Crypto transaction fees: What are you paying for?

18 May, 2019

Every attempt to buy or sell Bitcoin comes with a transaction fee. The same is true for any other cryptocurrency out there. You might also pay a fee when you use your bitcoins to pay for something. For example, any of the online casinos mentioned on the website might charge a small transaction fee for Bitcoin deposits.

So what do these fees pay for, exactly? Well, a lot of things. Fees are instituted within cryptocurrency for the same reason they exist in the traditional banking sector. The main difference between the two is that the crypto universe tends to offer lower fees across the board.

You may have noticed that crypto fees have started to rise. There are some very good reasons above and beyond profit. That is what we will discuss in this post. By the time you finish reading, you should have a thorough understanding of why cryptocurrency fees exist, who assesses them, and what they are actually paying for.

Fees for buying and selling

The main place for buying and selling cryptocurrency is the exchange. You might buy bitcoins on a global exchange accessible from anywhere in the world. You might choose to buy on a local exchange as well. In either case, you are virtually guaranteed to pay some sort of transaction fee. That fee applies to both you (as the buyer) and the seller from whom you purchase.

Yes, there are fees on both ends of the transaction. Every time a buy/sell transaction occurs on an exchange, the exchange owner charges a fee to both parties. It may be a flat fee or a percentage of the transaction. As for what those fees cover, there are three things to consider.

1. Operating expenses

We will start with operating expenses given that they are the easiest to understand. Running an exchange is not a cheap enterprise when you consider the amount of raw computing power necessary to make it happen. Therefore, exchange operators have to charge fees to cover their costs. The have to pay for the electricity somehow. They have to cover the cost of enough bandwidth to keep up with all of the orders.

How much of a transaction fee goes toward operating expenses is anyone's guess. Is it 40%? Is it 50%? There is no way to know. The one thing we do know for sure is that exchanges will probably never offer free trades for an extended amount of time because operating expenses still have to be paid.

2. Exchange profit

Equally easy to understand is the profit exchange operators are working to earn. With the exception of a small number of decentralized exchanges that do not operate as profit-making ventures, most exchanges exist for the purpose of making money. Exchanges are businesses first and foremost.

There's no point in begrudging exchanges for wanting to make a profit. The ability to generate profit fuels just about every new innovation that comes our way. Without the profit motive, the technologically advanced world we now live in would not exist. Profit is good; profit is necessary to keep innovation coming.

Once again, we don't know how much of an exchange's fees constitute profit. A good guess would be anywhere between 25% and 40%. But that is just a guess and it could obviously be higher or lower than that.

3. Incentivizing miners

The third component in cryptocurrency fees in an exchange environment is the need to incentivize miners. If you are familiar with the actual mechanics behind cryptocurrency, you know that miners are required to process transactions, verify the network's ledger, and even maintain the network over time.

Being a miner requires a heavy investment in hardware and infrastructure. Mining is also a costly enterprise due to the amount of computing power and electricity needed to make it work. So just like exchanges, miners have costs to cover. Those cost increase with every transaction that takes place across the network.

Exponential increases in cost explain why cryptocurrency fees suddenly spiked. All of that is explained in the next section. As you read that explanation, bear in mind that miners are paid for their work in new coins. If the value of the coins they earn does not exceed the amount of money they are spending to mine, mining is no longer financially viable.

The ever-growing ledger

Bitcoin and its descendants operate on what is known as a distributed ledger. This ledger consists of blocks of information pertaining to each and every transaction. The ledger itself is built on blockchain. As you may have guessed, the term 'blockchain' is derived from the fact that transaction data is continually added to the end of the ledger in a series of blocks. All of those blocks linked together form a chain.

Blockchain architecture dictates that the ledger continually grows with each new transaction. But remember, every new block in the chain is linked to the block before it and the one that will come after it. This means you have an ongoing stream of information that only continues to grow as transactions occur on the network.

Continual growth requires more computing power to generate new blocks. As the ledger grows, the amount of computing power required to mine also increases. Therefore, coins have to be worth more in order to incentivize miners to keep doing what they do. How do fees play into this? By inflating the cost of buying and selling coins.

Using Bitcoin as an example, the monetary value of a cryptocurrency is determined primarily by supply and demand. As more people buy bitcoins, their value goes up. Fees play a crucial role here.

Higher fees may dissuade some coin owners from selling at certain points. They do not want to sell and take a big hit in fees based on current price, so they hold. Preventing larger scale selloffs helps to maintain price stability.

On the other side of the coin, higher fees push the total cost of buying bitcoins up. While that does not directly affect coin price, it does affect coin price indirectly. Higher fees create a higher total cost of buying. In the minds of potential buyers, the overall higher cost is an invitation to buy in hopes that prices will go even higher.

Merchant fees on payments

Thus far we have only discussed the fees involved with buying and selling coins on an exchange. But what about those fees that merchants charge for making crypto payments? What are they all about? The answer lies in comparing said fees with the fees you might pay for using a debit or credit card.

Let us assume you normally fuel your car with a debit card. You will be paying a fee for that privilege whether you know it or not. One fuel station may tack on a fee to the cost of your fuel. We'll just pull a number out of thin air and say it's 1.5%. A $10 purchase would cost you $10.11 rounded up. Simple enough.

Another fuel station may build that fee into its price rather than charging it directly. You still pay the same $10.11 for your fuel, but that charge is determined by higher fuel price rather than a lower price with a direct charge added. The point is you will pay the fee one way or the other. Why? Because the fuel station pays a fee to accept your debit card.

Merchants do not have the ability or authority to process debit and credit card transactions on their own. Everything has to go through the centralized banking system, which requires several layers of electronic mediation. It could involve a minimum of two networks, though oftentimes it is three or four.

The fuel station must run all of its debit and credit card payments through a payment processor. That payment processor must run all its transactions through at least one payment network capable of settling payments between banks. So the fuel station pays a fee to the payment processor while the payment processor pays a fee to the network.

Guess what? The fuel station and payment processor aren't eating those fees. Ultimately you, as the customer, cover those fees all the way up the ladder.

The same is true with cryptocurrency. When a merchant charges a transaction fee to crypto users, that fee is going to cover the fees he is charged by the payment processor. The payment processor charges a fee to cover its costs, which might also include fees.

Demand pushes fees higher

Based on our explanation of incentivizing miners, it makes sense that higher demand for cryptocurrency will push fees higher. Every entity involved in a given transaction has to cover its costs and generate a little bit of profit. As such, increased activity on a cryptocurrency network means all of those entities are spending more to do what they do. That ultimately means higher costs that eventually trickle down to single users.

Cryptocurrency fees are increasing because the cryptocurrency winter appears to be over. More people are buying cryptocurrencies, pushing demand and prices higher. This means more transactions, more merchant payments, and higher fees for everyone.