Bitcoin Fee Market Dynamics - How It Works & What Inscriptions Mean For Miner Revenue

The fee market in Bitcoin is a testament to the decentralized and trustless nature of the network. Rather than relying on a centralized authority to determine transaction fees, users compete with one another to have their transactions included in the limited block space available. This market-driven approach ensures that transaction processing is efficient and fair while incentivizing miners.

In this article, we will delve into the intricacies of the Bitcoin fee market, exploring its evolution, dynamics, and the factors that influence fee levels. Fees can jump instantly, driving revenue for miners, sometimes doubling in a few days.  Here, we will examine the concept of inscriptions and how the fee market has evolved, considering technological advancements and the ever-changing landscape of Bitcoin.

How the Mempool and Fees Work

The mempool is a temporary storage area where unconfirmed transactions wait to be included in a block. Miners select transactions from the mempool based on transaction fees and size. Transactions with higher fees are typically prioritized for faster confirmation. Once a transaction is selected for inclusion in a block, it is removed from the mempool and considered confirmed.

Technically, everyone in the Bitcoin network maintains their node’s mempool (if they run a node). When a transaction is initiated, it is gossiped to peers until it reaches every node in the network. This method ensures that all participants have heard of the transaction and miners can see it in the mempool.

History of the Fee Market

The scarcity of block size and time in Bitcoin creates a competitive environment where transactions vie for limited block space, with one block being confirmed every ten minutes on average (600 seconds). As transaction demand increases, the fee market intensifies. Users seeking faster confirmation may attach higher fees to their transactions called Replace by Fee (RBF), or new transactions raise fee rates to incentivize miners to prioritize them. This heightened competition in the fee market reflects the increased demand for scarce block space. The interaction between transaction demand, limited block space, and the fee market showcases scarcity's essential role in shaping the transaction ecosystem within Bitcoin.

Limited block space, time, and funds contribute to a fluctuating free market of transactions. The chart below represents 'block time' (a scarce resource), wherein each block approximates 600 seconds, or every ten minutes, due to Bitcoin's programmatic nature. The yellow line signifies the 'Block Size.' During the peak of the bull market in 2017, it reached its maximum size. With the implementation of Segwit, the block size remained constant. However, additional transaction data can now be stored in the 'witness,' leading to block sizes that exceed 1MB. We'll delve further into this topic later in the article. Scarce block space, and scarce time, with scarce money, create a free market of transactions that can fluctuate equally. The below chart illustrates block time (scarce), where each block hits around 600 seconds or every ten minutes due to the programmatic nature of Bitcoin. The yellow line is Block Size, which at the height of the bull market in 2017, was hitting its peak size. Segwit was implemented, and the block size stayed the same, but now other transaction data can be stored in the “witness,” which is why the block size exceeds 1MB. We’ll cover this further in the article.

The block size limit issue has sparked considerable debate within the Bitcoin community. Initially established at 1 MB, disputes over block size and Bitcoin scalability arose as early as 2014. This led to a hard fork in 2017, resulting in Bitcoin Cash, during a period known as "The Blocksize War".

Segregated Witness (SegWit) was introduced as a backward-compatible upgrade to address these concerns. SegWit separates the transaction signature data, or "witness data", from the transactions themselves. This effectively increases the blocks' capacity by reducing each transaction's size. The optimization allows more transactions to fit within a block, which helps to alleviate network congestion and lower transaction fees.

SegWit doesn't just enhance scalability; it also offers additional benefits such as increased security and the potential for implementing new features. One such feature is a "Layer 2" solution known as "The Lightning Network." Since SegWit was activated in 2017, its adoption has been steadily increasing, effectively addressing the block size limit issue and enhancing the efficiency of the Bitcoin network.

The record for the largest transaction in Bitcoin history was set in February 2023, with a block and witness data totaling approximately 3.96MB.

Scaling with Lightning

Implementing Segregated Witness (SegWit) and the subsequent introduction of the Lightning Network has initiated a notable shift in transaction activity within the Bitcoin ecosystem. The Lightning Network offers significant advantages like lower fees and faster transaction processing times. As a result, smaller transactions that may not be economically viable on the base layer have found a suitable home on the Lightning Network. This transition to layer two likely contributed to a reduction in the number of transactions on the base layer, as depicted in the graph below. It illustrates a decline around 2019, reflecting the increasing adoption of the Lightning Network, followed by a substantial spike in Bitcoin within Lightning Network channels in 2021. This pattern aligns with the hypothesis that the Lightning Network has provided an alternative and more efficient medium for smaller transactions, relieving some of the demand from the base layer of Bitcoin. The final spike (2023) in transactions can be attributed to BRC-20 tokens and inscriptions, which we’ll cover in the next section.

Inscriptions Have Changed the Fee Market

Miners do not need to understand technically what inscriptions and ordinals are, but knowing why they exist and where they come from gives insight into how they affect the fee market.

What are Inscriptions and Ordinals?

Within Bitcoin, ordinals serve as unique identifiers attached to each transaction. They verify digital assets' authenticity, ownership, and distinctiveness, including inscriptions like Non-Fungible Tokens (NFTs) and BRC20 tokens (the Bitcoin equivalent of ERC-20 tokens). These ordinals enable the tracking and validating the transfer and ownership of digital assets on the Bitcoin blockchain. By leveraging the security and immutability of the Bitcoin network, inscriptions ensure the integrity of transactions and the assets associated with them. They enable tokenization, transfer, and verification of digital assets within the decentralized framework of Bitcoin.

