP) known as the internet. Video and data streaming are layers, Ethernet and WiFi are types of layers. Bitcoin is a layer of the internet, too, and there are layers on top of bitcoin.

There are three main times of layers for bitcoin, the Lightning Network, federated sidechains, and centralized services. Let's quickly look at each one.

Lightning Network

The Lightning Network (LN) is an open-source decentralized network with its own node software. To use LN you need a bitcoin node and a lightning node (or access to a service that runs them for you). These are typically run on the same computer.

Lightning nodes are connected through a web of payment channels that can send "transactions" back and forth or be routed through multiple channels to a receiver. The payment channels themselves are a special type of bitcoin transaction that can be cryptographically updated an unlimited number of times. LN is the decentralized layer 2 option.

Sidechains

Sidechains are tangential networks, connected to bitcoin through transactions. Users send a bitcoin transaction (with associated fees) to a sidechain address, locking the bitcoins in place and releasing sidechain tokens inside the tangential network. The sidechain has different capabilities than bitcoin, like altcoins, but are not altcoins because they are pegged to bitcoin as the monetary unit.

There are trade offs, however, for this greater functionality in the sidechain, namely greater centralization and threat of censorship. Currently, decentralized sidechains are not workable, so federations are used. This means several large players provide the service to normal users according to the rules of the software.

The most well-known sidechains to date are Liquid, which touts faster, cheaper, more private, and more programmable transactions; and Rootstock, which is a clone of ethereum, offering all the capabilities of a 'smart contract platform' with the monetary unit of bitcoin.

Centralized Layer 2's

These can also simply be thought of as centralized services or companies with their own databases. For example, Coinbase has many users and offers transactions between users for free, because all they have to do is update their own database.

These are properly considered layers of Bitcoin, because they give users unique functionality not available on the main network. An example of this is gambling. There has been lots of work done over the years to create a decentralized gambling protocol with limited success. However, an online casino accomplishes this quite easily. You deposit your bitcoins to an address and then can partake in online games managed by the company's centralized service. All of the movement of the bitcoin balance around the service is done without making a transaction on the bitcoin network itself until you withdraw your bitcoins back to your own wallet.

The Future of Bitcoin Innovation

As you can see, thanks to high fees on bitcoin's base layer, innovation is proceeding apace on layer 2 protocols. As bitcoin fees increase in the future, the incentive to innovate will increase as well. Far from a fatal flaw, fees which emerge naturally from market activity provide a powerful source of energy for the bitcoin ecosystem.

Of course, there is still very high-level work being done on the base layer, but it is extremely conservative in comparison to layer 2, and this slow foundational work being done on the base layer is often mistaken for the only work being done. However, the most exciting developments are coming from layer 2 and it wouldn't be possible without high fees to provide the incentive. Where we go from here is only limited by the imagination of the entrepreneur.