BTC Halving – Half the Rewards but Much More in Return
April 2024 Commentary
The Bitcoin Halving occurred quietly on a Friday night, April19, 8:09 pm Eastern time, when most were out unwinding from their workweek, at block 840,000. Programmatically, miners’ reward for securing a block on the blockchain dropped by a half to 3.125 BTC. Eventually, this reward will drop to 0 as the BTC supply asymptotically reaches a cap of 21 million. But declining rewards obscure the richness of the development around the Bitcoin blockchain.
The Halving was supposed to be a happy event, further boosted by expectations that investors would be pouring into the newly approved spot BTC ETFs. However, April didn’t prove to be as sanguine as hoped for. Strong ETF inflows during the first quarter of this year gave way to modest outflows across April.
Source: sosovalue.xyz
Macro conditions did not help either as, over the month, the expectations for a US Fed rate cut of 25 bps by mid-June dropped from a 56% probability to a mere 8.5%, according to the CME Fedwatch. After peaking above $73k, BTC retraced to just around the $59k handle by the end of April.
Mining = Security, Though Getting Paid Less
Historically on the Bitcoin chain, the block reward accounted for 80-90% of the miner's total revenue while transaction fees made up the rest. Immediately after each halving, the block reward was reduced by half in terms of Bitcoin, while the transaction fees would make up a larger share of miner’s total revenue.
Source: look into bitcoin
This revenue reduction is a shock to the network, even though it is well known ahead of time. Nonetheless, post halving, a cascade of events ensues. Miners become less profitable and less profitable ones shut down. The network’s hashrate (computational power focused on mining new blocks) declines, reducing the chain’s economic security while lengthening the average block time to over 10 minutes. The network automatically lowers the mining difficulty to make mining more attractive. Over time, miners will also upgrade to more efficient mining hardware and seek cheaper energy sources to improve their operational efficiency. Consequently, the network’s hashrate rebounds and its security improves. This shock is generally short-lived, reducing the hashrate temporarily by 10% to 20%. In contrast, when China cracked down on crypto mining in the middle of 2021, hashrates dropped by close to 50% and difficulty levels by 28% based on information provided by Hashrate Index and CoinDesk.
Source: CoinDesk, Hashlabs Mining
While hashrates have steadily climbed, miner profitability has been on a secular downtrend. Since this April’s halving, miner profitability has dropped to its all-time low, despite BTC being at around the $60k level.
Source: Hashrate Index
This raises the serious question as to how the Bitcoin network may be secured when the miner rewards become effectively 0. Rising BTC prices is a nice thought, but the price cannot be infinite! The answer seems to lie in the more recent network developments that hold the promise of higher total transaction fees being paid to the miners.
Not so Ordinary Ordinals
The Ordinal Theory is an innovative protocol introduced to the Bitcoin network to integrate non-fungible tokens (NFTs) directly onto the Bitcoin blockchain. It was developed by Casey Rodarmor and launched on the Bitcoin mainnet in January 2023.
The Taproot upgrade in 2021 enhanced Bitcoin's scripting capabilities and privacy features, making it more feasible to incorporate complex data on the Bitcoin blockchain, although it didn’t specifically target NFTs. The Ordinals protocol takes advantage of these capabilities by inscribing arbitrary digital data directly onto individual satoshis, the smallest unit of bitcoin equal to 10^-8 (i.e., one-one hundred millionth of a) BTC. Each inscribed satoshi effectively becomes a digital collectible or an NFT.
The Ordinals protocol assigns an "ordinal number" to every satoshi from the genesis block onward, providing a unique identifier for each. These ordinal numbers help track the specific satoshis that carry inscribed data. Unlike typical NFTs stored off-chain, inscribed satoshis are stored directly on the Bitcoin blockchain. This means they are secured by Bitcoin’s proof-of-work consensus mechanism. Trading these inscribed satoshis involves bitcoin transactions.
Most Ordinal NFTs are text based because of the limited block space associated with each satoshi, but the data can be images (e.g., png files), music (e.g., mp4 files), or other digital artifacts.
Source: Dune Analytics, h/t @ilemi
Beyond inscriptions, Casey Rodarmor also suggested that rare satoshis may be found in the significance of the ordinal number itself, with distinct definitions of the rarity levels. For example, the first Satoshi minted on the genesis block is of “mythic” rarity.
To add more functionality, in the latter part of 2023, Rodarmor proposed the Runes protocol, a UTXO-based protocol designed for creating fungible tokens on Bitcoin. As described in the proposal, this protocol minimizes its on-chain footprint thanks to the UTXO-based model and simplifies the issuance of native fungible tokens on Bitcoin.
Beyond Just Digital Gold
For most of the past 15 years, BTC has mostly served as a token for a “peer-to-peer electronic cash system” and as a digital, long-term store of value. The Lightning Network was conceived and implemented close to a decade later as an L2 solution to scale by processing and settling most of the BTC transactions off-chain. Over the past several years, Stacks has been working to build a different L2 solution for BTC. According to their whitepaper, the goal is “to grow the Bitcoin economy, by turning BTC into a productive rather than passive asset, and by enabling various decentralized applications.” The Stacks L2 will have its own scripting language that allows for smart contract functionality but will rely on the settlement finality of the Bitcoin network.
Then, suddenly in a period of just over a year, we have a couple of new protocols built that allow for select satoshis to become non-fungible through either having inscriptions or through its rarity and for new fungible tokens to be created right on the Bitcoin L1.
We cannot say what the original Satoshi Nakamoto may be saying about this development, but it certainly has its pros and cons. On one hand, it has breathed new life and use cases for BTC and satoshis. Non-fungible or fungible tokens created directly on the Bitcoin L1 are censorship resistant and immutable, once finalized on the chain. This has generated a significant increase in interest, as witnessed by the transaction fee increases since the introduction of the Ordinals in early 2023 and the Runes since this past April’s BTC Halving. In turn, these higher rewards incentivize the miners to continue to provide security for the network.
Source: Dune Analytics, h/t @dgtl_assets
Source: Hashrate Index
On the other hand, these developments are not without their detractors. Many worry that Ordinals could lead to “blockchain bloat” as they increase the block size, increase the storage requirements for nodes potentially making it more costly to operate a full node, thereby reducing decentralization. As well, the competition for block space may intensify, pushing transaction fees higher and restricting the accessibility of the network for its primary use as a digital currency.
The interest in the NFTs and Runes on the Bitcoin network appears somewhat short-lived. Overall however, it is energizing to see how engineering creativity has “modernized” the OG of blockchain tokens. BTC’s dominance was recently boosted by the expectation and subsequent trading of spot BTC ETFs. Broader functionality may lengthen that dominance for a while longer.