Financial Mathematics for Cryptocurrencies

CHAPTER 9Fee Models

Network fees in DeFi are dynamic and can significantly impact pricing, unlike TradFi where transaction costs are often negligible. This chapter develops mathematical models to capture fee dynamics and their effects on digital asset valuation.

• Explain the economic and technical role of network fees in blockchain systems.
• Develop mathematical models for fee dynamics, including congestion and oscillation effects.
• Present extensions and practical considerations for modeling fees in digital asset markets.

We begin by examining the basic structure and incentives behind blockchain fees.

9.1 FEES

The relationship between network activity and transaction costs described in the Blockchain Paradox in Section 8.3 highlights the central role that fees play in blockchain economics.

Fees are an important part of the blockchain ecosystem for two reasons:

• Fees are necessary to provide an incentive for miners or validators to approve transactions.
• For blockchains with a finite total number of coins mined, such as Bitcoin, fees are designed to provide a long-term incentive for the network to be maintained.

In other words, fees are compensation paid by network users to mitigate network failure, which we discuss in our risk decomposition in Section 8.2.3.1.

Fees can be substantial for a transaction and cannot always be ignored in pricing. While transaction costs are often ignored in most pricing theory in TradFi, we cannot make this approximation in DeFi. We provide ...