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When a Bitcoin miner successfully creates a new block on the blockchain, they are rewarded with a block reward. But that is only one aspect of the reward. Transaction fees paid by users, the blockchain fees, are also paid to miners. In this article, we explore the concept of Bitcoin fees, and their usefulness.

The amount of blockchain fees

The minimum transaction fee is zero. Paying a blockchain fee for sending a Bitcoin transaction is entirely voluntary. But: the miners receive these blockchain fees and thus benefit from prioritizing the transactions that have been sent along the most fees.

Exchanges and brokers benefit from actually executing their transactions to avoid customer dissatisfaction. Therefore, they will always try to set their blockchain fees just high enough to allow transactions to go through.

So with that, blockchain fees are in fact network dependent. It is a game of supply and demand, dictated by how busy the network is. During times when the price of Bitcoin is high, fees tend to be higher as well.

As a result, someone who wants to transfer 10 euros in Bitcoin may even pay more than 10 euros purely in transaction fees. Therefore, for small investors, exchanges often group multiple transactions from different clients. The advantage: this way the transaction costs are shared and are lower per customer. The disadvantage: it is no longer possible to trace exactly which piece of the transaction belongs to which customer. Thus, the customer gives up control.

Fixed in the mempool

When too few transaction costs are included, as mentioned above, miners will prefer to give other transactions priority. In that case, the transaction may get stuck in the mempool. We simplify this idea:

The mempool is where all transactions are collected before they are executed. Think of it as a bus stop.

Everyone at the bus stop is waiting for the next bus (the next block). However, there are more people at the bus stop, than there is room on the bus. So the bus driver decides to let the best-paying people enter the bus and leaves the rest standing, waiting for the next bus. But between this and the next bus, new people have started to gather at the bus stop. So it can take as many as ten buses before the person who wants to pay the least can get on a bus.

After several days at the bus stop, someone is sent home: the transaction is deleted and will not be carried out if they are still stuck in the mempool by then. Each bus driver (miner) varies when this deadline expires and they send someone home.

Limited space in a block

The question for many is: why doesn't the bus company deploy larger buses so they can carry more people?

In 2017, this was a topic of discussion that eventually led to the creation of Bitcoin Cash (BCH). The group behind BCH wanted to use larger blocks to increase transaction speed and lower costs. Because the majority of the Bitcoin community was against this plan, they split from Bitcoin by creating Bitcoin Cash with a hard fork.

SegWit

Bitcoin itself found a solution to the problem of limited block size. With Segregated Witness (SegWit), the size of each transaction was reduced, allowing more transactions to be processed per block without adjusting the block size. Transactions to native SegWit addresses are typically about 70% cheaper in transaction fees.

Cryptocurrencies without fees

There are several other cryptocurrencies, or altcoins, that charge no or virtually no transaction fees. These often bear little resemblance to Bitcoin's technology.

Bitcoin also has its solution for (almost) no-cost transactions: the Lightning Network. This is a second-layer solution on top of the blockchain that enables microtransactions and aims to make Bitcoin available for daily payments. Even if you increased the block size, you would still have to wait for confirmation of a transaction, which is not practical in situations such as at the grocery store. For transactions of more than a few euros in value, the Lightning Network is less suitable.

Bitcoin is the first cryptocurrency ever created, with its main feature being the underlying blockchain technology. Bitcoin is used both as a means of payment and a significant asset in investment portfolios of private and institutional investors. Notably, Bitcoin has been recognised as legal tender in El Salvador. This article explores the history, use cases, and basic principles of Bitcoin in a straightforward manner.

The Creation of Bitcoin

Bitcoin is the first and oldest cryptocurrency. Before Bitcoin, several digital currency concepts were proposed and some implemented, potentially inspiring its development. The 2008 banking crisis highlighted the vulnerabilities of reliance on large financial institutions. Bitcoin was designed as a decentralised currency without a central authority.

The first block of the Bitcoin blockchain, known as the Genesis block, includes a message: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” This message refers to the newspaper of The Times, shortly after the Lehman Brothers fell and the economic crisis started. The fact that this message was included in the first block suggests that Bitcoin was a counter-movement against the existing financial system. Bitcoin has remained the leading cryptocurrency since its launch.

Satoshi Nakamoto

The founder(s) of Bitcoin has remain unidentified since the inception of Bitcoin. This person or group of people went by the name Satoshi Nakamoto. Over the years, there has been speculation and even lawsuits regarding the identity of Satoshi. A name that is often speculated is Hal Finney, who was also the receiver of the first Bitcoin transaction. Unfortunately Hal Finney passed away in 2014. The addresses that were used by Satoshi are publicly known and verifiable. Therefor it is known that most of Satoshi's bitcoins have remained untouched, with a total balance of over 1 million bitcoins.

What is a Blockchain?

