Upcoming Demand for Bitcoin Block Space and Its Impact on Mining Revenue

Source: Image made with DALL-E 3

Key Takeaways

• The upcoming Bitcoin halving will reduce miners’ primary source of income. This has led miners to invest in more efficient machines and prepare for a loss in production.
• Transaction fees are also expected to significantly increase due to atypical uses of Bitcoin’s block space. These fees are becoming a more substantial part of mining revenue, potentially even offsetting the reductions from the halving.
• The resurgence of Bitcoin-based projects not focused on monetary use cases, like on-chain marketplaces, collectibles, and layered platforms have recently spiked demand for transactions.
• These projects also pave way for additional new revenue strategies, like Miner Extractable Value (MEV) and transaction accelerators, that capitalize on material changes in the Bitcoin transaction market.
• It’s very possible in the next halving period that transaction fees become the primary source of miner revenue.
• It’s also very plausible that the upcoming boost in transaction demand could recoup almost half (~43%) of the halving’s impact in fee revenue.

Introduction

The event that everyone has been waiting for is fast-approaching — Bitcoin inflation will soon be cut in half. While many in the community are celebrating, miners are more apprehensive as they face a significant reduction in their primary element of mining revenue. So, as the story tends to go, miners have been proactively preparing for the drop in production. Installing more efficient machines, shedding debt, and optimistically hoping (begging?) for a face-melting rip in bitcoin’s market price.

But, what if I told you that this time around the other element of mining revenue could significantly, or even completely offset the effects of the halving? That transaction fees, what has historically been an inconsequential source of revenue, has a strong likelihood of increasing. And coincidentally, increasing at the exact moment, in the precise block, when the halving takes effect.

My prediction of a significant increase in fees is based on the motivation behind many bitcoin transactions changing. With new ways of using Bitcoin’s block space, wholly new sectors of users, developers and businesses are forming, and their non-monetary use cases are bringing higher variance to the fee market. The simple peer-to-peer electronic cash system, as we know it, is taking on more complex forms of settlement. It is not the first time, but it is happening at a rate never seen before, to the point these ancillary use cases are becoming real players in the fee market.

Users are opting into outside software that allows them to see Bitcoin in a different light. One is like putting on kaleidoscope glasses, letting users see the bitcoin supply in uniquely fragmented pieces, rather than the fluid sea of fungible units that they actually are. Another reads into data files that can be attached to a transaction, letting users claim ownership of various media riding alongside the coins they receive (think NFTs). Last, some interpret certain standardised messages across many transactions as the issuance or spending of outside assets — watching for any such transactions on the chain, and creating a trail of ownership for a wholly separate record system (think sidechains or higher layers).

It’s unconventional. It’s also highly controversial. But that’s not what this post is about. We won’t get into what is right or wrong or good or bad for Bitcoin. This paper will instead focus on the less-discussed component of mining revenue — transaction fees — and how unusual demand vectors for Bitcoin transactions could potentially offset the revenue losses around the halving.

Unusual Vectors of Bitcoin Transaction Demand

Fungible Tokens Standards

Initial efforts to introduce new assets within Bitcoin were creative but rough around the edges. Early experiments would actually come to lay the groundwork for popular Ethereum applications (and Ethereum itself), while at the same time highlighting certain challenges that ultimately stifled adoption within Bitcoin.

Projects like Counterparty, Colored Coins, and Mastercoin (later rebranded to Omni), were significant innovations in the wider cryptocurrency sphere, leading what is commonly deemed the first Initial Coin Offering (ICO) and Decentralised Exchange (DEX), as well as several other precursor technologies. However, they failed to achieve widespread adoption and acceptance within the Bitcoin community. The mixture of an unwelcoming culture, scalability and other technical issues, plus an eventually fast-growing competitive environment outside of Bitcoin curbed their success. Usage of these projects never really took off and they all sort of faded into irrelevance.

