The blockchain requires upkeep in terms of both the technology base used for processing transactions and for maintaining the economic incentive of users responsible for running the networks. This means that an economy has to be in place for ensuring the uninterrupted flow of funds. Considering the speculative nature of most cryptocurrencies, they cannot be construed as a reliable means of generating stable income for the participants of network maintenance processes. As such, the only constant that can be leveraged for providing stable returns is the only element of the decentralized environment that is mandatory and fundamental for its operation – the transaction.
Since transactions are ongoing and have to be conducted for effectuating every single type of operation on the blockchain, they can be construed as the sole source of true income. As such, a fee is put in place for processing every transaction, allowing network operators to recuperate the expenses incurred for making such a transaction possible. However, the fee and its size has an impact on the end price of coins and tokens, as it is considered an inextricable element of the pricing formula.
Blockchain Fees Explained
A blockchain or transaction fee is a commission charged by the network operator for conducting a transaction. The cost includes the node or network operator’s fee based on the current energy requirements necessary for processing the operation.
As the blockchain is demand-based, the fee can increase with the rise in blockchain activity, as network operators will be facing queues of transactions. Should users be pressed to process their transactions in priority fashion, they can choose to pay a higher fee and place their operation higher in the queue, thus reducing wait times.
The Ethereum network calls the fee a gas cost, which entails the time and electricity requirements of the servers and nodes involved in processing the transaction. The ETH coin is used as payment for gas in this case. Some actions on the blockchain have different fees assigned to them, depending on their processing complexity and energy requirements.
The need for transaction costs is essentially justified by two main reasons:
- Maintaining the economic incentive of node operators and miners;
- Adhering to blockchain security principles to prevent spam attacks and deter hackers from launching massive transaction spikes.
Transaction fees also act as an important instrument for regulating network load. This ensures transaction sequencing based on the price the user is willing to pay for the proportionate time needed to process the operation, confirm, and hash it in the blockchain.
Blockchain Fee Calculation and Impact on Token Economics
Each blockchain network has its own rules of transaction fee calculation. The main principle for the applied formula is the type of network model. Proof-of-Work networks apply a formula that includes energy and hardware depreciation incurred by miners, while Proof-of-Stake networks also include the validator fee. However, the main principle that determines the size of the transaction fee is the level of network congestion at any given time.
The size of the fee will have a colossal impact on the price of certain coins and tokens, as well as their overall market performance. High fees can discourage users from performing transactions. Low fees, however, can result in higher network loads and security hazards.
The main reasons why transaction fees play a key role in token economics are the following:
- Network participant economic incentive provision through fees for work done and profit generation;
- Network load control via price adjustment to balance supply and demand, thus ensuring proper allocation of limited network computing resources;
- Economic sustainability via revenue generation and resulting upkeep of the network ecosystem;
- Scarcity principle maintenance to stimulate demand for tokens and coins and provide value;
- Governance via fees as a means of voting on network development and traction vector.
The resources required to process transactions are the determining elements of the formula. Since resources are limited, a higher transaction fee will cover the expenses entailed in processing the transaction. There are several types of fee model structures employed across networks, with the main ones being:
Fixed fee – where the cost for processing transactions never changes and does not depend on the complexity of the operation, allowing for predictability and transparency of pricing. The given type, however, can result in network congestion at peak times, as a miner incentive element is lacking.
Dynamic fee – a model where the fee is set dynamically based on the demand for transaction processing on the network at any given time. The users have the option of paying higher fees for having their transactions processed in priority fashion, resulting in a fair and transparent model.
Schedule – this model is rare, as it entails a predefined schedule of fees based on a system that ranks transactions by type and complexity. Such a structure is quite flexible and fair, allowing users to have a clear picture of how much they will pay for which kind of operation.
Token-based – this is a common structure that involves the use of native tokens for paying for certain actions within a platform or ecosystem of applications. The given model is focused on incentivizing users to resort to native tokens and push their turnover and demand.
Resource-based – as the name implies, this model calculates fees based on the amount of resources needed to process a certain operation. The resources involved are usually energy and computational expenses, like hardware depreciation over time.
Delegated fees – a rare model, whereby users delegate fee payment to someone else, like a third party. This model is usually applied in intermediary relationships.
Market-based – a common type of model that relies on market dynamics to evaluate the optimal size of the fee. Much like the dynamic model, this approach is best described as demand-based.
The Price Impact
To better understand the impact of transaction fees on token prices, it is important to look at the price from the user’s standpoint, rather than the standpoint of the network operator. Among the factors to consider in this regard are the following metrics:
Token velocity – a formula used for calculating the speed of token turnover within an ecosystem or blockchain network. High velocity means high demand for a token and short periods of their holding in wallets.
Liquidity – a key metric that determines how fast some coins and tokens are purchased once a bid for them is placed on an exchange. High liquidity is the required standard, as it allows for calculating many other metrics like bid-ask spreads, capitalization, order depth, and much more – all vital data for traders.
The effectiveness of the fee redistribution mechanism applied by a network will have a direct impact on the activity of trade, as it will encourage users to get involved in market operations. If the mechanism is set to curb demand, then users will likely be inclined to hold their tokens instead of paying high transaction fees involved in frequent operations.
Every blockchain needs funds to cover the expenses involved in maintaining operating resources. The transaction fee is the most reliable source of such income, incentivizing network operators via economic means, and users by virtue of stimulating demand for tokens and coins. The models of fee transaction calculation may be different, but they all serve the same purpose in the end.