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Bitcoin: Fee-Based Security Modeling

Bitcoin: Fee-Based Security Modeling

Posted 3/9/21 by Lyn Alden

Over the past decade, the Bitcoin network has been the most secure public blockchain.

This is because it has by far the highest market capital­iza­tion and hash rate in the asset class, along with customized hardware required to mine it, meaning that the cost for a poten­tial attacker to try to control 51% of the hash rate for a lengthy period of time (which would allow for double-spending attacks and other security disrup­tions) is quite high.

However, in the decade ahead, bitcoin will gradu­ally shift from paying miners primarily through bitcoin block rewards to paying miners primarily through bitcoin trans­ac­tion fees, and so it has to navigate a gradual change in its security model.

Some bitcoin bears consider it inevitable that bitcoin will fail in this transi­tion and encounter security problems. Many bitcoin bulls consider the risk to be a non-issue.

Like most things in life, in my analysis I find the transi­tion to be middling in terms of risk poten­tial. It’s something to think about and monitor to see how it develops over time as one of bitcoin’s final tests on its way to maturity, but not something that has insur­mount­able economic or technical issues.

This article dives into some of the nuances, where I analyze the topic mostly from an economic point of view rather than a technical point of view.

How Bitcoin Manages Security

Bitcoin’s blockchain is a public and immutable ledger of past trans­ac­tions, stored by count­less devices around the world.

Every ten minutes on average, another block is added to the blockchain by a miner that solves a puzzle from the previous block, and in doing so, it processes up to a few thousand bitcoin trans­ac­tions and adds them to the blockchain, encased in that new block. Once several more blocks have been built on top of that block, the trans­ac­tions in that block become effec­tively perma­nent. As of this writing, there are over 670,000 blocks on the bitcoin blockchain since its genesis in 2009.

The primary reward for the miner that adds the block is a certain number of newly-gener­ated bitcoins. That’s the only way that new bitcoins are created. During the first 210,000 blocks (approx­i­mately 4 years of time), the reward was 50 new bitcoins per block, to the successful miner. During the next 210,000 blocks, the reward was 25 new bitcoins per block. It keeps getting cut in half like that every 210,000 blocks, and is currently 6.25 new bitcoins per block. This process asymp­tot­i­cally approaches a total number of 21 million coins in existence sometime after 2100, although by 2030, the vast majority will have been mined.

The secondary reward is trans­ac­tion fees. Users can add fees to their trans­ac­tions to incen­tivize miners, which during busy times (meaning too many trans­ac­tions trying to clear vs the amount of avail­able block space) helps miners prior­i­tize high-impor­tance trans­ac­tions. If you’re trying to settle a $10 million trans­ac­tion, for example, you’ll be willing to pay a higher fee than someone trying to settle a $1,000 trans­ac­tion. This dynamic helps get the most trans­ac­tion value settled per block in a free market way. The fees are denom­i­nated in fractional bitcoins and paid by the sender as part of the transaction.

Here’s an annual history of block rewards and fees for miners, in terms of dollar value, from back in autumn 2020:

Bitcoin Fee History

Chart Source: NYDIG: The Power of Bitcoin’s Network Effect

The numbers in this chart repre­sent the annual security and processing budget for the store of value and payment settle­ment network.

As bitcoin’s price has gone up over time, miner revenue has increased, even though the block reward was cut in half every 4 years. In other words, miners receive fewer coins for their efforts, but a higher dollar amount worth of coins, and a small but growing amount of fees. Fees tend to spike during congested periods, in addition to having a struc­tural growth trend.

Here in 2021, there will be a total of about 330,000 bitcoins rewarded to miners as block rewards. At an average bitcoin price of $40,000 as an example, the total amount of block rewards to miners would be approx­i­mately $13 billion. Fees would be added to that. We won’t know the total security budget until the end of the year, based on average prices and fees. Until then we can monitor it over time.

Looking back over the past decade, this chart shows the average market capital­iza­tion of bitcoin, the annual security spend, and the percent of market capital­iza­tion spent on security:

Bitcoin Annual Security

Data Source: YCharts

For the first two months of 2021, the average market capital­iza­tion was $740 billion, with an annual­ized security spend rate of $15.3 billion, repre­senting 2.0% of the market capital­iza­tion. This continued the trend of higher absolute security with a smaller percentage of market capital­iza­tion being spent on security.