A resurging appetite for outside assets has however mounted once again. Newer attempts have not solved the challenges that held back projects in the past, but today’s market timing has made it a different story. Nowadays, awareness of Bitcoin has spread substantially, venture capital is more available, and, as silly as it sounds, there are many prominent success stories of memecoin speculation.

Regardless of the reason, or whether sustainable, we are seeing notable transaction demand for some of the newly tested Bitcoin token projects. Over $180 million (4.8k btc) in fees has been spent issuing and transferring BRC-20 assets since launching in March 2023. These transactions have made up nearly one third (30%) of all bitcoin transactions and paid 17% of the total fees since their release.

This is especially relevant for the fee market at the halving because a new standard — called Runes — is launching , with material upfront demand and growing attention.

Demand for future Runes tokens is over $1.2 bn in market cap, already half that of all BRC-20 assets, and markets have only been available since around November. Note that the issuance of Runes tokens must use bitcoin transactions, and that when BRC-20 assets were first issued, fee levels spiked to over $16 per transaction and 300 btc daily.

The potential implication is a flood of transaction demand to issue outside assets on Bitcoin when Runes tokens are released, precisely at the same block height of the halving. Other standards will not give up with the launch of Runes either, as updates for BRC-20, Taproot Assets and RGB have stayed on track.

If transaction demand mimics the period when BRC-20s first released, fees could well reach 150 bitcoin per day, offsetting a whole third of the halving’s reduction of mining revenue.

Yet still, Runes will not be the only catalyst building transaction demand.

Collectibles

The Ordinals protocol release unveiled a method for users to voluntarily agree upon a tracing system for the smallest units of a bitcoin, called satoshis (equivalent to 0.00000001 or 10^-8 btc). Under the Ordinals protocol, each unit is assigned an ordered number. By adopting such a standard, each subdivision of a bitcoin is persistently labelled and recognised along a sequential number line, from the first satoshi minted, all the way to the last satoshi released. In other words, when looking at bitcoin units in this way, each satoshi becomes a separate non-fungible unit.

By opting in, users can also choose to embed additional uniqueness to their discernable satoshis by attaching arbitrary data files to any unit. These files are called inscriptions. Users can commingle an inscription with any of the satoshis they own, while retaining the ability to transfer and store such modified satoshis on the Bitcoin network, akin to general btc.

With this, many tiny units of bitcoin have now become earmarked with image, text, and even full video game files, making them uniquely distinguishable from one another, and offering investors reasons to value otherwise fungible units of bitcoin, differently.

The collectible value of certain satoshis, due to numeral significance or an associated inscription, has already been proven on the open market.

The highest satoshi sale (to our knowledge) auctioned for $240,000 with an inscription called the ‘Genesis Cat’, branded as a unique 1/1 art piece that has both cultural and political significance: its part of a collection of similar inscriptions meant to symbolise and support reinstating a previously removed function in the Bitcoin protocol. Another satoshi without an attached inscription sold for $165,100, marketed as being a rare unit of the supply because of its provenance dating back to Bitcoin’s first difficulty period.

Proof of these sales is encouraging to those on the hunt for expensive satoshis. The aim of flipping a bitcoin unit on secondary markets for well above its usual market price is changing certain user’s propensity to pay transaction fees. It’s safe to say the possibility of hundreds of thousands of dollars in purchasing power, for collecting a single satoshi, makes for a much higher fee bid than most competing peer-to-peer transactions.

Given the halving is both a fully predictable and scarce event in Bitcoin history, competition is bound to arise in both collecting satoshis and etching inscriptions in the first block. Demand for the first minted satoshi following the halving is expected to be so valuable that Foundry USA pool is even planning to share its proceeds with miners should they be lucky enough to win the block. It may be short-lived, but such heightened competition will almost certainly amount to a fee spike.

