Ordinals and BTC Fees

Over the past week. Bitcoin slipped a bit from the spotlight it has enjoyed for the majority of 2023 – primarily because the ongoing bellwether Ripple vs SEC case took an unexpected turn, with the court ruling that XRP token may not clearly constitute a security, and that part of the XRP token offering may not have been an illegal sale of securities. There has been plenty of analysis since the decision, including BitOoda’s 7/17/23 report.

We will therefore summarize the situation as mildly positive for the alt-coin ecosystem, although several questions still remain. Over the medium term, until there is more legislative and judiciary clarity on alt-coin tokens, Bitcoin continues to have several strong tailwinds that we described last week.

In this week’s piece, we will focus on a BTC phenomenon that originated just this January: the rise of Bitcoin Ordinals.

Ordinals present an opportunity for Bitcoin to increase its functionality

beyond a pristine store of value to a property rights layer. Until now, the “programmable settlement layer” function has belonged to the Ethereum network, which differentiates itself from BTC via higher utility and fees.

Ordinals, which are NFTs that can be stored entirely on the Bitcoin blockchain, begin to level the playing field by adding utility, a diversified revenue stream for miners (beyond block subsidies), and a scarce property rights layer on BTC.

What is an NFT?

• First, let’s quickly dig into the utility of NFTs and whether the NFT movement is worth the hype we saw during the 2021 bull market. NFTs, or non-fungible tokens, are digital ownership deeds. In the physical world, we own physical title to homes or to cars, we own physical identification cards, etc. With the movement toward digitalization increasing, there is an open space for digital representations of ownership deeds.
• How do we ensure that the digital ownership deeds cannot be copied (just like we verify authenticity of property titles via a notary stamp)? The blockchain is a verifiable settlement layer for digital deeds, or NFTs.
• While crypto is mostly associated with fungible tokens (the ERC-20 standard set), the non-fungible deed market has far more potential to create ownership representations for digital goods (e.g., digital art) as well as physical goods (digital property deeds, digital identification, etc.)

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What is an Ordinal?

• So if NFTs have such a large potential addressable market, why did the NFT movement begin on Ethereum? Ethereum created a programmable settlement layer enabling smart contracts. As a result, a wave of innovation happened on Ethereum, from ICOs to DeFi to memes to NFTs.
• Initially, the Bitcoin infrastructure did not support NFTs, as the base layer was not programmable. However, two major updates happened in 2017 and 2021: SegWit and Taproot. SegWit was instrumental in expanding the amount of arbitrary data that could be included in a BTC transaction, allowing for Bitcoin’s blocksize to increase from 1MB to 4MB. Taproot allowed for more flexible data storage on BTC blocks, increasing blockspace functionality and throughput.
• Together, SegWit and Taproot paved the way for Bitcoin to develop its own NFT standard to compete with Ethereum – this is referred to as Ordinals.

Ordinals Adoption

• Ordinals create, arguably, a cleaner NFT standard on BTC than the existing ERC-721 standard on Ethereum. This is because Ethereum NFTs contain “metadata” that points to the NFT content, but the actual content is generally stored off-chain (e.g., on IPFS – decentralized storage – or a traditional server).
• In contrast, Ordinals permit the entire content of NFTs to be stored fully on-chain in one accessible package. This reduces trust assumptions or external dependencies when compared to Ethereum’s ERC-721 NFTs.
• Ordinals were introduced in Jan 2023 by Casey Rodarmor, a former BTC Core Contributor. Since then, the amount of inscriptions (Ordinals created) went parabolic.
• Many NFTs that existed first on Ethereum ported over to BTC in the form of Ordinals. However, the innovation wave is just getting started.

Sustainable BTC Fee Driver?

• One key point is that block subsidies to miners will reduce every 4 years. While this preserves the scarcity and the 21 million supply cap for Bitcoin, this means that every 4 years, BTC miners will receive smaller subsidies to mine Bitcoin. The argument has been that as long as BTC price increases (doubles every BTC halving), the mining industry can remain profitable.
• However, the real answer is that the BTC economy needs a second, non-correlated source of transaction fees that can pay miners in addition to block subsidies. Ethereum solved for this by creating a smart contract layer, where every transaction in the Ethereum economy results in fees for ETH validators. BTC had very little fee income due to the store-of-value nature.
• Ordinals could change this paradigm. This chart shows the fee spike after Ordinals emerged, which could provide sustainable fees for BTC.