Impor­tantly, the market decided how much security there would be, rather than some central authority. As bitcoin followed its algorithm, including diffi­culty adjust­ments and supply flow halvings, users purchased or sold bitcoin based on the prices they wanted, and miners allocated capital to mining based on risk/reward assess­ments. Miners could have mined other blockchains or they could have done something entirely different with their capital.

This chart shows what the average cost of trans­ac­tion was since incep­tion of the data, along with the fee portion of that cost:

Bitcoin Cost and Fees

A Closer Look at 2020

If I take a snapshot of full-year 2020, we can dig a little deeper and firm up the numbers of what a given year looked like.

307,439 trans­ac­tions were settled per day on average:

Bitcoin Transactions per Day

Since a single trans­ac­tion can send to multiple addresses, the total number of individual payments was higher, at over half a million.

The average cost per trans­ac­tion was over $44, which includes fees and block rewards to miners:

Bitcoin Cost Per Transaction

With 366 days in the leap year, that gives us a total of well over 100 million trans­ac­tions and over $5 billion in miner revenue.

The average market capital­iza­tion was $203.53 billion:

Bitcoin Average Market Capitalization

So, bitcoin spent about 2.5% of its average market capital­iza­tion on security and processing that year.

However, the vast majority of the cost per trans­ac­tion was in the form of block rewards, which is a form of infla­tion that doesn’t affect the sender directly, and instead affects the whole network. In terms of fees for the sender, the average trans­ac­tion took just $2.86 in fees:

Bitcoin Transaction Fees

The mean trans­ac­tion size was several thousand dollars, while the median trans­ac­tion was much smaller.

Coinmetrics Bitcoin Fees

Special thanks to Nic Carter for the Coin Metrics chart and his previous work on the subject of bitcoin fees. He gave a talk at MIT back in 2019 about this topic that remains relevant through today.

Overall, nearly $1 trillion in USD value was settled on the bitcoin blockchain during the 2020 year. That’s impor­tant to note; annual settle­ment value was much higher than bitcoin’s average market capital­iza­tion, and that’s true for prior years as well.

If bitcoin were running on a fee-driven model in 2020, with say $40 in fees per trans­ac­tion, the average $8,000-sized trans­ac­tion would have a relatively low fee (~0.5%), but many of the median-or-smaller trans­ac­tions would no longer make sense. Most folks wouldn’t want more than, say, a 1 – 2% trans­ac­tion fee, and so trans­ac­tions under $4,000-$8,000 would be less attrac­tive to do as a matter of normal operation.

Bitcoin, there­fore, would be a base settle­ment layer, rather than a frequent payment network. Payment networks can be built on top of it, as some appli­ca­tions are already doing via the light­ning network and other solutions. This should work well if bitcoin’s adoption continues to increase in the decade ahead.

Incentives Against Attacks

Small blockchains are often the victims of 51% attacks. With little hash power, few nodes, and small devel­oper commu­ni­ties, they have limited resources to deal with an attack. A profit-driven entity can invest a manage­able sum of money and perform a double-spend attack to steal millions of dollars worth of tokens.

Bitcoin, however, is extremely resis­tant to 51% attacks, because the amount of dedicated hardware and electricity that an entity must acquire to attempt one is massive.

In the early days, mining rigs believed to belong to Satoshi Nakamoto controlled over half of the bitcoin network, but he had no incen­tive to under­mine his own creation, and as the network prolif­er­ated, these rigs became less impor­tant and eventu­ally ceased. And in 2014, a mining pool came rather close to the 51% threshold, but seemingly without intent to attack it. As bitcoin has grown larger, there haven’t been any more instances of entities coming near the 51% threshold.

Besides the consensus node network, rational self-interest is basically the backup defense for a 51% attack. Miners invest a ton of capital into their rigs and gener­ally own a lot of coins; if they were to achieve a successful 51% attack on bitcoin and threaten the security of the system, it would likely damage the market capital­iza­tion of the network, resulting in a reduc­tion in their income and net worth, even if they were able to steal some coins in the attack. And the resulting pushback from the rest of the ecosystem in the wake of such an attack against them would be immense.

