Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Bitcoin Ordinals: An existential but valuable crisis
Mads Eberhardt
Cryptocurrency Analyst
Summary: Bitcoin has at no time enjoyed a thriving ecosystem of non-fungible tokens and decentralized applications, as the blockchain does not natively support such usage. That may change slowly seeing that a developer managed to support NFTs on Bitcoin in January. The latter quickly realized great traction but has pushed Bitcoin into an existential crisis, as some of its loudest supporters are against NFTs on Bitcoin. On the other hand, we argue that it is an epoch-making event for Bitcoin if such usages are provided with the necessary patience to thrive and stress its relevance. If not, Bitcoin underscores its position as a cryptocurrency that enjoys status-quo but no further innovation, potentially slowly pushing Bitcoin into irrelevance.
In what felt like a flash in 2021, NFTs (non-fungible tokens) came into vogue as the new crown jewel of the crypto industry, prompting Collins Dictionary to name NFT word of the year in 2021. However, the trend thoroughly bypassed the largest cryptocurrency Bitcoin, as it does not largely facilitate such tokens and decentralized protocols for NFTs natively on its blockchain. Instead, NFTs were mainly minted on Ethereum and to a limited extent on other blockchains, such as Solana and Avalanche. No matter what one thinks about NFTs, they have undoubtedly boosted the value of the blockchains, on which they have mainly been minted, since they have increased the activity on these chains, altogether boosting the transaction fees paid.
In that NFTs have not largely been supported by Bitcoin, the cryptocurrency has been left in the dust with no way to profit from NFTs, at least until recently. In January 2023, a developer by the name of Casey Rodarmor released open-source software named Bitcoin Ordinals. The latter has managed to natively incorporate characteristics into the Bitcoin blockchain that are widely similar to NFTs on other blockchains. This has fueled broad enthusiasm as millions of Ordinals have been issued, causing daily transaction fees paid on Bitcoin to surge. Although Ordinals appears to be an important step forward for Bitcoin, the most loud-mouthed critics of Ordinals are in fact the largest Bitcoin maximalists. This is fairly counterintuitive, but it originates from a long-standing conflict in the Bitcoin community on whatever should be the key properties of the blockchain. More on that later. First, we must regard Ordinals.
What is Bitcoin Ordinals?
To incorporate Ordinals into the Bitcoin network, Rodarmor applied two fairly recent Bitcoin improvements called SegWit and Taproot activated on the network in August 2017 and November 2021, respectively. In tandem, SegWit and Taproot allow data such as text, images, and videos to be assigned to individually transferable and traceable so-called Satoshis, also known as sats. The latter is the smallest possible unit of a Bitcoin derived by dividing a single Bitcoin by 100mn. It is named after the pseudonymous person or persons who developed Bitcoin.
The act of earmarking data to individually numbered satoshis is named inscribing. In a like manner, it is labeled inscriptions when measured in units. Not only is the inscribed data immutable, but it is also entirely stored on-chain on Bitcoin rather than by metadata referring to off-chain data stored elsewhere, a technique often used by NFTs on other blockchains. Ordinals are not at all as user-friendly to issue and transfer compared to NFTs on other blockchains, along with the fact that they cannot be traded decentralized. However, it is expected that user-friendliness gradually improves, after which decentralized trading applications may arise, although they may not happen for a long time to come.
One of the most epoch-making events of Bitcoin
In its about 6-month existence, Bitcoin Ordinals has truly thrived. Now, over 11.5mn inscriptions have been made on Bitcoin. With respect to the limited time period and the difficulties of creating an inscription, this is an encouraging number, particularly in view of the fact that Ordinals came out of thin air with largely no prior ecosystem of NFTs nor decentralized applications on Bitcoin.
The surge of inscriptions on Bitcoin is plain as day seeing the daily paid transaction fees on Bitcoin over the past year. The paid fees started to increase in January 2023, at which month Bitcoin Ordinals was launched. Next, transaction fees gradually gained momentum in 2023 before reaching May, at which point the total transaction fees surged heavily as Ordinals turned into a fad of the industry. To further stress the impact of Ordinals, the daily transaction fees measured in Bitcoin rose to a 5-year high of 635 Bitcoins on the 8th of May. In the bull market of 2021, the most lucrative day was nowhere near amounting to about 300 BTC in transaction fees, although the amount was greater in real terms.
