The Breakdown - Why Ordinals and BRC20 Tokens are Driving Bitcoin Layer 2 Development

Episode Date: May 21, 2023

Bitcoin has been experiencing much higher-than-normal fees of late, driven by Ordinal inscriptions and BRC-20 token memecoin mania. On this Long Reads Sunday, NLW reads two essays that explore how they're driving layer 2 development. Frogs, Fevers and Fees: Bitcoin’s New Governance Challenge - Michael Casey As Bitcoin Scales, We Need Better Custodial Solutions - George Kaloudis  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Sunday, May 21st, and that means it's time for Long Read Sunday. A quick note before we dive in. If you were enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.L.Y. All right, friends, well, as it is Bitcoin Conference Week, I thought, why not do an LRS all focused on Bitcoin? So today, we have two essays, both sort of grounded in the recent fee spikes,

and both really focused on what happens next, and more specifically, what sort of additional emphasis on layer two's we might need as a Bitcoin community. The first piece was written by CoinDesk Michael Casey and is called Frogs, Fevers, and Fees, Bitcoin's New Governance Challenge. Michael writes, This is why we can't have nice things. Just when we thought we'd learned our lessons from the blowups of FTX, 3 arrows capital, Celsius at all,

meme coin fever strikes again. Crazy crypto casinos are back. People are making ridiculous gobs of money from tokens based on a frog image, while others stand to lose massively as irrational bidding takes hold. And this time, the fever is not only infecting greedy human minds, but messing with the functioning of the most valuable blockchain in the world. The ability to create tokens based on the new BRC20 standard, which was enabled by Bitcoin's Taproot upgrade, has fostered a variety of new Bitcoin-based meme coins, many mimicking those

released on other chains that have recently experienced wild price movements. This past week, for example, the Ethereum-based Pepe coin rose almost 5 million percent, then lost 50 percent off its highs. This follows the creation of the Ordinals Protocol, which gave rise to Bitcoin-based data inscriptions that function as non-fungible tokens. These use up a lot more data than a basic Bitcoin transaction, which means they're driving up Bitcoin fees. Bitcoin miners have lately been earning more from transaction fees than from their routine

6.25 Bitcoin block reward. And that means if you want to send a small amount of Bitcoin on chain, it won't be accepted or you'll have to pay a prohibitively exorbitant price for doing so. I can hear Elizabeth Warren's anti-crypto army sniggering. These crypto bros are so obsessed with mooning into Lambos that they're destroying what they claim to be this technology's core purpose as a better form of money and value exchange. The fighting begins. Not surprisingly, this is causing a stink within the Bitcoin community. The fight over the scarce resource of block space has long stirred tensions, most memorably

during the block size wars of 2016 to 2017. It motivated the founding of the Lightning Network, which allows for small transactions to be processed off-chain to save valuable block space for bigger ones. The potential for tension is arguably even greater, in this case. Purists who believe Bitcoin's sole purpose is as an alternative currency are incensed to see it being used for frivolous frog JPEGs. On the other hand, those building and using these new BRC 20 and Ordinals-based tokens counter that no one gets to say what Bitcoin is for. It's an open protocol, after all. We can all agree that rising transaction fees in Bitcoin congestion are a problem. It goes to the heart of Bitcoin's resource efficiency and utility.

But what can be done about it? I'll go out on a limb and say the answer does not lie in the suggestion offered by Luke Dash Jr., a high-profile early Bitcoin developer who essentially wants to stop BRC tokens and Ordinals projects by imposing a filter. That Luke's critics say is censorship. No matter what you believe Bitcoin is for, surely its censorship resistance must be preserved. Echoing Bitcoin Institute fellow Troy Cross's view on taxation and energy policy, on our podcast this week, he said that the White House's proposal on tax Bitcoin mining discriminated one person's energy choice over another's. Echoing Bitcoin Policy Institute fellow Troy Cross's view on taxation

and energy policy, I'd say Bitcoin's community cannot constrain what forms of value exchange Bitcoin's blockchain is used for. Limits on speculation? What is fair game, in my humble opinion, are code upgrades that would take pressure off block-space limits to improve the overall functioning of the system in a use-case agnostic way. If lightning is not sufficient to improve Bitcoin scalability, is there anything to learn from the various layer two scaling projects of the Ethereum community, such as ZK roll-ups or optimistic roll-ups? Or might it be possible or even appropriate for the protocol to bake in time-lock constraints or costs on certain speculative activities that challenge the liquidity of the entire system. I'm specifically thinking of short-term asset flipping.

