All About Fees: Understanding Value in a Blockchain

A short post on our thoughts about blockchain fees

Feb 10, 2022

Introduction

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After our post on ve(3,3), we’ve spent a lot of our time thinking about fees. Ugh! Although fees are typically mentioned in a negative connotation and usually bring up emotions of annoyance or outright pain (Those who have done a DEX swap on Ethereum know what we are talking about), fees are ultimately the value driver of any blockchain. We’re writing this post because we think that a lot of people don’t really understand the importance of fees. So… here are our thoughts! If you enjoyed this post, please give it a share!

The Negative Connotation of Fees

Usually when you think of fees, you probably don’t associate them with happy thoughts. We’d say when the average person thinks of fees, they probably think of overdraft fees, credit card late fees, loan fees, etc. Typically, all those fees are rent seeking. They generate extra wealth for those charging them but provide no real value to you in return. Of course, not all fees are rent seeking in nature, but we’d argue most people associate them with rent seeking activities.

What about blockchain fees? We’re writing this section because we feel there may be misconceptions around blockchain fees. We’d wager that many people associate blockchain fees with rent seeking fees such as the ones you pay on your late credit card bill. In reality, that can be any further away from the truth.

We propose that instead of blockchain fees, they should be really thought of blockchain costs. You may think of this as just semantics, but costs are more representative of the price you pay to use a blockchain rather than fees. When you pay to use a blockchain, you are getting in return something of value. An immutable ledger with your transaction forever etched into it is valuable.

When you go to the store and buy goods with definitive value, let’s just say groceries for simplicity, no one thinks to themselves that the price they paid is a fee. Rather, it is just simply the cost of the good. A blockchain fee is just the cost to get your transaction into the blockchain.

A Perfect Market

For this section, we’re going to take you back to your high school economics class. Ever heard of perfectly competitive markets? If not, here are the attributes of a perfectly competitive market, courtesy of Investopedia:

All firms sell an identical product (the product is a commodity or homogeneous).
All firms are price takers (they cannot influence the market price of their products).
Market share has no influence on prices.
Buyers have complete or perfect information (in the past, present, and future) about the product being sold and the prices charged by each firm.
Capital resources and labor are perfectly mobile.
Firms can enter or exit the market without cost.

Perfectly competitive markets are ideal for a society as they are the most efficient markets and exhibit no deadweight loss. However, perfectly competitive markets had largely been something that existed only in theory and academia… until now.

One of the beauties of the blockchain is that they can be the holy grail of perfectly competitive markets. Reread those attributes again and apply them to the fees of an individual blockchain.

A blockchain sell an identical product, blocks. Check.
Miners/validators take whatever the market is willing to pay for the fee. Check.
Market share or concentration of miners/validators do not influence prices. Check.
- This is assuming 51% attack does not happen as it is not financially incentivized to do so
Users have perfect information about the blockchain. It’s all in the code! Check.
Miners/validators are mobile to an extent. Things such as the China ban on Bitcoin banning did temporary reduce hash rate, but it has recovered. Quasi-Check.
Miners/validators can enter or exit the market without *sunk* costs. Check.

Are blockchain markets perfect in their current state? Probably not, but it’s the closest thing we got to a perfectly competitive market! If Bitcoin or Ethereum or whatever blockchain truly goes global, its market of buying and selling block space will be the closest thing we have to a perfectly competitive market in all of human history. That’s pretty damn neat if you ask us.

A Paradox of Fees

If you’re a lurker on crypto Twitter like we are, you’ve probably come across an image like the one above a few times. BTC Maxis will post it and boast that Bitcoin’s lower fees means it is more valuable than Ethereum. ETH Maxis will post it and boast that Ethereum’s higher fees means it is more valuable than Bitcoin. So, who’s right? To answer this question, we’re going to take you on a short history lesson.

Way back in 1974, before our time, President Gerald Ford and his administration was discussing every politician’s favorite topic, taxes! To advocate his position of lowering taxes, economist Arthur Laffer illustrated his reasoning why on a napkin. That’s right… We’re talking about the Laffer Curve! Although the Laffer Curve wouldn’t become prominent in American politics until the Reagan years, it was actually popularized during the 70s. But that is neither here nor there, how does this relate to blockchain fees? First off, a quick overview of the Laffer Curve. Here’s a diagram:

Source

The Laffer Curve is a fairly simple concept that has to do with maximizing tax revenue. Starting with the extremes, a government will collect no tax revenues if the tax rate is 0% (duh) or if it was 100% as there is no longer an incentive to create value. The important part of the Laffer Curve is that there is a tax rate where revenues are maximized. If the tax rate is greater or less than that maximum point, a government’s tax revenues will go down.

The Laffer Curve is also applicable to blockchains! Just replace Tax Rate with Fees Rate and Tax Revenue with Fees Revenue. The goal of any blockchain should be to maximize fee revenue. Why? Because ultimately the value of any blockchain should theoretically be the summation of the present value of all future fees (Possible exception: Bitcoin, especially if it is continually seen as ‘digital gold’). In order for a blockchain to create the most value possible, it needs to generate the most fees possible. The same is also true for many DeFi protocols such as Curve or MakerDAO.

And no, we’re not trying to say that Ethereum’s high fees are good for Ethereum. Ethereum is most certainly operating at a point greater than the maximum fee point. As Ethereum lowers fees, it will onboard more and more users, generating more fees in the aggregate. As far as what the optimal fee should be, that is something that will be discovered over time and through trial and error.

Fees are necessary to the value of any blockchain. It’s why we think feeless blockchains are just a pipe dream. But to us, that is the paradox of fees. No one wants to pay them, but ultimately, your blockchain would be valueless if it didn’t charge fees.

Conclusion and Something to Celebrate

Well, there you have it, our ramblings on the relevance and important of blockchain fees. Perhaps this post was boring, or perhaps you learned something new… Whatever the case may be, we would love to hear your feedback! Ultimately, the point of this Substack is to help you guys out. Your feedback is a crucial aspect of that! Please leave a comment or hit us up on Twitter!

The Average Joe’s Crypto