Blockchain is a distributed ledger technology (DLT). For those familiar with accounting, ledger is not a new term. A general ledger account is, simply put, a collection of all income and expenses.

In the past, transactions and mutations were kept in writing: in paper ledgers that could only be accessed and checked by certain people. With blockchain it is ensured that all information in the ledger can be viewed by anyone, at any time. The network of computers ensure that the ledgers are always accessible.

Bitcoin blockchain

The data of the Bitcoin ledger is divided into blocks (of 2 Megabytes), which can store up to 4.000 transactions. These blocks are chained in a sequential order, hence the name blockchain. Information in the previous block is required to create the next block.

If someone wants to do a Bitcoin transaction, it has to be written in the ledger. In order to get this done, the network of computers have you be informed that the transfer wants to be executed. The network of computers are together responsible to add your transaction into the backlog of the ledger.

In order to create the next block, a Bitcoin miner needs to resolve a complex mathematical puzzle. A Bitcoin miner is just a computer that is designed to be very fast at solving mathematical equations. Once a Bitcoin miner has found the right answer, it can use this to create the next block. All miners will check and confirm that the miner who proposed the new block is correct. Once approved, all miners continue to mine the next block. With this method, independent computers all work together to maintain a ledger of transactions.

Satoshi Nakamoto came up with a system design that would ensure that the average time it takes to create a new block would be 10 minutes. However, it is important to keep in mind that there is many Bitcoin miners around the world attempting to create the next block. In order to allow for fair participation of all miners, the principle of mining pools was introduced. A group of miners basically increase their odds of finding the next block, but they equally divide the block subsidy within the group

How Many Bitcoins Exist?

Satoshi Nakamoto implemented a fixed supply of 21 million bitcoins, of which the last bitcoins will be mined around 2140. New Bitcoins are created through mining, as bitcoin miners are rewarded for solving the complex puzzle. This reward is called the block subsidy, which is halved every 210.000 blocks. Initially, the block subsidy was 50 BTC per block, but it decreases over time through the halvings. Therefor the inflation of Bitcoin is very predictable: it has been defined in the code of the Bitcoin software.

In order to ensure divisibility, the smallest denomination of a bitcoin has been named satoshi, or sat. This is 1 out of 100 million, or 0,00000001 bitcoin. Therefore there is no need to buy a whole bitcoin, it is also possible to buy a fraction.

What is the Use Case for Bitcoin?

Bitcoin, as defined in its whitepaper, is a peer-to-peer electronic cash system. Since the introduction of the computer and digital transactions, it has not been possible to transfer bearer assets digitally. Bitcoin is the first ever asset that allows for digital transfers of goods. Some people call Bitcoin a “global settlement system”, as it is possible to transfer Bitcoin from A to B. Comparing this to our current systems, financial institutions never actually transfer assets. Instead, the ledger held at every institution is updated with outstanding credit and debt.

In a more day-to-day basis, Bitcoin can operate as a form of digital cash. Since the adoption is still low, and transactions are considered expensive, many people refer to Bitcoin as a “digital gold” asset. Many of the properties of Bitcoin are similar to gold, such as the divisibility, scarcity, durability and uniformity.

Common blockchain definitions

• Structure: Transactions are recorded in blocks linked cryptographically to form a chain.
• Mining: Miners solve cryptographic puzzles to add new blocks.
• Block Subsidy: Miners receive a reward, which decreases over time due to halving events.
• Immutability: Once validated, altering data in blocks is extremely difficult and requires consensus from the majority of the network.
• Distributed Network: Nodes across a global network confirm transactions and validate history.

How Do I Buy Bitcoin?

This can be done through brokers or cryptocurrency exchanges, where you can pay with local currency or swap other cryptocurrencies. Your Bitcoin will be stored in a wallet, either at the exchange or with an external wallet.

Some of the solutions include:

• Crypto Asset Management: Using a crypto asset management service to outsource investment decisions.
• Crypto Companies: Investing in companies involved in the cryptocurrency industry.
• Bitcoin ETF: Bitcoin ETFs allow investors to gain exposure to Bitcoin without directly buying and holding it. However, these are not available in all countries due to regulatory restrictions.
• Investing in Technology: You can invest in companies developing blockchain technology.

Is Bitcoin a Revolution?

When considering the technology behind Bitcoin, it represents a revolutionary advancement. Bitcoin has gained traction as a means of payment, though widespread adoption as legal tender worldwide is still in progress. As an investment, Bitcoin has become a strategic addition to many portfolios. Institutional adoption is expected to grow with clear regulatory frameworks and enhanced consumer protections.

The Lightning Network is an advanced technology built on top of Bitcoin, serving as a second layer. Introduced in 2016 by Joseph Poon and Thaddeus Dryja, it aims to resolve some inherent issues of the Bitcoin blockchain. In short, the Lightning Network allows users to make transactions off-chain without the need for block confirmation on the blockchain.