Note this could only be relevant to non-fungible tokens. You can't impose a limit on fungible BRC 20 tokens precisely because the owner can just sell a different one. Money can't be constrained in this way. Folks way smarter than I will, I'm sure, point out flaws in these suggestions. Indeed, if someone were to say that in singling out asset flipping, which after all brings liquidity to the market, I'm no different than Luke Dash Jr. rallying against meme coins, they'd have a point. I'm judging one person's activity over another's. Still, the core problem here is not that Bitcoin is being used to represent frog images per se, but that its value as an efficient, intermediary free settlement system for transferring value of all kinds is undermined by blocked space congestion.

That's where the governance conversation needs to be focused. The question of how to balance the rights of the individual with the interest of the group is the core challenge of any blockchain community. Bitcoin is no different. All right, back to NLW here, and I want to get to the next piece, but before I will just say this, one of the really important perspectives that I've seen represented, but maybe not enough, is that one of the temptations we should likely fight, when we see some sort of momentary new challenge for Bitcoin, such as the fee surge that we've experienced around ordinals and BRC 20 tokens, is to race to assume that some sort of protocol change is needed, or some sort of governance change as Michael is proposing is needed.

Now, I think Michael is being clear that he's just engaging in an intellectual exercise. He's not racing out to advocate for these specific things. He's provoking a conversation. But he's far from the only person to actually advocate for some sort of big change based on what we've seen. It is, of course, possible that ordinals and BRC 20 tokens continue their ascendance, and that the community decides that they are legitimately crowding out more valuable uses of block space. But boy, should it involve a lot to determine that one use of block space is more valuable than another in a free market system. What I certainly think is true is that this whole conversation is focusing us on a couple of

important things. One, the value, the scarcity of Bitcoin block space. Two, the fact that in the future, Bitcoin itself as a settlement layer is likely to be used primarily for very, very big transactions. In other words, it likely won't be a daily transaction network. It will be a big settlement layer. This is something that folks like Nick Carter have talked about extensively. It's one of the reasons that Nick has always bristled at comparisons to Visa transactions, for example. But the third thing it hones us in on is the need for layer 2s and more layer 2 infrastructure. And so with that in mind, let's turn to the second piece. It's by George Kulutis and is called, as Bitcoin scales, we need better custodial solutions.

If Bitcoin is going to scale through layer 2s, then we need more options and more clarity around the tradeoffs between the different ways to use the cryptocurrency. Crypto-Unintelligensia discourse has been set aflame by this week's big crisis in Bitcoin, the culprit, big, fat, unwieldy fee rates. Until recently, you could have sent a Bitcoin transaction rather cheaply, probably at a fee rate of one Satoshi per V-byte, equivalent to a fraction of assent. Now, with the rise of the use of non-fundable token-like inscriptions and the BRC-20 token standard on Bitcoin, nominal fee rates are comparatively absurd.

At the time of writing, getting a Bitcoin transaction sent in a reasonable time period would cost something like 100 Satoshis per V byte. All things considered, that's actually still pretty cheap, but it's way, way more expensive than Bitcoiners are used to. And so, people are upset. The thing is, they are upset not because fee rates are high, but because of why fee rates are high. See, the Bitcoin blockchain has always had scarce block space.