As the network has grown larger and larger, and the bitcoin network consumes as much electricity as a small country, the cost for coming anywhere close to a 51% attack threshold and holding it persis­tently, is out of the reach of most entities. Only an extremely well-capital­ized attack, such as a consor­tium of state actors, could poten­tially be incen­tivized to attempt a credible attack of that magnitude.

A Hypothetical State Attack

For a sophis­ti­cated state entity to attempt an attack on bitcoin in its current form (most likely for reasons other than profit, although they could also short the protocol to recoup costs and poten­tially make a profit), they’d have to do a bunch of things.

First, they’d have to acquire the majority of dedicated ASIC hardware for bitcoin mining. These are often in short supply, meaning if they tried to buy up a signif­i­cant portion of new mining rigs from manufac­turers and old mining rigs from the second-hand market, they’d likely be unable to, and the market would notice. As I write this, new mining rigs are sold out months in advance.

If they were to build their own mining rigs in some covert way, down to custom chips via their own foundry (and very few countries have sizable foundries), it would be a long and challenging process and require avoiding infor­ma­tion leaks. This would be a multi-billion dollar long-term effort in secret.

If over half of the mining capacity exists within a single country, the govern­ment could theoret­i­cally confis­cate enough mining rigs to reach a 51% attack threshold without buying new rigs. The only country where this is a possi­bility is China due to their large hash rate exposure, although it’s only an estimate that China has over half of the hash rate. However, miners often keep their locations relatively secret, because finding cheap sources of electricity is a key business advan­tage vs competi­tors. In addition, many miners are mobile; they move around to wet seasons where hydro­elec­tric overca­pacity exists, or to stranded shale energy. And if miners start getting confis­cated system­i­cally, the remaining miners would disap­pear. It would be exceed­ingly diffi­cult for the Chinese govern­ment to locate and simul­ta­ne­ously seize the vast majority of mining that occurs in its juris­dic­tion. And over time, if mining becomes more diver­si­fied across geogra­phies, it would take that unlikely mass-confis­ca­tion option off the table entirely.

That’s the hardest part of doing a 51% attack on bitcoin; getting the dedicated hardware. Folks often calcu­late the cost of a hypothet­ical attack based on electricity or per-hour rates, but the sheer amount of hardware that would have to be acquired is immense. This is unlike GPU-based blockchains where a user could conceiv­ably rent cloud GPU time (a use-case of gener­al­ized hardware, rather than dedicated hardware) to perform an attack.

Second, once they have this in place somehow, either through buying it, building it, or confis­cating it, the state actor(s) have to concen­trate more electricity than Singa­pore consumes, and channel it at the bitcoin blockchain through their dedicated ASIC hardware to try to do a constant series of double-spend attacks or other disrup­tive efforts. With their massive covert invest­ment, they could very well be successful at messing up a few blocks and performing double-spend attacks or similar disrup­tions. They could, for example, send an entity some bitcoins in exchange for money, and then use their majority hash power to reverse that trans­ac­tion and keep the bitcoins. They’d have to sustain this multiple blocks deep in order for it to have a sizable impact on trans­ac­tions that were thought to be fully-confirmed.

At that point, it would become a battle between nodes and the majority miner, with the possi­bility of nodes changing to another algorithm or taking other major steps to avoid ongoing assault. A 51% attack does not undo the full blockchain; it reorga­nizes a few blocks deep or disrupts the process of ongoing blocks added to the blockchain, which gives time for counter­mea­sures. It would be one of the biggest tests that bitcoin has ever faced.

The diffi­culty and cost for this type of attack is why so far it has not occurred for bitcoin, and why only a large state actor, or collec­tion of state actors, who are partic­u­larly hostile to bitcoin’s existence and not concerned with the poten­tially unprof­itable nature of the attack, could conceiv­ably attempt it.

The more broadly that bitcoin spreads, including to a state’s own citizens, the more self-destruc­tive such an effort would be even if successful, which deters this “James Bond villain” secre­tive level of capital and effort the state would have to go through to attempt it.