Why the Lightning Network?

To understand the necessity of the Lightning Network, it's crucial to know how Bitcoin transactions work. While building and broadcasting transactions is relatively quick, the time-consuming part is the transaction confirmation process. A standard consumer computer can process around 14,000 transactions per second. However, each Bitcoin block, capable of containing approximately 2,000 transactions, is validated roughly every ten minutes. Therefore, processing 14,000 transactions would take about an hour and ten minutes.

This confirmation process is vital because it ensures the integrity and security of transactions, eliminating the need for third-party intermediaries. This verification allows people to trust that the transactions are accurate and legitimate. Shortly put: Bitcoin is a decentralised with an immutable ledger system, which come at a cost.

Challenge of scaling

As Bitcoin adoption grows, more transactions are submitted for verification in the Mempool, leading to higher transaction fees. This increase in fees makes small payments less attractive and practical.

To address these challenges and facilitate faster and cheaper transactions, the Lightning Network was developed as a solution. By creating a second layer on top of the Bitcoin blockchain, the Lightning Network allows for quicker transaction processing without compromising security, making it an essential advancement in the cryptocurrency space.

How the Lightning Network Works

To grasp the functionality of the Lightning Network, we need to explore the process of opening a payment channel, transacting within the channel, and routing payments through the network.

Opening a Channel

Opening a payment channel between two parties, such as Alice and Bob, is the foundational step in using the Lightning Network. This involves creating a funding transaction on the Bitcoin blockchain, locking a specified amount of Bitcoin into a multi-signature wallet controlled by both parties. Once confirmed, the initial state of the channel reflects the allocation of funds, enabling transactions within the channel. For example, if Alice deposits 1 BTC into the channel, the initial state shows Alice with 1 BTC and Bob with 0 BTC. This setup enables them to begin transacting within the channel.

Transacting Within the Channel

With the channel open, Alice and Bob can perform numerous off-chain transactions quickly and with minimal fees. Each transaction updates the channel's state. For example, if Alice sends 0.1 BTC to Bob, the new state shows Alice with 0.9 BTC and Bob with 0.1 BTC. Cryptographic techniques and revocation keys secure these updates, preventing fraud.

Keeping the Channel Open

Channels can remain open indefinitely, allowing unlimited transactions over time without the need to frequently close and reopen them, saving on fees and improving transaction speed.

Settling Transactions

Alice and Bob can settle their balances at any time by agreeing on the final state and broadcasting it to the Bitcoin blockchain. They might choose to keep the channel open for future transactions, settling on-chain only when necessary.

Routing Payments

The Lightning Network consists of interconnected payment channels, forming a robust network. Payments can be routed through multiple nodes if a direct channel does not exist. For instance, Alice can send payments to Charlie through Bob if Bob has a channel with Charlie. Atomic Multi-Path Payments (AMP) ensure that payments are either fully completed or not at all, preventing partial payments or loss of funds.

Concerns About the Lightning Network

Centralisation

The Lightning Network, aimed at improving Bitcoin's scalability and speed, may lead to centralisation of transaction distribution. If a few large nodes, often run by well-funded entities, control much of the network's liquidity, they become the main transaction routes due to their reliability. This can marginalise smaller nodes, reducing decentralisation. High costs and technical expertise needed for large nodes further exacerbate this issue, creating barriers for smaller players. This concentration of power risks undermining Bitcoin's decentralised nature, making the network vulnerable to censorship, manipulation, and single points of failure.

Fraudulent Channel Closures

The Lightning Network speeds up Bitcoin transactions and cuts costs, but it has risks, including fraudulent channel closures. This happens when someone tries to close a payment channel using an outdated balance that favours them.

For example, if Alice and Bob have a channel and update their balances over time, Alice could cheat by broadcasting an old balance that gives her more Bitcoin than she currently has, effectively stealing from Bob.

The Lightning Network has built-in safeguards to prevent this:

1. Time-locks: When a channel is closed, there's a waiting period allowing the other party to contest if they spot fraud.
2. Revocation Keys: Each update invalidates the previous state with a key. If someone tries to use an old state, the other party can use the key to reclaim funds.

How to Access the Lightning Network

To use the Lightning Network, set up a Lightning wallet (mobile, desktop, or hardware), and fund it with Bitcoin from your regular wallet. Open a payment channel by committing Bitcoin. Once the channel is established, you can conduct transactions within the network. The wallet will automatically route payments if you don't have a direct channel with the recipient.

The Lightning Network enhances Bitcoin's scalability and transaction efficiency through off-chain transactions. It offers benefits like faster and cheaper transactions but also poses challenges such as potential centralisation and fraudulent channel closures. Understanding how to use and safeguard the network helps maximise its advantages and mitigate risks, contributing to a more robust and decentralised Bitcoin ecosystem.