When billions and billions of people want to use Bitcoin, will it become too expensive to use, has always been an open question about Bitcoin. It was even a central point of contention during the block size wars in 2015 to 2017, which led to the introduction of segregated witness or Segwit to Bitcoin and the Bitcoin Cash hard fork. Of note, Segwit solved for transaction malleability and open the door to our most recent reason for fees going up. Funny how that works. This time around, Bitcoin fees have skyrocketed because a lot more people want to use Bitcoin, and not to send permissionless sound money to others or because they want to store wealth, but instead to put monkey pictures on the Bitcoin blockchain and speculate on tokens.

Blasphemous! Bitcoin should be used for financial transactions, hence the hullabaloo. Putting aside the moralistic argument of what Bitcoin should be used for, Bitcoiners have never really had a good response to how the network should handle periods of time when transaction fees spike. Canned answers that, quote, people will just pay for the block space, or, quote, the free market will figure it out, are setting up a world where only people who are able to afford to transact on the network are the Bitcoin rich. Yuck, so much for unseating the rent

seekers. Of course, high Bitcoin fees have some potential solutions. The most commonly cited solution is Bitcoin's Lightning Network, which has been pinpointed as a serviceable means to send Bitcoin quickly and cheaply. When you're already onboarded and using the Lightning Network and you know what you're doing, it's absolutely great. Transactions feel magic. They're fast and cheap when they don't fail. But the problem is, you can't get to Layer 2 without sending initial transactions on layer one. In this case, the currently comparatively expensive Bitcoin blockchain. It's just like you can't get to the second story of most buildings without first stepping into the first story. In both cases, you can just wait until fees go down, or until the elevator

banks free up, or take the stairs, I guess. But what if fees don't go down? What if people keep piling into the building you're in? One way to solve this could be through third-party custody. That's like your friend setting up a zip line from another building to the second floor through a window they opened up for you so that you can get to the second floor without ever touching the first floor. All you need is a little trust. Of course, this is exactly what Bitcoin was created to avoid, as a purely pure-to-peer version of electronic cash that can be sent directly from one party to another without going through a financial institution. But it's true, custodial solutions might actually be the easiest way to use the Lightning Network. Doesn't it feel dirty, though?

Unfortunately, the current design of Bitcoin probably doesn't allow for the entirety of the world to efficiently onboard through layer one. Maybe the big philosophical discussion around being financially self-sovereign ends for most because it really is difficult to be fully self-sovereign, even with Bitcoin. Our future conversations around Bitcoin should then probably focus on one thing. Tradeoffs. Maybe it's fine that I use my Bitcoin in a custodial way because it's easier for me, and you use it non-custodially. Fine, maybe I'm wrong and you're right. Maybe it's none of your business how I use my own or rather my custodians' money. The point is, we should be more open to discussing custodial solutions to our problems, no matter how dirty it might make us feel.

and to that end, applying some custodial products in your financial or Bitcoin life need not bar you from using non-custodial products. You can use both. We just deserve more clarity and options when it comes to these particular trade-offs. So again, my goal here isn't necessarily to get too deep into George's particular arguments about custodial solutions and onboarding. I think it's the flag that these are kind of the right conversations to be having. It would strike me as very strange to find people who were bitcoins who, when they really think about it, didn't assume that they that at some point there was going to be this sort of competition for Bitcoin block space, even if this isn't exactly how they would have imagined it happening. Now, again, I think it's a

reasonable position to say that this isn't the time or the way or the context that we want to be dealing with these problems, but at least they create a context for having the important conversations. It's one of the reasons I'm so excited to be collaborating with people like Wolf on the Bitcoin Builders Show and on the breakdown network more broadly, because they're actually out there trying to help startups who are thinking about exactly this set of problems and making Bitcoin more useful for the next billion users. Anyways, guys, lots of food for thought, and I just wanted to share these as examples of what some people see as a pretty big negative in BRC 20 tokens and ordinals, or if nothing else, producing some great conversations. I hope whatever you are up to this weekend, you are having a good one.

Until tomorrow, be safe and take care of each other. Peace.