Fee Market Competition: Bitcoin Ordinals And Inscriptions
A new use case for bitcoin is causing a stir because of its ability to include data directly on-chain. We analyze current transaction fees and how they might be impacted by inscriptions in the future.
Relevant Past Articles:
The Crypto Contagion Intensifies: Who Else Is Swimming Naked?
This Time Isn’t Different: Miners Are Biggest Risk Facing Bitcoin Market In Repeat of 2018 Cycle
Bitcoin Ordinals And Inscriptions
A recent and somewhat contentious use of Bitcoin is an innovative application of the Taproot soft fork that was merged into the protocol in 2021. Ordinal Theory is a way of serializing each individual unit of bitcoin and labeling these specific satoshis “ordinals.” The creator of this numbering scheme, Casey Rodarmor, described it in his blog saying, “Satoshis are numbered in the order in which they’re mined, and transferred from transaction inputs to transaction outputs in first-in-first-out order.”
By serializing these individual satoshis and utilizing the Taproot upgrade, Bitcoin users can also include arbitrary data directly on the blockchain. While this was already possible with text using the OP_RETURN function, these new “inscriptions” can be anything from jpegs, short sound clips and even simple games.
There is growing debate in the development community about the implications of storing all this data directly on Bitcoin and what that means for users who want to run a full archival node. While this discussion is important, we want to dig into how inscriptions are currently impacting Bitcoin’s fee market and how it might look in the future.
Efficient Use Of Block Space
By their nature, inscriptions are larger files and therefore take up more of the finite space in each Bitcoin block. The users that are creating inscriptions are required to pay the necessary fees in order to send their transactions, however, inscriptions are included in witness data which is given a slight fee discount thanks to the SegWit soft fork in 2017.
Ordinals officially launched on January 21, 2023. Less than three weeks later, inscriptions are already taking up 50% of Bitcoin’s block space according to Pierre Rochard, vice president of research at Riot Platforms.
Source: Pierre Rochard
What does this mean for bitcoin transaction fees?
Bitcoin’s fee market is a constantly changing landscape. Fees rise when demand to transact on-chain is high and users want to get their transaction included in the next block. Inversely, the fee rate drops when demand is low and users don’t need their transactions confirmed in a timely manner.
As inscriptions have gained attention and users, pending transactions have continued to fill up the Bitcoin mempool, but the fee rate still hasn’t adjusted to match this demand. Even with nearly 21,000 transactions waiting to clear at the time of writing, the minimum fee to be included in the next Bitcoin block is only 3 sat/vByte.
Source: Mempool.space
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Whether or not these inscriptions should be considered an “acceptable” use of Bitcoin, the market will decide the appropriate fee pricing for those who wish to include this arbitrary data into each block. Should transaction fees rise enough, it’s likely that any less important or smaller bitcoin transactions will be priced out of the market and move to Layer 2 protocols, such as Lightning. These additional layers were always the game-theoretical hypothesis of Bitcoin’s fee structure, even predicted by Hal Finney in 2010. It’s possible that inscriptions will be one of these less important uses of Bitcoin block space and fall by the wayside as fees increase.
Historical Block Weight
This is not the first time that a significant number of transactions have filled the mempool with the fee rate increasing accordingly. As noted, Bitcoin’s fee market is dynamic and the cycle of high fees create efficient uses of block space, create low fees, create inefficient use of block space, create high fees will repeat ad infinitum.
Source: Pierre Rochard
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Historical data on bitcoin transaction fees. 💸
Analysis of transaction fees as a percentage of miner revenue.💰
Growth of Taproot adoption. 🌳
The perpetuation of consistently full blocks in Bitcoin’s history was one of the reasons for the addition of SegWit into the protocol. After the soft fork, the signature data was separated from the record of who is sending or receiving the bitcoin. This allowed for more space to be used for necessary transaction data with the signature “witness” data being discounted and prunable by nodes who do not wish to store extra, unnecessary data beyond the requisite transaction ledger.
Shown below is mempool data and fee prices going back to the beginning of 2017. Blockspace tends to be at a premium during bull runs as many people are sending bitcoin back and forth from exchanges or cold storage or spending it at the relatively high exchange rate.
Source: Johoe's Bitcoin Mempool Statistics
Zooming in on the past three months, it’s clear that there was a significant number of transactions happening in the second half of November as bitcoin flew off exchanges with users protecting themselves from any other potential contagion events. We covered exchange flows in “The Crypto Contagion Intensifies: Who Else Is Swimming Naked?” and noted the “similar trend for the last three major market panic events: the March 2020 COVID crash, the Luna crash and now the FTX and Alameda crash. Bitcoin flies off exchanges as exchange and counterparty risk becomes priority No. 1 to mitigate.”
Source: Johoe's Bitcoin Mempool Statistics
Beyond extreme cases, transaction fees have been low for long stretches of time and have led to questions about Bitcoin’s long-term security budget as the block subsidy dwindles and fees must become a larger percentage of bitcoin miners’ revenue. Again, the hypothesis from Bitcoin proponents is that demand for block space will increase over time as bitcoin gains adoption and scales, causing more usage to migrate to other layers built on top of the protocol.
In the meantime, during the doldrums of the bear market with retail investor attention focused elsewhere, fee pressure and demand for block space has been low, contributing to the squeeze on miner profits. In the “State Of The Mining Industry: Survival Of The Fittest,” we wrote:
“Mining revenue pressures relative to recent trends can be easily viewed through the Puell Multiple, capturing a ratio of current daily revenue over the last 365-days moving average daily revenue. Daily revenues are still fairly depressed from the one-year trend and look more akin to the 2015 cycle where it stayed this way for many months to come. The fall in revenue comes at the same time as miners facing a regime shift to higher energy costs with rising electricity prices across the board.”
The myriad forces creating a cutthroat business environment for miners is unrelenting, but there may be hope with the creation of ordinals and inscriptions. In the last few weeks, the average block size has seen a massive spike.
But even with this major increase in block size, fee market competition has yet to heat up. It’s likely that those who wish to send monetary transactions will increase their fees to get their transaction included more quickly or those who want to mint an inscription without having to wait will do the same. Either way, should fees increase, so will profitability for mining pools who would collect additional revenue in the block reward in the form of higher transaction fees.
As a whole, transaction fees are still an insignificant percentage of the mining block reward, falling somewhere between 1% and 3%. Will fees begin to rise as more and more people attempt to use bitcoin for sending money and minting inscriptions?
Conclusion
The long-term impacts of inscriptions remains to be seen. We believe in Bitcoin’s inimitable incentive structure, and think that monetary transactions and inscriptions will work themselves out through free market competition. While our minds are not made up about the implications of ordinals on bitcoin’s fungibility, we are optimistic that blocks are full and new interest is sparked in the minds of innovators and those who see Bitcoin as something completely permissionless with unforeseeable benefits to society.
Also, Taproot adoption is going up and to the right.
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Good take. I must say I think ordinals are dumb, but I’d rather free market work all that out instead of changing code again.
Great work on this Craig! Interesting time to be in bitcoin!