On the Bitcoin Fee Markets

Bitcoin has been undergoing a big experiment over the last couple of years, as the demand for transactions have surpassed the supply. In the early days, one could easily toss in a transaction without any fee paid at all - and it would eventually be confirmed. Most transactions did pay a fee, but the fee was insignificant. We had some "fee events" in the early bitcoin days, but they were resolved quickly (either by increasing the default max generated block size soft limit in the Bitcoin Core software, or by reducing the default fee in the Bitcoin Core software) - and in any case, the fees were never as bad as today.

We've gone from a situation where the fees were to be considered a complimentary tip to the miners to a situation where there does exist some sort of a "fee market", and transactions with too low fee paid basically may be stuck for hours, days or weeks, or even not executed at all.

Characteristics of an inefficient market

The Bitcoin Fee Market is unfortunately not a well-working market - not at all. Here are some characteristics:

• No stable market price - no good price discovery (the range of the fees paid is huge, and the minimum fee for getting the transaction included in a block changes erratically)
• Capacity and demand does not always meet each other (there may be people out there that are willing to transact for a much higher price than the minimum fee needed to get into the block - due to lack of information and/or risk of stuck transaction problem they do not transact - and quite often there are even periods with idle capacity).
• Most of the time people are paying much more than needed in fees.
• Demand is ultimately destroyed (people flee from crypto in general due to bad user experiences, starts using alt-coins, limit their transactions to a bare minimum, just keep their coins on centralized exchanges rather than in their own wallet, or exchange IOU-tabs instead of transacting.

Reasons for market place inefficiencies

Traffic flow vs marketplace

Bitcoin used to work so that one could just press a button for "send bitcoins" whenever they need to send money, the money would eventually come to the intended recipient and be irreversibly confirmed within an hour or two. This is still the expectancy of most of the users. As the traffic volume started hitting the capacity limits, this became more of a traffic flow/congestion-style problem than a market place problem. The big difference between traffic flow and Bitcoin is that whomever pays the highest fee gets through first - but still, traffic flow theories applies much more than theories of economics.

Missing information

An efficient market requires that most participants to have full knowledge of all available information.

I believe there is a big problem that many participants in the "fee market" aren't even aware that they are participating in a "fee market" nor how the mechanics of the market works; this can be witnessed by the endless debates in social media:

A: This Bitcoin thing doesn't work, I had to pay $30 for my $5 transaction yesterday
B: Nonsense, the fees aren't that bad - I paid $.30 for my $5000 transaction today, that's really insignificant!

To throw in a transaction with the perfect fee, one also needs to know a bit about the immediate future; the perfect fee estimate at the time the transaction was broadcast may prove to be far too little when one hour has passed without any miners finding a block.

Due to those information gaps one does have free capacity every now and then (well, not during the last few weeks at the time of writing, but it has still been possible to get transactions through spending low fees). At the same time there is potential demand out there due to people that have either stopped using bitcoin completely because "fees are too high", or who is procrastinating a transaction, paying by other means than Bitcoin or producing a tab because they believe the "fees are too high".

Usability problem

In most auctions the bids either has an expiration time or it can be cancelled - or the auction itself is fast-paced and over within minutes. Not so with the Bitcoin fees - a low bid may be stuck forever. Further, in most auctions there aren't much more at stake but the trade itself. With the bitcoin fees, the important part is not the fee itself but the bitcoins in the transaction, which also will be stuck if the "fee bid" fails to clear. It's a bit like stacking up all your belongings preparing to move from A to B, throw in a bid for a moving company to do the actual moving and then have to sleep on the concrete floor until someone picks up the bid - potentially forever if the bid is too low. You would make sure to make the bid high enough, wouldn't you?

"Settlement layer" philosophy

The "Bitcoin Core" philosophy is that the Bitcoin blockchain should only be used for bigger settlements, with daily transactions going offchain (with sidechains and lightning network being the long-term strategy, and tabs or internal transfers on the exchanges being the short-term solution). Such settlement transactions are usually not time-sensitive, so there is no need to pay the premium charges to ensure fast settlement.

The risk of having the transaction stuck forever is still a problem - but there exists three solutions to that - RBF (allowing the sender to increase the fee as well as modify the transaction), CPFP (the receiver of the funds may forward the funds and spend a high fee to ensure confirmation of both transactions), and bribing a miner to prioritize the transaction.

With Bitcoin one has RBF - "Replace By Fee". If an optional "replaceable"-flag is set when sending the transaction, one may replace the pending unconfirmed transaction with a new transaction with more fee paid. This way one can increase the bid any time as well as modify the transaction (i.e. pay more/less to the receiver or add more payments into the same bitcoin transaction). The resulting fee market should work quite a bit better - though, there is still no way to cancel a losing bid (all your boxes are packed and ready for the moving, and you discover the prices for moving is unacceptably high).

This "settlement vision" is largely incompatible with "pay for a coffee"-use case. The hope is that the Lightning network will solve this use case - however, the Lightning Network is not ready, it may be overhyped, we don't know if it will live up to the promises.

Bitcoin Cash philosophy

Most of the Bitcoin Cash supporters believes the main problem with the fee market is that the supply side is artificially limited - hence the maximum block size limit has been increased. Then again, as long as there frequently is free capacity in the network, there isn't any real "fee market". The supply outweighs the demand, probably transactions may be included for free, but there exists an established fee recommendation.

Some critics claim that there exists a nearly a bottomless demand for cheap transactions, the 8 MB block size limit will sooner or later be met, and a blockchain growing exponentially in size isn't much sustainable. There is another aspect of the fee market - the potential tragedy of the commons - the blockchain itself is the "commons", every node has to carry the cost of a bloated blockchain, while the cost of mining a block is largely independent of the block size. Peter Ruzin has suggested that miners will want to keep the blocks small to reduce the orphan risk, further there is the "emergent consensus"-proposal where the miners agree on a de-facto block size limit and enforces it.

Another thought, a blockchain is basically an immutable, long-term redundant data storage, and such storage should have a non-zero market price. If such storage is for free, nothing stops people from using the blockchain as a backup storage for encrypted personal photos and videos. Few would disagree that this is a bad idea and abuse of the blockchain, but still you can't have a censorship-resistant blockchain without allowing for such a use case. In the long run, probably the only thing that can save the blockchain from such abuse is a working fee market. Bitcoin Cash has not solved the fundamental problems of the Bitcoin fee market - rather the opposite, as RBF (which may complicate a coffee purchase a lot) has been removed. However, in practice "spam" is rarely a big problem in cryptos, bitcoin has mostly been working great until we started banging our head into the capacity celiling, and Bitcoin Cash continues functioning well.