Transaction Fee Mechanisms and User Welfare in Permissionless Blockchains

Abstract

A transaction fee is fundamental in maintaining the stability and decentralization of a permissionless blockchain, the infrastructure underlying major cryptocurrency networks such as Ethereum and Bitcoin. This fee, set and paid by users when initiating each transaction, aggregates to over $24 million daily on Ethereum, imposing a nontrivial barrier to wider adoption. What is worse is that it is disproportionately borne by small users. Like Bitcoin, Ethereum started with a name-your-own-price style fee mechanism. Under this Legacy mechanism, we demonstrate that, surprisingly, only three-quarters of the transaction fee is necessary for users to attain the service quality they receive; the remaining one-quarter thus constitutes welfare loss. In August 2021, Ethereum implemented a fee mechanism change. Together, the Legacy methods and the new scheme, which we call Cap-Tip, describe the two most widely used fee mechanisms in all major permissionless blockchains. We explain the innovations embedded in the Cap-Tip mechanism through the lens of information quality and task decomposition. Collecting over 123 million transactions covering the change period, we estimate the causal impact of Cap-Tip on welfare improvement using a doubly robust difference-in-difference estimator that accommodates heterogeneity across timing of and exposure after adoption. The result is an astounding 80% reduction in welfare loss, achieved by users only 6 days after adoption. Interestingly, we also find that adoption benefits small users more than large ones, alleviating fee disparity and improving fairness. We theorize this difference through user experience and the overconfidence bias. Our study offers a novel operational perspective to unpack how the arguably most significant fee mechanism change in the blockchain space affects user welfare.