The transaction fees may appear to be insignificant, but it is in fact more vital for the long-term sustainability of Bitcoin than most regard. We wrote about the lack of long-term compensation to miners to maintain adequate security last year. In short, the Bitcoin mining reward is halved every fourth year, but as transaction fees are a fraction of the present compensation to miners, their compensation is effectively nearly cut in half every fourth year. All things equal, we estimate that the absence of a sufficient security budget turns into an issue for Bitcoin in the next decade or so.
We mainly view three answers to establish a viable long-term security budget: remove the maximum supply of 21mn Bitcoins, adopt a proof-of-stake consensus mechanism instead of proof-of-work, or shape greater scalability to significantly boost transaction fees. For the latter to function as an eternal compensation instead of fairly consistent mining rewards, these transaction fees must 1) be stable and 2) be substantial in volume. In a few days in May, the fees might have been great enough, but there is, as it stands, a severe shortage of constancy in the transaction fees for it to possibly be the sole compensation to miners. Even if there is a long way to go for transaction fees to reach those two criteria, if at all possible, then Ordinals have stressed that ecosystems of decentralized matters thrive within Bitcoin as well. Despite those other cryptocurrencies have proved this as early as around 2017, it is a first for Bitcoin to attain solid traction on such a concept. Not only does Ordinals add to transaction fees, but it is also the source of the much-needed utility of the Bitcoin blockchain. These are also the arguments why we stress Ordinals as one of the most pivotal movements of Bitcoin so far in its 14-year life.
Not that fast
However, not all share our positive view on Bitcoin Ordinals, particularly some Bitcoin maximalists regard Ordinals adversely. Adam Back, a Bitcoin thought leader and CEO of Bitcoin-focused firm Blockstream, said on Twitter that it is “...sheer waste and stupidity of an encoding”. Sheer waste compared to what? The mere transactional throughput of 7 transactions per second of Bitcoin’s mainnet has for years led Bitcoin to be anything but a great means of exchange, particularly in developing countries, in which the high transaction fees are much steeper in real terms. This implies that the vast majority of transactions on Bitcoin are speculative by nature, so by that definition, almost every transaction on Bitcoin is arguably sheer waste next to Ordinals.
Rather than Ordinals, the poor transactional throughput is due to the reluctance and conservatism of the community of Bitcoin towards changes, including scalability solutions presented throughout the years, of which the vocal Bitcoin blocksize war that unfolded between 2015 and 2017 stands clear as crystal. The philosophical dispute was about the block size of Bitcoin. At its heart, increasing block sizes boost transactional throughput, whereas the larger blocks were to inflate the cost associated with mining and running nodes, possibly making Bitcoin more centralized, as fewer entities could potentially bear the increased cost. In the end, small blocks won at the expense of scalability, ultimately triggering a hard fork of Bitcoin named Bitcoin Cash offering much larger blocks. Since then, Bitcoin has focused on Lightning Network and other Layer 2 solutions, including Blockstream’s Liquid Network, but all without much utilization, especially relative to Ethereum’s Layer 2s, which have realized way more traction in less time.
The Bitcoin maximalists who are opposed to Ordinals must look at themselves in the mirror. Bitcoin Ordinals is the first sincere effort to create an ecosystem on Bitcoin of non-monetary dealings, similar to what Ethereum, Solana, Avalanche, and pretty much every other Layer 1 blockchain have had for years. This creates utility, boosts transaction fees, and might be the most effective call for innovation within the Bitcoin community to embrace suitable scalability to advance its monetary applications too. The latter is something the Ordinals community has already contributed to by as late as last week locating a more efficient way to apply Ordinals. In our view, Ordinals might turn out to be one of the most influential developments for Bitcoin, which the Bitcoin community simply must welcome to minimize the risk of fading into irrelevance. Latest Market Insights
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