Transaction Fee Mechanism Design

Abstract

Demand for blockchains such as Bitcoin and Ethereum is far larger than supply, necessitating a mechanism that selects a subset of transactions to include “on-chain” from the pool of all pending transactions. This article investigates the problem of designing a blockchain transaction fee mechanism through the lens of mechanism design. We introduce two new forms of incentive compatibility that capture some of the idiosyncrasies of the blockchain setting, one (MMIC) that protects against deviations by profit-maximizing miners and one (OCA-proofness) that protects against off-chain collusion between miners and users. This study is immediately applicable to a major change to Ethereum’s transaction fee mechanism, made on August 5, 2021, based on a proposal called “EIP-1559.” Originally, Ethereum’s transaction fee mechanism was a first-price (pay-as-bid) auction. EIP-1559 suggested making several tightly coupled changes, including the introduction of variable-size blocks, a history-dependent reserve price, and the burning of a significant portion of the transaction fees. We prove that this new mechanism earns an impressive report card: it satisfies the MMIC and OCA-proofness conditions, and is also dominant-strategy incentive compatible (DSIC) except when there is a sudden demand spike. We also introduce an alternative design, the “tipless mechanism,” which offers an incomparable slate of incentive-compatibility guarantees—it is MMIC and DSIC, and OCA-proof unless in the midst of a demand spike.