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.
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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.
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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. 🌳
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