Why are bitcoin transaction fees dropping so low?

No single factor explains it, and they don't quite fit even when you put them all together.

Bitcoin transaction fees have dropped to their lowest point in about 6 months, and it's hard to say exactly why.

The coin hit a wall in December as its network got clogged up with hype and ground to a halt. The same thing happened to Ethereum, except in its case the network was clogged with cats instead. Both of them were experiencing the same shortfall of early blockchain technology: the scaling problem.

The problem is that blocks need to be chained but each block can only carry a limited amount of data. If too many people want to put data (transactions) on the block then a queue forms. When this happens to bitcoin it raises fees, because people can jump the queue by paying higher transaction fees and it quickly becomes an auction.

There are a few ways coins might solve this.

• Make the blocks appear faster. More blocks, more transactions. It's not an option for bitcoin due to the relation between block creation time and mining rewards and other factors.
• Make the blocks larger. Bitcoin's block size is a puny 1MB, while Bitcoin Cash forked off with an 8MB block size to improve transactions. The downside of this is that it increases the size of the entire chain, raising data storage costs for full nodes (who keep a copy of the entire blockchain and all its transactions). There are various ways to solve this secondary problem, but it's still a bit of a bandaid solution to a larger problem. If you want to scale all the way to tens or hundreds of thousands of transactions per second, you'll need a lot more than a larger block size, so the downsides might not be worth it.
• Use another fancy system. Some coins like Nano and IOTA run on a kind of blockweb rather than a blockchain, while Ethereum and others are moving towards proof-of-stake systems and other mining algorithms which can decouple mining rewards from block creation time and lets one make blocks faster without the downsides. And bitcoin and others are moving towards the Lightning Network and SegWit.

• The Lightning Network. The short version is that this lets bitcoin run transactions outside the blockchain, with a few caveats. The long version is here.
• SegWit. This is a more space-efficient way of packing data into blocks. The upside is more transactions, the downside is that it needs specially made SegWit wallets and addresses, and is kind of annoying so people don't use it unless they have to.

Why are bitcoin transaction fees dropping so low?

So low relative to before at least. A US$2 average is still pretty high by cryptocurrency standards.

There are a few possible reasons for it and it's almost certainly a combination of them rather than any one in particular. The main one might be that there are fewer transactions happening now. It peaked at almost 400,000 bitcoin transactions per day in December, but now it's down to under 200,000. Fewer transactions mean less demand, which means lower fees. This could be a reflection of the slumping price and waning interest.

But these numbers aren't everything. The number of transactions isn't a perfect mirror of the average transaction fees, and the ongoing bitcoin trade volume doesn't suggest any real corresponding decline in interest. And there are some confounding factors involved. For example:

• People can choose their own fees. If you want to pay for express delivery you can. Plus transaction fees are paid by the byte, but...
• Not all transactions are the same size. Heavily encrypted transactions, for example, take up more data space and are therefore more expensive. And if everyone's sending large transactions then it might slow the network significantly.
• Batching is becoming more popular. This is the practice of clumping multiple user transactions into a single batch and then sending them all as one blockchain transaction. It's typically done by exchanges who have to handle a lot of third party transactions and can therefore save a fortune on fees with batching. This drops fees and reduces network congestion all round. It also skews the number of blockchain transactions downwards, which means the number of blockchain transactions isn't necessarily an accurate reflection of bitcoin's current popularity.

As you can see, the number of confirmed transactions per day is now showing up as lower than it's been in years. This is probably the result of all the exchanges batching by necessity in December, and then continuing to do so even though the network has cooled down.

But it might also be worth bearing in mind that these are the numbers of confirmed transactions per day, not counting any that were sitting in the queue. The number of attempted transactions in November and December may have been considerably higher. Plus, larger transaction sizes means fewer total transactions confirmed that day meaning less apparent network activity.

In short, it's pretty much impossible to numerically determine the extent to which waning popularity is contributing to lower fees, or even the extent to which popularity is actually waning.

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The Lightning Network and SegWit might be more likely culprits for dropping transaction fees. Bitcoin developers recently made a major push towards ease of SegWit adoption and exchanges are racing to implement it.

But unfortunately for the sake of this argument, the actual proportion of transactions using SegWit hasn't changed much over time, remaining fairly steady at about 15% throughout bitcoin's ups and downs. It's making a difference overall, but might not be playing a role in the disproportionate recent drop.

Source

So onto the Lightning Network. Would its use drop transaction fees? Absolutely. Are people using it? Definitely.

But is it responsible for the low fees right now? Probably not. Even though the Lightning mainnet is live, it's still not ready for prime time and is strictly in the testing phase. People are still using it to send bitcoin, but only the crazy ones. It's probably not enough to make too much of a dent in transaction fees.

So what's causing the low fees?

It looks like the number of transactions on the network is playing the dominating role, but for the reasons mentioned it's not possible to cleanly pin it on the dropping transaction count, or to get a clear sense of how accurate the transaction numbers actually are.

It's also worth considering how people's behaviour changes over time. Just as high transaction fees pushed exchanges into batching, it also pushed users into coin conversions for the purposes of moving money. If someone wanted to send bitcoin from one exchange to another, it was often most cost-effective to convert it into Litecoin or something else and duck the bitcoin fees. Because the conversion happens on the exchange, it wouldn't necessarily show up on the blockchain as a transaction.

At their heart, bitcoin and other cryptocurrency networks are organic systems composed of people, their behaviour programmed through monetary incentives like mining rewards, and penalties like fees. This is what gives us all the confounding factors and makes it almost impossible to precisely pick out cause and effect in these kinds of situations.

So what's the diagnosis after all the exploratory surgery and examination of bitcoin's low fee symptoms? Who knows. It's probably something people are doing or not doing somewhere.

Picture: Shutterstock

Disclosure: At the time of writing the author holds ETH, IOTA, ICX, VEN, XLM, NANO, SALT, BTC