Grayscale Research Report: Can Ordinals unlock new potential for Bitcoin?

Since its inception, Bitcoin has been hailed as a revolutionary technology that has the potential to change the way traditional "financial layer" transactions are conducted. Recently, an innovation has emerged on the Bitcoin network that brings more possibilities and will even affect the entire "cultural layer" of the crypto community.

At the end of 2022, the NFT protocol Ordinals, created by software engineer Casey Rodarmor, was officially launched on the Bitcoin mainnet. The protocol allows users to create Bitcoin versions of NFTs - described as "digital artifacts" on the Bitcoin network, supporting JPEG images, PDF, video or audio format content. Similar to many NFT projects on the Ethereum chain, these "digital artifacts" will be minted on the Bitcoin network.

Above: Simplified Bitcoin inscription and ordinal example (Source: Grayscale Research)

The Ordinals protocol assigns values ​​to the smallest unit of Bitcoin, "satoshis", to achieve uniqueness. More specifically, the Ordinals protocol, which runs on top of the Bitcoin Core full node, allows users to add arbitrary data to Bitcoin transactions ("inscriptions") and bind the data to a single satoshi ("ordinals"). The Ordinals protocol has attracted great attention in the crypto ecosystem. On April 8, 2023, the Ordinals protocol inscription minting exceeded 1 million (as shown in the figure below), which has also triggered discussions about unlocking new potential for the Bitcoin network.

Data source for the above image: Dune Analytics

The Originals protocol allows people to create NFTs on the Bitcoin network. Although some people have criticized the protocol, warning against expanding the Bitcoin blockchain or damaging fungibility, Grayscale believes that the Ordinals protocol can effectively promote Bitcoin adoption. It should be noted that the Bitcoin network has always been regarded as a strict blockchain ecosystem, and no practical innovations have appeared for many years.

A brief history of NFTs on the Bitcoin network

Although the Ordinals protocol has been widely welcomed by the crypto community since its launch, it is not actually the first NFT instance on the Bitcoin blockchain. For example, Rare Pepe Cards previously used a 2.5-layer network called "Counterparty" to try to launch NFTs.

The "Counterparty" network was founded in 2014, but it has been criticized for being too complex for its Layer 2 infrastructure. However, it is precisely because of Counterparty's pioneering spirit that more people have begun to pay attention to NFTs on the Bitcoin network. Although the Counterparty network is not as important today, it still represents an early example of users creating and trading unique digital assets in the history of encryption, and has widely inspired people's enthusiasm for Bitcoin NFTs.

Above: Rare Pepe Cards on the Counterparty network (Source: Rare Pepe)

The Ordinals protocol is a Bitcoin NFT solution that is independent of Layer 2, which is why it is able to stand out from other competitors. Not only that, the Ordinals protocol does not rely entirely on Layer 2 solutions, but instead takes advantage of enhancements to the Bitcoin network itself, such as Segregated Witness SegWit (implemented in 2017 and increased the Bitcoin block size limit to 4 MB) and Taproot (implemented in 2021 and added more complex scripts in the Witness6 section). This means that the Ordinals protocol can enable data to be embedded directly in the witness part of a Bitcoin transaction, which can consist of almost any type of data, such as pictures, videos, or even applications.

Above: Example of Bitcoin Ordinal inscription (Data source: Doom Clone NFT)

Opposition to Bitcoin Ordinals

Frankly speaking, the inscription cast by the Ordinals protocol more or less deviates from the "Satoshi Nakamoto concept", which is to make Bitcoin a traditional peer-to-peer electronic cash system, so the crypto community has raised a lot of criticisms about it. Generally speaking, these criticisms can be classified into the following three points:

1. Deviation from Bitcoin’s original purpose: Using the Bitcoin network to store arbitrary data contradicts the main goal outlined in Satoshi Nakamoto’s 2013 white paper, which positioned Bitcoin as a “peer-to-peer electronic cash system.”

2. Blockchain bloat: Embedding additional data into the Bitcoin blockchain increases its size, making it more challenging to download, and some believe that Ordinals will clutter the blockchain with irrelevant information.

3. Damage to fungibility: If a large amount of content is written into the smallest unit of Bitcoin, “Satoshi”, the fungibility of Bitcoin will be weakened, which will in turn affect its main use case as an electronic currency.

In fact, these concerns are not unfounded: the original Bitcoin whitepaper did not specify that digital assets on the blockchain are unique, nor did it specify inscriptions that could reduce the fungibility of the network, thereby introducing additional data that bloats the blockchain. Ordinals are essentially a byproduct of utilizing the Bitcoin blockchain and subsequent cryptographic innovations, even if Bitcoin’s creators did not originally envision this.

However, it should be noted that although the inscriptions minted by the Ordinals protocol do reduce the fungibility of Bitcoin, it is estimated that the total number of inscriptions minted in 238 years only accounts for about 0.24% of the total BTC supply.

Potential Opportunities for Bitcoin Ordinals

Grayscale believes that Ordinals have a positive impact on the Bitcoin network in two key ways:

1. The increase in Bitcoin miner fee income makes the Bitcoin network more secure.

2. Promote cultural transformation within the Bitcoin community.

The Bitcoin network will become secure

One of the most relevant open questions about Bitcoin’s economic model is the security budget, a long-standing concern in the Bitcoin community that once all bitcoins are mined, the rewards miners receive from transaction activity may eventually be insufficient to incentivize miners to maintain sufficient hash rate to ensure the security of the Bitcoin network.

The emergence of Ordinals will drive an increase in the total fees paid to miners (as shown in the figure below), which may establish a sustainable baseline level of transaction fees to incentivize miners and thus continue to ensure the security of the Bitcoin network throughout its life cycle.

Above: Bitcoin total fees (data source: Glassnode, as of April 21, 2023, for illustration purposes only)

Bitcoin Cultural Transformation: Rekindling Developer Enthusiasm

Bitcoin is the number one digital asset in mainstream awareness or by market capitalization, but despite this, some crypto insiders and developers still believe that its community and blockchain development are still relatively lagging behind. Compared with the speed of NFT popularization and adoption on other blockchains such as Ethereum, Bitcoin is indeed a bit "outdated", but with the emergence of Ordinals, some new users who may not have considered using the Bitcoin network may enter the market, in which case, it may promote a development-oriented community and culture.

Comparison of Ordinals and Ethereum’s ERC-721

Since its launch in 2017, the ERC-721 standard has been adopted by some of the most well-known NFT series on Ethereum. Although other blockchains use their own standards, considering that Ethereum NFTs account for nearly 90% of the entire market share, it makes sense to compare Bitcoin Ordinals with the Ethereum ERC-721 standard.

From the analysis, there are significant differences between the Ordinals protocol and ERC-21 in at least three aspects, as follows:

Ultimately, unlike the Ethereum ERC-721 standard, Ordinals present the key features of non-fungible digital assets due to their immutability, lack of programmability, and mandatory on-chain inscription requirements. On the other hand, while Ethereum NFTs currently dominate the NFT market in terms of volume and popularity, despite their greater programmability, Ordinals may be a more attractive option for users seeking direct, scarce digital assets on mature, usable blockchains.

in conclusion

Despite the Ordinals protocol’s relatively new history, its surge in popularity during the bear market, with over 1 million NFT inscriptions minted in just four months, is certainly surprising, and the trend may also indicate a renewed shift in the broader perception of Bitcoin (despite its reputation as a rigid blockchain by some crypto users).

Legitimate concerns aside, the Ordinals protocol has the potential to have a positive impact on the Bitcoin network in the long run and will attract a new wave of enthusiastic users and developers to embrace the Bitcoin community.