When you hand someone a dollar bill, gold coin, or bushel of wheat, the transaction doesnt require much effort to execute. The seller holds a physical object, and apart from counterfeiting, knows that he or she has been paid. When you pay someone by credit card, money must be digitally transferred between accounts, but this is all done by a centralized company and requires only a trivial amount of computing power. But when you pay someone with a cryptocurrency such as Bitcoin, computers in a decentralized network around the world must verify the transfer from one Bitcoin wallet to another. Executing the transaction therefore requires significant real resourcesenergy needed to run computers. Those who spend the time, energy and computing power to execute payments need to be compensated.

This compensation comes in two forms. The more well-known form of compensation is newly created bitcoinsthis is the reason we call those running the software miners. Miners currently earn 12.5 bitcoins for each block of transactions (about 1MB in size) verified, over $30,000 at todays prices. But the code behind Bitcoin is designed so that this reward is cut in half when the all-time number of transactions hit certain milestones (the reward was originally 50 bitcoins). This causes the number of new coins to slow down as they reach the predetermined limit of 21 million bitcoins. The limit isnt projected to be reached for 100 years, but this form of compensation for running the system will inevitably decline in importance.

Miners are also compensated by transaction fees in the form of small fractions of a bitcoin every time you or I make a transaction. Many people dont know about these feeswidely used wallet services like Coinbase have an algorithm to determine how much you pay. Like most things about Bitcoin, the transaction fee system is decentralized, market based, and a little hard for the beginner to understand. You choose the size of the transaction fee you will pay (or no fee at all), and miners decide based on that amount whether or not to include you in a verified block. Transactions with lower fees therefore risk taking a longer time for the system to verify.

Average transaction fees have increased at a staggering pace this year, from 35 cents on January 1 to almost $4.50 today. That works out to a little more than $10,000 on average per verified block. Much of this increase is due to competition as the system becomes more crowded with transactions. But over a longer time frame, this incentive will become more important as fewer new coins are mined. Predicting the future level of these fees is difficult and depends on variables such as future computing speed, energy costs, and the value of a bitcoin. But they will be essential to provide incentives to keep the system running.

Could high transaction fees provide an open door for a competitor to disrupt Bitcoin? Bitcoin makes the verification process even more difficult and energy consuming than it needs to be in order to get the economic incentives right and keep a lid on the number of new Bitcoins. If someone designed a digital currency that solved those problems while making verification more efficient, it could presumably save consumers millions in transaction fees. Such a scenario is yet another reason why hard and fast predictions about the future of Bitcoin are a fools errand.

Read more:

Who Pays to Keep Bitcoin Running? - American Institute for Economic Research (blog)