How Mining Incentives Work
Mining bitcoin takes energy, which costs money, so there needs to be some sort of reward in order to motivate people to mine bitcoin and keep the network running securely. Block rewards do just that, and they are given out to miners each time they mine a block. Block rewards are composed of both a block subsidy, as well as transaction fees. The block subsidy is some number of bitcoins (as determined by the bitcoin protocol), and the transaction fees are paid by the people who are making bitcoin transactions within that block of the bitcoin blockchain.
Bootstrapping the Network
In the early days the only incentive to mine bitcoin was the block subsidy because transaction fees were so low. When bitcoin first started, the block subsidy was 50 bitcoins, but at that time, they had no monetary value. People mostly mined as a hobby, or with the hope that one day the value of bitcoin would increase.
Diminishing Block Subsidy
Roughly every four years (or after 210,000 additional blocks have been mined), the bitcoin subsidy decreases by half. Simultaneously, as bitcoin becomes more valuable/popular, more transactions occur, which increases the demand for block space. This means that, ideally, as the bitcoin subsidy decreases, transaction fees will increase, making the block reward stay high enough that bitcoin miners will remain motivated to continue mining.
On November 28, 2012, the first halving in bitcoin’s history occurred. By this point, bitcoin had already left its bootstrapping phase and was being used in the real world, with the price of a single bitcoin being over $10 USD. The block reward for block 210,000 consisted of the newly halved block subsidy of 25 BTC as well over 13 BTC worth of transaction fees. This marked the first time where a bitcoin block paid out less than 50 BTC, and there were fears that the decreased reward would cause miners to stop securing the network. Some miners did stop mining, but many continued since it was still profitable to do so. But this highlighted an important point: somehow, we need total transaction fees to continue increasing in order to incentivize miners.
Below is a summary of bitcoin halvings up until this point in time, which shows that transaction fees do not need to fully replace block subsidies as long as the value of BTC continues to increase:
Halving 1: November 28, 2012
- Block 210,000
- Block Reward = 38.56 BTC (25 subsidy + 13.56 fees)
- 1 BTC = $12.35 USD
- Total value = $476.25 USD
Halving 2: November 28, 2012
- Block 420,000
- Block Reward = 13.08 BTC (12.5 subsidy + 0.58 fees)
- 1 BTC = $649 USD
- Total value = $8489 USD
Halving 3: May 11, 2020
- Block 630,000
- Block Reward = 7.16 BTC (6.25 subsidy + 0.91 fees)
- 1 BTC = $8566 USD
- Total value = $61,330 USD
Transaction Fee-Driven Security
Eventually, around the year 2140, the block subsidy will have gone through enough halvings that it will reach the point that it can’t be halved any more. At this point, the block subsidy will be removed completely and the block reward will come from transaction fees only.
Just like people were worried about the security implications of the first halving back in 2012, people are also worried about what will happen in the future when bitcoin’s security is solely funded by transaction fees. It’s impossible to predict what the price of bitcoin will be and how high transaction fees will need to be to secure the network in the year 2140, but as long as the majority of miners continue being incentivized to mine, then the security of bitcoin should be sustainable.
Of course, it’s impossible to know what the world will look like over 100 years from now. In practical terms, however, this problem is only a decade or two away. Today, the block reward is 6.67 BTC (or $68,837 USD). By the year 2032, the block subsidy will be reduced to only 1.5625 BTC. At this point, the miners will probably be more incentivized by transaction fees than by block subsidies. It may be essential that we have an increase in the price of bitcoin, or in the size of transaction fees, in order to maintain our current security budget. If the price of bitcoin doesn’t increase, then a block subsidy of 1.5625 BTC will mean we need 5.11 BTC of transaction fees to meet our current level of security. Conversely, if we only keep the 0.42 BTC of transaction fees that we have now, then the total block reward would be 1.9825 BTC and the bitcoin price would need to be $34,722 to have the same amount spent on bitcoin security.
- Bitcoin miners are incentivized to mine by the block reward, which consists of a block subsidy and transaction fees.
- Bitcoin halvings reduce the block subsidy, while increases in the price and usage of bitcoin causes transaction fees to go up, balancing the impact of the halvings.
- Once the last bitcoin has been mined, miners will still be incentivized by a block reward, but it will only consist of the transaction fees. Transaction fees will need to be high enough to incentivize adequate mining security.
- The last bitcoins likely won’t be mined for another 120 years, so it is impossible to know exactly what will happen.