Private Transaction Flow

Another possibility for atypical demand is transaction accelerators. Marathon kicked off a product called Slipstream in late February opening an avenue to sidestep Bitcoin’s mempool, the native waiting room for transactions, by giving users the option to communicate and pay for transactions directly with MARA Pool. The product hasn’t provided a consistent advantage in terms of earning fees relative to other mining pools, however there have still been several instances of success.

While not popularised, accelerators like Slipstream have the potential with enough demand to increase fees in an indirect way. If transactions are submitted directly to a mining pool, they aren’t known to any other bitcoin users ahead of time. Therefore, users may come to find out their transactions that were next in line to be processed have to actually continue waiting, due to the stealthy inclusion of those submitted directly to a pool instead. This can confuse spenders of what precise fee amount to attach with their transactions to encourage timely processing. With enough transaction flow towards these accelerators, multiple fee markets emerge, one public as part of the Bitcoin protocol and the others private.

In a state of utmost urgency, a user may resort to vastly overpaying compared to what would actually be expected based on public markets. This muddling of the fee market could well increase fees. We don’t see this really happening on any meaningful scale, but it’s worth noting.

Miner Extractable Value (MEV)

MEV is another emerging dimension of demand for Bitcoin block space. MEV refers to cases where miners (read: mining pools) have a chance to make extra profit from manipulating the order of transactions within a block. Previously, MEV has mostly been a potential feature of Bitcoin that was traditionally limited due to its more rigid features and simpler transaction model. The possible vectors of MEV have however become more pronounced due to changes in Bitcoin software, and the nature of how some users are making bitcoin transactions, as we’ve touched on throughout this post. Here’s a brief breakdown:

1. Collectibles: The high-value tag of certain inscriptions and satoshis, along with inefficiencies in marketplace tech, make for the extracting of additional fees by buying, or “sniping”, and reselling mispriced marketplace items, as well as sacrificing fee revenue in favour of chasing higher value satoshis.
2. Tokenized Assets — Runes, BRC-20, RBG, Taproot Assets, and possibly others: The mentioned protocols provide fungible assets, hence opening the door for miners to participate in front-running and arbitrage trading for added rewards.
3. Bitcoin Plugins: As more outside platforms, or so called “layer-twos”, use Bitcoin to settle value, miners may be able to take advantage of vulnerabilities in early designs and added incentives for higher revenue.

Another halving means another reduction in block rewards and relative increase in the importance of transaction fees for miners. This may provide added impetus to miners to, in turn, push for benefits related to transaction selection and look for diversifying means of revenue. As mercenaries in a tightly competitive industry, MEV strategies will, in our opinion, at the very least be attempted.

The Transaction Fee Market is Gaining Relevance to Miners

The diversification of Bitcoin’s transaction demand makes for a possible saving grace in the economics of mining. As halving events reduce block rewards, these new uses of Bitcoin’s block space are likely to significantly increase transaction fees. This is crucial for miners, as these fees could offset the loss in block rewards and maintain their profitability.

As discussed, the increase in near term fees will be driven by heightened competition in new market segments, including the issuing of outside assets and the hunt for unique collectibles. Each of these applications not only brings additional transaction fees but may also encourage a more strategic approach to transaction processing.

Ultimately, the shift towards a more complex and transaction fee-reliant economic model underlines the increasing significance of understanding and leveraging new demand vectors to remain competitive.

Looking ahead, current transaction fee levels project to make up approximately 14% of mining revenue post-halving, a figure already several times larger than years past. However, I anticipate that this percentage will run much higher, exceeding well above 50% in certain blocks. Reflecting on the two-month period at the end of 2023, which was largely driven by high demand for inscriptions, average fees levels would have accounted for 30% of post-halving mining revenue. Repeating this average (193 btc/day) would recoup a whole 43% of the halving’s impact.

Given the current trajectory, it is entirely plausible that during the upcoming halving period, transaction fees could become the primary source of revenue for miners. It remains an open question however the sustainability of these non-monetary demand drivers — are they leading a long-term shift in the market for Bitcoin transactions or will they merely be a fleeting symptom of the bull market?

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