Bitcoin May Work Better As Money Than For NFTs

There are now thousands of NFTs being inscribed directly into the Bitcoin network’s blockchain, which may harm bitcoin’s long term value as a digital currency.

The latest innovation that crypto fans are buzzing about, also referred to as Ordinals and inscriptions, allows users to embed up to four megabytes of data directly onto the Bitcoin blockchain. This has divided the Bitcoin community, as it raises some existential questions on the purpose and future of Bitcoin.

To be fair, the Bitcoin blockchain has always contained random, non-financial data — one might argue that the secret message in the genesis block is the first example. The last two major upgrades to Bitcoin, SegWit and Taproot, allowed for more of this data to be included in the Bitcoin blockchain.

Inscriptions simply provided the tool to easily enable the loading of such data, along with a manufactured ordering system that aims to create an aura of non-fungibility over satoshis, tiny pieces of bitcoin almost like a penny is to a dollar. Bitcoin’s fungible unit of account, the satoshi, is inherently different from these bitcoin-inscribed NFTs. But is turning Bitcoin into a public data repository good or bad? In short, it’s not great if the goal is to keep the “coin” aspect of bitcoin.

Bitcoin NFTs

To answer the question about bitcoin NFTs, let's classify transactions in Bitcoin in two groups: financial transactions and non-financial transactions (NFTs, pun intended). Financial transactions are transfers of value from party A to party B. This type of transaction serves Bitcoin's original purpose as a peer-to-peer electronic cash system. These transactions utilize the core computational scaffolding of Bitcoin: transfers of value (satoshis) combined with digital signatures that can unlock that value.

In contrast, NFTs load arbitrary data into the transaction which can vastly exceed in size the normal components of the transaction. Digital monkeys are examples of such data, but so are medical records, 3D-printed designs, land titles, audio files, pornography, and political images.

Limited Block Space

Since inscriptions launched, these NFTs have taken a larger share of scarce Bitcoin block space. Once the blocks fill up, as they have recently, the Bitcoin transaction fee market will clear by adjusting prices upward. In short, it becomes more expensive to use bitcoin for financial transactions.

Are higher transaction fees a problem? Advocates of inscription would say no. These fees accrue to miners and require users to run more nodes. Some of these new users may start using Bitcoin for money. Increasing transaction fees also increases the network’s security budget, preparing Bitcoin for the future when the block subsidy for miners vanishes. Third, this bitcoin NFT trend will inspire future Bitcoin developers and entrepreneurs to build better financial tools to compete with all the new attention Bitcoin blocks are now receiving from the art world. Fourth, NFTs may drive more traffic to the Lightning Network.

Higher Transaction Fees

However, my chief critique of these arguments is that they ignore the equilibrium effects between different bitcoin users. Demand for Bitcoin block space comes from two different sources, financial transactions and NFTs. Yet they both clear in a single market. If the fee market clears at a higher price from greater NFT demand, all users will face that higher price.

These higher fees will repel financial users away from Bitcoin and towards other alternatives, likely in the legacy financial system. The Lightning Network is still experimental and most financial use cases still rely heavily on the base layer Bitcoin blockchain.

Inscriptions may increase bitcoin adoption among NFT users, but will, all else equal, decrease adoption among financial users. An art collector in Tribeca can now store a Bored Ape on Bitcoin, but a bank in Dhaka is also less able to afford to settle a transaction using bitcoin.

What matters for the security budget is not the transaction fee alone, but miner revenue. Miners can earn revenue from high fees and low transaction volume, or alternatively, low fees and high transaction volume. The former describes a Bitcoin which serves elite art collectors, the latter a Bitcoin as global base money. When framed this way, the choice is not between large and small blocks, but between large and small transactions. Finally, inscriptions just made the job of every Bitcoin entrepreneur harder. The increase in transaction fees will only increase the customer acquisition cost for any entrepreneur seeking to build a product that facilitates bitcoin payments. Fees matter.

The Future Of Bitcoin

Rather than rushing to execute a software patch or advocate for a soft fork, now is the time to start the hard conversation about what kind of Bitcoin we, as users, want. There is no question that inscriptions will increase demand for bitcoin. But which Bitcoin? NFT Bitcoin or Financial Bitcoin?

I have nothing against NFT artists and the creative work they do. Plus, I’m sympathetic to the financial abuses and frauds that NFT artists unwittingly face in the broader cryptocurrency space. But I believe that in the pantheon of problems facing humanity, a distributed, secure, and immutable art gallery does not fulfill Bitcoin’s highest purpose. Bitcoin is uniquely positioned to serve as base money for the world, able to free billions of people from the iron fist of central banks. And that, indeed, is its most poetic use.