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Transaction Fee

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What Is A Transaction Fee?

What Is A Transaction Fee?

A Bitcoin Transaction Fee, commonly known as a miner fee, is the amount of bitcoin that a sender attaches to their transaction to incentivize Bitcoin miners to confirm the transaction and add it to the blockchain.

Transaction fees are part of the block reward and are paid to the miner in the coinbase transaction along with the block subsidy.

Fees are driven by three primary factors.

– Transaction Data Size
– Block Space Supply
– Block Space Demand

Transaction Data Size

Unlike payments within the traditional financial system, Bitcoin fees are not a percentage of the amount being sent.

Instead, Bitcoin transaction fees are based on how much data is in a transaction. Transactions with more sending and receiving addresses (inputs & outputs) tend to take up more block space than those with fewer. As a result, the more inputs and output addresses that a transaction has, the greater the likelihood that a larger fee will be needed. The number of sats per byte that the sender is willing to pay is commonly known as the fee rate.

Another important part of what determines the amount of data in a transaction is the address format and whether or not the addresses support a bitcoin improvement proposal known as SegWit (segregated witness). Addresses that support SegWit have segregated the witness part of transaction data to allow for a more efficient use of block space and allow for fewer bytes in transactions. As a result, transactions involving SegWit use less data and need a smaller fee.

Block Space Supply

The reason that transaction data size is so important is because bitcoin blocks are limited to 1 MB of data each. In order for pay the smallest fee possible, there’s a financial incentive for senders to use that limited block space as efficiently as possible. Sending transactions that require the least amount of data possible ensures that transactions will pay the lowest fee.

Everyone sending bitcoin is technically “competing” for the same limited 1MB of block space. While block space itself is limited, there is no limit to the number of blocks that will ever be mined.

Once a transaction has been sent on the Bitcoin network, it enters a pool of unconfirmed Bitcoin transactions known as the MemPool where they queue to be confirmed by miners and added to the blockchain. When bitcoin miners are building their candidate blocks, they have a financial incentive to select transactions with the highest fee rate.

Block Space Demand

With block space limited to 1MB per block, the Bitcoin MemPool acts as a sort of fee market. Those who need/want transactions confirmed as soon as possible are able to outbid other unconfirmed transactions by attaching a larger miner fee than other transactions. Naturally, Bitcoin miners tend to prioritize the higher paying transactions in order to to maximize revenue.

The fee rate of any given transaction is typically a reflection of how quickly a user wants their transaction confirmed. Using a high fee rate signals more urgency while a lower fee rate signals less urgency. Those who are willing to wait hours, days, or even weeks to have a transaction confirmed can send with a low fee rate and the miners will add it to the blockchain when the MemPool clears.

Transaction Fee Bumping

In the event that a transaction is taking too long to confirm, the owner of the sending address or any of the receiving addresses can use one of the transaction fee bumping methods to create a second transaction with an increased fee.

Fee bumping is also helping Bitcoin to scale by enabling a more precise fee market.

Bitcoin Exchange Fees

Most Bitcoin exchanges and brokerages charge some sort of fees for buying, selling, and withdrawing bitcoin. However, the fees charged by exchanges are entirely separate from the fees required to send a transaction on the Bitcoin network itself.

The only fees associated with the Bitcoin protocol are on-chain transaction fees to send Bitcoin from one address to another. There are also routing fees on a second layer of Bitcoin known as the Lightning network but they tend to be much lower than on-chain fees.