Inscriptions and the Fee Market

In 2023, inscriptions increased fees and congestion in the Bitcoin mempool. Users attached higher fees to their transactions to reach confirmations sooner, leading to intensified competition for limited block space and longer confirmation times. This resulted in an overall increase in fees and a more congested mempool. The increased fee market started partially in Feb 2023 and significantly increased in late April, when fees spiked due to the emergence of BRC-20 meme tokens created through inscriptions within Bitcoin blocks.

They are literal meme tokens. Examples include “pepe”, “moon” and “meme”.

Inscriptions can be categorized into two major types: NFT inscriptions and BRC20 inscriptions. NFT inscriptions (Blue in the chart below) are associated with Non-Fungible Tokens and typically require more block space due to the complexity and size of NFT transactions.

On the other hand, BRC20 inscriptions are linked to BRC20 tokens, which generally have smaller transaction sizes and consume less block space. This distinction in transaction size between NFT and BRC20 inscriptions highlights the varying space requirements and impact on the mempool congestion for different tokens within the Bitcoin network.

The two significant types of ordinal transactions can be categorized as "Boulders" (NFTs) and "Grains of Sand" (BRC-20). NFT transactions, represented by the Boulders, are larger transactions that put a significant load on the network but still leave room for regular transactions. Despite the relatively lower frequency of NFT transactions, they still compete for fees, contributing to the overall fee market dynamics. Alternatively, the “Grains of Sand” represent smaller transactions, often associated with BRC20 tokens. These transactions can generate a significant volume simultaneously, effectively "clogging" the mempool and driving up fees. The influx of BRC-20 transactions led to a substantial spike in transaction fees. The combination of both types of transactions, characterized by their different sizes and transaction volumes, increased congestion and significantly higher fees on the Bitcoin network.

The introduction of BRC-20 tokens significantly increased the number of transactions waiting in the Bitcoin mempool. This influx of transactions put substantial pressure on the network, driving prices upwards and causing a fee surge. The increased competition for block space resulted in users increasing their fees to ensure their transactions were prioritized for inclusion in a block. This fee spike persisted for approximately ten days in May 2023, during which users had to adjust to the heightened fee market conditions, and miners were getting paid more through fees than the actual block reward. However, as the initial surge of BRC-20 transactions subsided, the mempool congestion gradually diminished, leading to a fee decline. The market eventually normalized, bringing fees back to more manageable levels.

More Transactions per Second

Due to the small transaction sizes of BRC20 tokens, the number of Bitcoin transactions surged to over 6 per second. This increase in transaction volume can be observed by examining the Median Transaction Size historically. The influx of BRC20 transactions notably impacted the overall transaction activity and the mempool, resulting in heightened congestion. However, as the surge in ordinal transactions subsides, the transaction activity and mempool gradually return to a calmer state. In the future, the transaction ecosystem is expected to find an equilibrium as users and the network adapt to the increased utilization of BRC20 tokens and optimize fee market dynamics accordingly.

The Future of the Fee Market and Inscriptions

The creation and minting of BRC20 tokens and NFTs currently appear focused on generating these assets, with a low transfer rate observed in transactional history. It suggests that creators are positioning themselves for the next bull run, intending to transfer these assets to other buyers during that period.

The total fees associated with inscriptions have reached an impressive $55 million. This significant expenditure without an immediate return on investment diverges from the historical goal of seeking profits in altcoins and NFTs. In contrast, Bitcoin has traditionally been viewed more as a store of value than a speculative tool.

Looking ahead to the coming bull market, there will likely be an influx of new participants seeking to take advantage of meme token types and NFTs, driven by the desire to make substantial gains through gambling and speculation. This anticipation may increase creation and transfer activity, potentially driving up the fee market. With the vitality of a new bull market, fees could reach unprecedented heights never seen before as these transaction types are brand new, and we need to understand how they will impact the fee market during high transaction volumes.

History of Fee Market Exhuberance

Historically, a notable fee surge within the Bitcoin network has occurred during each bull cycle. As the market experiences heightened activity and increased demand for transactions, fees gradually accumulate, and the mempool grows. This growth continues until reaching a peak of exuberance. It is often observed that this peak in fees coincides with the market's top during the bull cycle, although it may not be an exact timing indicator. During this period, more users are eager to send transactions, and the pricing of each transaction is predominantly valued in USD rather than BTC. This psychological shift is significant since Bitcoin is priced in USD, influencing users to think and spend in terms of USD pricing. This trend is consistently observed throughout each bull market, with the peak of weekly average fees typically reaching around $50 as an example of this pricing dynamic.

Predicting the exact impact of inscriptions on the fee market during the upcoming bull run is impossible. Several factors contribute to the evolving fee dynamics, including adopting layer two solutions that reduce the reliance on layer one transactions.

Additionally, the influx of new participants attracted by the rebranding of NFTs and altcoins on the Bitcoin blockchain adds an element of uncertainty to the fee market. The market's behavior could follow different scenarios, such as increased congestion with transactions still being processed or a similar pattern of transaction spikes as observed in previous cycles. Observing how the market evolves and whether it experiences more extended periods of whole blocks with transactions being processed or follows a familiar pattern of transaction surges will be interesting. The future direction of the fee market remains uncertain, but what is known is the resilience of the Bitcoin network and eb and flow in fees.

Only time will reveal the impact of inscriptions on the fee market during the next bull run. This helps miners understand the dynamics, potential transaction charges, fees, and mempool. This understanding should help users navigate the fee market more effectively. Observing the interplay between inscriptions and fees will provide valuable insights as the market evolves. Time will ultimately unveil the full implications of inscriptions.