TL;DR
Bitcoin's fee-to-reward ratio refers to the proportion of the miner's income from transaction fees compared to the total block reward.
The ratio is calculated as the transaction fees divided by the total block reward, which includes block subsidy and transaction fees.
The ratio significantly impacts the health and security of the Bitcoin network as the block subsidy continues to halve over time to eventually reach zero in 2140.
In early 2023, activities relating to BRC-20 tokens pushed Bitcoin’s fee-to-reward ratio to over 50%, a rare occurrence.
What Is Block Reward in Bitcoin?
We must examine how miners are compensated to better understand Bitcoin’s fee-to-reward ratio. In the Bitcoin network, the block reward is a certain amount of bitcoins miners receive for successfully mining a new block.
The block reward comprises the block subsidy and the transaction fees.
What is a block subsidy?
In Bitcoin’s Proof of Work consensus mechanism, miners commit significant computational resources to solve the complex calculations required to add new blocks to the blockchain. In return, miners receive a fixed amount of newly minted bitcoins for every block they add to the blockchain, called a block subsidy. It’s a key incentive for miners to keep the network secure.
The newly generated bitcoins are created by a special kind of transaction called a coinbase transaction. Typically, the coinbase transaction is the first to be added to a block, generating coins out of nothing because the coins come from a single blank input.
What are transaction fees?
Each transaction on the Bitcoin network includes a small fee paid to miners for processing the transaction. Miners prioritize transactions with higher fees, meaning the higher the fees, the more likely a transaction will be included in the next block.
Bitcoin transaction fees work similarly to a bidding system, in which users attach higher fees to transactions, so miners will include it in a block when demand is high.
Since transaction fees generally make up a tiny ratio of the total block reward, the term “block reward” was sometimes used interchangeably with “block subsidy.” However, as transaction fees on the Bitcoin network increase over time, it’s becoming more vital to differentiate between them.
For this article, we’ll use the definitions outlined above. Therefore, block reward can be expressed in this formula:
Block reward = block subsidy + transaction fees
How To Calculate Fee-To-Reward Ratio
The fee-to-reward ratio is usually expressed as a percentage and calculated by dividing the transaction fees by the block reward using the following formula:
Fee-to-reward ratio = transaction fees / block reward X 100%
It can also be expressed as:
Fee-to-reward ratio = transaction fees / block reward
Why Are Block Rewards Necessary?
Block rewards serve as an incentive for miners to commit computational power to keeping the Bitcoin network up and running. Miners are rewarded for this commitment with newly mined bitcoins and the bitcoins earned via transaction fees. The design of the block reward is key to Bitcoin’s tokenomics because it keeps a controlled introduction of new bitcoins into the system at a decreasing rate.
This creates a deflationary economic model and mimics the mining of precious metals, where new metal gets harder to find. It also ensures that no more than 21 million bitcoins will ever exist, according to the code of the Bitcoin protocol.
What Is Bitcoin Halving?
The fee-to-reward ratio is gaining more attention, partially because of the Bitcoin halving, which refers to the phenomenon where the block subsidy miners stand to receive halves roughly every four years.
Bitcoin’s block subsidy started at 50 BTC and has been reduced by half every 210,000 blocks, or approximately every four years. Bitcoin’s block subsidy was reduced to 25 BTC in 2012, 12.5 BTC in 2016, and 6.25 BTC in 2020. It will be reduced to 3.125 BTC in 2024.
Why Is Fee-To-Reward Ratio Important To Bitcoin’s Security?
At this halving rate, it’s estimated that the last bitcoin will be mined around the year 2140. After that point, miners will no longer receive block subsidies but will instead be compensated solely through transaction fees.
Even though that eventual scenario is still many years into the future, some have raised the question of whether transaction fees will grow enough so miners are compensated sufficiently in the absence of block subsidy.
As block subsidy decreases to 3.125 BTC in 2024 and 1.5625 BTC in 2028 - a level significantly lower than the past decade, this question also seems valid in the immediate future.
What Is the Outlook for Bitcoin’s Fee-To-Reward Ratio?
During most of the Bitcoin network’s existence, the fee-to-reward ratio has hovered around low single digits. Transaction fees have generally contributed little to miners’ overall revenue.
However, transaction fees are determined by various factors, including supply and demand. When demand for Bitcoin’s block space increases, there is greater competition among users to bid higher transaction fees to get their transactions included in the next block.
For instance, transaction fees increased significantly during periods around 2017 and 2020, presumably due to increased mainstream adoption, bitcoin price volatility, and network congestion.
In early 2023, activities relating to BRC-20 tokens pushed Bitcoin’s fee-to-reward ratio to new historical highs. The fee-to-reward ratio exceeded 50%, meaning that transaction fees in a block were higher than the block subsidy, a rare occurrence. However, such a high fee-to-reward ratio may not be sustainable.
Closing Thoughts
Eventually, when the block subsidy reaches zero, transaction fees will make up 100% of miners’ compensation. Before that, transaction fees may need to gradually increase and achieve a steady rate of sustainable growth so that mining remains profitable enough to incentivize miners to participate in the Bitcoin network.
This should be achieved while balancing the need to increase the fee-to-reward ratio while keeping transaction fees low enough for users.
Further Reading
Disclaimer and Risk Warning: This content is presented to you on an “as is” basis for general information and educational purposes only, without representation or warranty of any kind. It should not be construed as financial, legal or other professional advice, nor is it intended to recommend the purchase of any specific product or service. You should seek your own advice from appropriate professional advisors. Where the article is contributed by a third party contributor, please note that those views expressed belong to the third party contributor, and do not necessarily reflect those of Binance Academy. Please read our full disclaimer here for further details. Digital asset prices can be volatile. The value of your investment may go down or up and you may not get back the amount invested. You are solely responsible for your investment decisions and Binance Academy is not liable for any losses you may incur. This material should not be construed as financial, legal or other professional advice. For more information, see our Terms of Use and Risk Warning.