However, if it’s going to remain as successful as it has been, Bitcoin does have to grow a sustain­able fee market to keep those types of attacks very expensive.

Determining an Appropriate Security Model

As bitcoin’s market capital­iza­tion has grown, the absolute amount spent on security has grown as well, but the percentage of the market capital­iza­tion spent on security has diminished.

Indeed, that’s what we should expect to occur over time. Paying a huge percentage of the market capital­iza­tion in security each year made sense in the begin­ning when the protocol was small, vulner­able, and highly infla­tionary, but in the long run from a large market size and small issuance rate, something more like 0.5% to 1.5% of market capital­iza­tion spent on security would probably be appropriate.

And remember, bitcoin’s annual settle­ment value is a few times larger than its market capital­iza­tion. Relatively small fees on trans­ac­tions can poten­tially result in a sizable percentage of bitcoin’s market capitalization.

Ideally, the security spending rate should be large enough in absolute terms to deter most realistic attacks, and large enough as percentage of the market cap or annual settled value to make attacks uneco­nomic, while not so large as to make normal settle­ment trans­ac­tions uneco­nomic due to needlessly high fees.

The challenging thing is that there’s no firm number on what level would be appro­priate; it’s all an approx­i­ma­tion. In practice, bitcoin doesn’t optimize itself for security, but rather security is a natural byproduct of the incen­tive mecha­nism for mining, which means there could conceiv­ably be times where security is quite high or quite low compared to credible threats. Bitcoin’s network is not doing a quali­ta­tive or quanti­ta­tive assess­ment of the threat landscape and adjusting fees accordingly.

After the next supply halving in 2024, bitcoin’s infla­tion rate will be less than 1% per year, and it will continue dropping every 4 years from there asymp­tot­i­cally toward zero, so in order to maintain something like a 0.5%-1.5% ongoing security rate as a percentage of market capital­iza­tion, it’ll need to develop a sizable and persis­tent fee market.

This chart shows the amount of fees per year and the percentage of the average market capital­iza­tion that the fees made up each year:

Bitcoin Annual Fees

Data Source: YCharts

For the first two months of 2021, the average market capital­iza­tion was $740 billion, with an annual­ized fee spend rate of $1.85 billion, repre­senting 0.25% of the market capitalization.

Inflation vs Fees

If security is paid for primarily through block rewards, then the holders of the coins are the ones primarily paying for it, in the form of inflation.

If security is paid for primarily through fees, then the senders of the coins are the ones primarily paying for it, in the form of the miner taking a cut from their transactions.

So, over time, bitcoin’s security model is programmed to shift primarily from charging the holders to charging those whom transact.

If, in some alter­na­tive design, bitcoin eventu­ally reached a point after a certain number of halvings where it had a constant issuance, like say 0.5% per year perpet­u­ally, then along with fees that senders pay, it would have a situa­tion where both holders and senders continue to pay for a base level of security. But as it was designed, bitcoin shifts over time to putting all of the emphasis on sender fees for security, with holders paying virtu­ally nothing.

Whether that’s good or bad is up for debate. On one hand, it’s sensible to argue that both holders and senders should contribute to security, since they both benefit from it. On the other hand, the hard supply limit has been a main selling point for people to buy units of the system, and likely increased its adoption rate and attrac­tive­ness as a store of value. A shift from a hard cap to low perpetual issuance would be the last resort among the commu­nity, so navigating to a fee model will be impor­tant for the ongoing success of the protocol.

A Spectrum of Security

This table shows the amount of money that would need to be spent on security to achieve a certain percentage of market capital­iza­tion, for various market capitalizations:

Bitcoin Security Spectrum

Bitcoin in its current form can settle 120+ million trans­ac­tions per year on the base layer. Let’s call it 100 million as a round number, since we’re talking orders of magni­tude here. And impor­tantly, a trans­ac­tion can send bitcoin to multiple addresses, so you can batch multiple payments into a trans­ac­tion. So, the number of payments is realis­ti­cally up to a few hundred million per year.

If bitcoin reaches a state where the average trans­ac­tion fee is about $10, it would trans­late into $1+ billion per year towards miners. If we add a zero, and the average trans­ac­tion fee gets to about $100, it would trans­late into $10+ billion per year towards miners. For refer­ence, as of the first couple months of 2021, the fee has been up to $20+.

For payments of $10,000 or more, $100 or less in fees trans­lates into 1% or less of the trans­ac­tion value. So, the base layer would remain attrac­tive for large settle­ment trans­ac­tions, but would be unattrac­tive for small payments. Bitcoin, in that sense, becomes something like a decen­tral­ized and permis­sion­less Fedwire system, relying on secondary layers to improve trans­ac­tion throughput for smaller users.

We can also compare it to gold, as a store of value. If you buy physical bullion, you would expect to pay a 2 – 10% or more markup over the spot price for your trans­ac­tion, depending on whether you’re buying coins or bars, and sometimes more during supply short­ages. And then you have to protect it yourself or pay a vault to store it safely.

Payment Scaling Solutions

If we look at the current finan­cial system, it consists of layers.

There are deep settle­ment layers like Fedwire at the base, which process relatively low numbers of irreversible seven-figure trans­ac­tions between banks.

On top of those deep layers, there are layers that optimize for more frequent and smaller consumer trans­ac­tions which are reversible. When you spend with your Visa card, for example, that’s not a final settle­ment irreversible payment in and of itself; that’s merely a trans­ac­tion that the bank will later batch into a larger Fedwire payment with another bank.

This is why the “bitcoin doesn’t scale; it processes only a fraction of what Visa can do” argument is like comparing apples to oranges. Or more specif­i­cally, it’s like comparing a whole­sale distrib­utor of apples to a retail apple-selling stand.

The bitcoin network has trans­ac­tion count throughput capacity similar to Fedwire; when and if more and cheaper trans­ac­tions than that are needed, that’s what secondary layers are for.

The various bitcoin forks that attempted to increase trans­ac­tion throughput on the base layer didn’t work out well so far; they split the commu­nity, still didn’t achieve throughput anywhere near that of Visa, and sacri­ficed too much (acces­si­bility and decen­tral­iza­tion of node operation).

Bitcoin Secondary Layers

Not all or even most bitcoin trans­ac­tions have to settle on the base layer of the protocol. The base layer is ideal for final settle­ment for large trans­ac­tions, especially as trans­ac­tion fees grow as a percentage of the security budget.

Above the base layer, there are various scaling solutions for higher-frequency trans­ac­tions, and they can be either trusted or trust­less, or somewhere in the middle.

For a trusted example, every central­ized exchange is basically a scaling mecha­nism. When you trade bitcoin or various altcoins on an exchange, those aren’t on-chain trans­ac­tions. Those are trans­ac­tions within the internal ledger of that exchange. In other words, many trans­ac­tions occur back and forth, and some of the value is settled on-chain eventu­ally when entities withdraw or deposit coins. The custo­dian acts as a way to greatly increase trans­ac­tion volume, since those intra-exchange trans­ac­tions are settling off-chain with occasional batching into bigger trans­ac­tions to actually move coins.

For a trust­less example, there’s the Light­ning network. The Light­ning network lets users open multi-signa­ture channels with each other, and from there they can send fractions of bitcoins back and forth without the cost of an on-chain settle­ment. If at any point one of them wants to settle, they can close the channel and settle back on the base layer with an on-chain trans­ac­tion. There­fore, you can fit many trans­ac­tions, for a nearly free cost, into one fee-driven large settle­ment. Impor­tantly, you don’t need a channel open with the person you’re trying to transact with. You only need to have a path from node to node to node that eventu­ally links to that person.

The limita­tion of the Light­ning network is liquidity. If you don’t want to open a private channel with someone, you have to send fractional bitcoins around from node to node to node in order to reach the target, and that means there has to be a sizable amount of channels between you and the target to make that possible, and there have to be suffi­cient tools to automate it. Public node opera­tors can place some bitcoins on their channels, and sell access to those channels for a tiny fee, and thus earn a small ongoing yield on their bitcoins.

Light­ning Labs and other devel­opers continue to build tools to help apps and users enhance liquidity and usability on the network. The Light­ning network itself, like the under­lying base layer of bitcoin, is owned by no one. If it continues to grow larger and larger, then liquidity becomes less of a constraint, and the usability increases.

And then there are mixed solutions. Some trusted proto­cols can use a set of private channels in the Light­ning network to provide fiat-to-BTC-to-fiat payment solutions to customers that don’t neces­sarily even know that they are using the Light­ning network, like with the Strike and Bottlepay apps. The total address­able market for that, partic­u­larly with regard to small domestic and inter­na­tional payments, is huge.

Micro­pay­ments on the internet, such as through Sphinx Chat (which uses the Light­ning network) open up all sorts of revenue models for online businesses, as well as anti-spam measures in chat inter­faces (via a tiny but nonzero cost to post a message).

Other Uses of Block Space

Block space in bitcoin’s blockchain is just infor­ma­tion; it doesn’t all have to be used purely for payment trans­ac­tions. Messages can be and have been included in various trans­ac­tions within blocks, including by Satoshi Nakamoto in the genesis block.

A given block on the bitcoin blockchain, as an immutable distrib­uted public ledger, can be thought of as virtual real estate, and only 144 blocks are avail­able per day on average. Most uses are for settling bitcoin payments, but the space within a trans­ac­tion can be used for other purposes too, because any infor­ma­tion you put there becomes perma­nent and publicly-available.

There’s poten­tially a use-case for that, because you can put something there as a matter of public record, as an arbiter of truth that is stored on count­less devices around the world that can never be changed once it’s buried under more blocks.

Over time, various services have been willing to pay trans­ac­tion fees to secure messages inside of the bitcoin blockchain. Veriblock, for example, has a service that allows weaker blockchains to “inherit” bitcoin’s security by using the OP Return operator. Veriblock and similar solutions accounted for a double-digit percentage of Bitcoin’s ongoing trans­ac­tions for a couple years, although in recent years this practice has tapered off:

OP Return Usage

Chart Source:

Overall, non-trans­ac­tional messages are no longer a big portion of bitcoin’s block space usage, but in the future this could conceiv­ably pop up again if new use-cases are identi­fied. Many of the previous use-cases have migrated to become ethereum tokens and trading around in that space instead.

Potential Security Quirks

It seems that we’ve estab­lished that econom­i­cally, bitcoin should be able to comfort­ably sustain itself with fees, although it’s by no means assured. It depends on bitcoin’s overall level of adoption and usage.

If bitcoin grows and sustains into a multi-trillion market capital­iza­tion protocol, and fees can become 0.5%-1.5% of the market capital­iza­tion due to packing a lot of value into the block space (including batching of smaller trans­ac­tions), it would trans­late into a $5 billion to $15 billion annual security budget per trillion dollars in market capital­iza­tion, with dedicated hardware and high electricity costs.

On the other hand, if it fails to sustain a suffi­cient market capital­iza­tion, or annual fees fail to reach and sustain 0.5%-1.5% or more of the market cap, then bitcoin could face some security issues in the long run, with 51% attacks becoming more econom­ical to attempt compared to the possible rewards of achieving it.

From there, we can look into some non-economic issues that could theoret­i­cally occur.

Block Variability

A 2016 paper called “On the Insta­bility of Bitcoin Without the Block Reward” by Princeton Univer­sity researchers used game theory and simula­tions to assert that fee variability could be an issue, even if total fees are high enough. In other words, timing matters in addition to just average fee levels.

Blocks are gener­ated every 10 minutes on average. However, there is a lot of random­ness in the amount of time between blocks, since it relies on count­less machines racing to solve a crypto­graphic puzzle. A block could be added seconds after the previous block, or could take 30 minutes or more.

In the current regime, that doesn’t matter too much because each successful block, no matter how short or long it took, provides economic value to the miner because it comes with a number of new coins. However, in a future world with virtu­ally no block rewards and primary reliance on fees, a block that happens to be gener­ated mere seconds after a previous block, might find itself with rather few trans­ac­tions in it, making it a low-value block. With big variance in value between blocks, there are some games miners can play to fork the protocol to try to maximize their fee value, which could result in longer confir­ma­tion times or other security issues.

The primary counter­ar­gu­ment for that, as described back in Dan Held’s 2019 piece refer­encing Dan McArdle, is that miners, as large opera­tions with dedicated equip­ment and serious sunk capital expen­di­tures, are unlikely to mess around with block-by-block games and instead will optimize for revenue over a full quarter.

Further­more, if block reward variability does become a security issue over time, there are theoret­ical updates to smooth out the fees without increasing the 21 million supply limit.

Off-Chain Dominance

A blockchain that is entirely reliant on fees rather than infla­tion for security, as bitcoin is destined to be in the future unless consensus rules change, only gains security benefits when its tokens are trans­acted with rather than held.

In that fee-based model, those who are holding the coins perma­nently and not moving them are not contributing to security, whereas those who are moving coins around for one reason or another are contributing to security.

If bitcoin theoret­i­cally were to reach a state of very low velocity, with plenty of people holding it but relying heavily on custo­dian solutions or things like ethereum-wrapped BTC to move it around without being willing to pay substan­tial fees for on-chain trans­ac­tions, that can under­mine the fee-based security model.

However, such a problem is likely self-correcting towards equilib­rium. If few entities use on-chain trans­ac­tions, then fees will diminish, as the supply/demand balance tilts more towards supply. That can attract entities back to using on-chain trans­ac­tions, due to the security assur­ances of doing so.

The question is whether fees can reach a point where they reliably are 0.5%-1.5% of market capital­iza­tion, but fortu­nately the protocol has another full halving cycle or two to get there.

If bitcoin user adoption goes up another 5x or 10x in the years ahead while block space remains unchanged, it shouldn’t be too diffi­cult to generate a persis­tent high fee market, with off-chain solutions used for smaller trans­ac­tions where the fees would be uneconomic.

Final Thoughts

By the time the late 2020s are here, some of bitcoin’s hard forks such as BCH and BSV are likely to face increas­ingly existen­tial security issues, since their large block space doesn’t have enough demand relative to supply to drive fees up, and block subsi­dies will diminish.

Indeed, their hash rates are already about 1% or less of bitcoin’s hash rate, and are near their all-time lows while bitcoin’s hash rate is near its all-time high:


Chart Source: BitIn­foCharts

Bitcoin itself, however, has a sizable fee market for its rather tight block space; even at $10 in fees per trans­ac­tion, it can sustain a $1+ billion annual fee rate. $20 per trans­ac­tion gets you $2+ billion in annual fees, $30 per trans­ac­tion gets you $3+ billion in annual fees, and so forth.

The question will be whether that’s enough, or whether fees will be notably higher than that. And overall, the answer to that question will largely depend on bitcoin’s eventual level of adoption.

Ultimately, since security through fees is econom­i­cally workable based on achieving suffi­cient long-term adoption, it boils down to one of Satoshi’s original propo­si­tions that bitcoin will have a rather binary outcome:

I’m sure that in 20 years there will either be very large trans­ac­tion volume or no volume.

Satoshi Nakamoto

The ideal state for the bitcoin network in the future is to reach equilib­rium in the fee market such that blocks are consis­tently full, mostly with large trans­ac­tions, and fees are substan­tial in absolute terms but low in percentage-of-value terms.

Some of those large trans­ac­tions would be settle­ment between major entities, while another portion of those large trans­ac­tions would be batches of many smaller trans­ac­tions on the Light­ning network and other trusted and trust­less scaling solutions.

This blog offers thoughts and opinions on Bitcoin from the Swan Bitcoin team and friends. Swan Bitcoin is the easiest way to buy Bitcoin using your bank account automatically every week or month, starting with as little as $10. Sign up or learn more here.

Lyn Alden

Lyn is an investment strategist at Lyn Alden Investment Strategy. She holds bachelor’s degree in electrical engineering and a master’s degree in engineering management, with a focus on engineering economics and financial modeling. Lyn has been performing investment research for over fifteen years in various public and private capacities.

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26565 Agoura Rd Ste 200
Calabasas, CA USA

Swan Bitcoin does not provide any investment, financial, tax, legal or other professional advice. We recommend that you consult with financial and tax advisors to understand the risks and consequences of buying, selling and holding Bitcoin.