State of Bitcoin Q4 2023

Key Insights

• NFT sales volume was up 1,294% QoQ. Bitcoin’s volume of $881 million in December exceeded the volumes of both Ethereum and Solana, combined.
• Fees increased 699% QoQ to $502 million. Inscriptions and other Bitcoin programmability could lead to a long-term security budget solution.
• Inscriptions activity exploded in 2023, contributing to the 85% YoY increase in daily transactions. Inscriptions (primarily BRC-20s) accounted for over 40% of total transactions in Q4.
• Several teams are building Bitcoin L2s. Stacks is leading current “layers,” with more sovereign rollups on the way.
• Spot BTC ETFs are on the horizon. The final deadline for the first ETF application is January 10, 2024.

Primer

Bitcoin (BTC) is the first distributed consensus-based, peer-to-peer payment settlement network. Bitcoin (BTC), the native asset of the Bitcoin blockchain, was the world's first digital currency without a central bank or administrator. Often referred to as digital gold, bitcoin has a predictable, stable monetary policy that operates autonomously, giving it the ideal store-of-value properties.

To secure its network, Bitcoin uses a consensus mechanism known as Proof-of-Work (PoW) to solve the “double-spend problem.” PoW requires participants (miners) to contribute computing power to solve arbitrary mathematical puzzles in order to add a new block to the blockchain. Bitcoin is awarded to the miner who solves the puzzle first, thus minting new bitcoins.

Whitepaper / Reddit / GitHub

Key Metrics

Financial Analysis

BTC was up 56.8% QoQ and 155.8% YoY, closing 2023 at $42,283. This price increase drove BTC’s market cap dominance up to 48.2%. The various pending proposals for spot BTC ETFs have been a source of speculation that has been affecting price action throughout Q4.

Activity from Inscriptions drove total fees up 699.4% QoQ to $501.8 million in Q4. The urgency to mint these assets was first seen in May and returned in Q4, with transaction fees following. The average transaction fee rose to $9.90, an increase of 546.5% QoQ and 714.4% YoY. Bitcoin fees even exceeded Ethereum fees on several days throughout Q4.

Bitcoin pays ~$40 million per day for security (900 BTC per day at a price of $45,000). Fees averaged $10.9 million throughout December, covering 25% of Bitcoin’s security budget.

Inscription fees accounted for 25.8% of total transaction fees in Q4, up from 23.4% in 2023. Inscriptions alone are currently too inconsistent to solve the security budget issue. However, the usage of Bitcoin’s arbitrary blockspace is being further explored by additional protocols. Their innovations could become constant demand drivers and revenue generators, as detailed in the Bitcoin L2s section below. BTC issuance (and hence, the security budget) will halve in April 2024, making fees an even more relevant factor in overall revenue. After the halving, the current volume of fees would cover ~50% of the security budget rather than 25%.

Network Analysis

Average daily transactions increased 2.0% QoQ and 85.3% YoY. Daily active addresses, on the other hand, declined 4.7% QoQ. This led the ratio of transactions to active addresses to increase for the sixth consecutive quarter, to 0.51. The changes suggest that either the average user is becoming more active or the network has gained a relatively small group of “super users” that account for a large portion of the activity. Regardless of the user makeup, this behavior shift is likely due to ecosystem innovations such as Inscriptions.

The average block size stayed generally flat throughout Q4. Overall, the average block size has stabilized following the increase in early 2023, which aligned with the introduction of Inscriptions in early Q1. In addition, transaction activity didn’t see significant increases until the end of Q2. As such, the type of transactions (i.e., Inscriptions) is likely what increased the average block size YTD rather than the volume of transactions themselves. The effects of Inscriptions can be seen in other network metrics as well, such as Bitcoin’s recently packed mempool.

Mining and Security

In Q4, only 83.8% of miner revenue came from BTC issuance rather than transaction fees. In total, 92.4% of miner revenue came from BTC issuance in 2023, compared to 98.4% in 2022. The change shows that fees are increasingly making up a larger portion of revenue. Miner revenue reached $64 million on December 16, 2023, the highest level since 2021.

At block 740,000, which will occur in April 2024, the block reward will halve from 6.25 BTC to 3.125 BTC. Because revenue comes almost entirely (92.4% in 2023) from this block reward, miner revenue will be nearly cut in half in Q2 2024.

The economic effects of the Q2 2024 issuance halving will be important to watch as hashrate continues to grow. As hashrate grows, miner profitability decreases (assuming a constant BTC price). Hashrate represents the security of the Bitcoin network.

State Growth

The fees from Inscriptions are a possible solution to Bitcoin's long-term security budget issues. However, a side effect of Inscriptions is UTXO state bloat. The number of UTXOs on Bitcoin has increased 73% since the beginning of 2023 to over 140 million. BRC-20s create a new UTXO with each transfer and contribute to growing UTXO sets that cannot be pruned. Because this state bloat requires more physical resources from full nodes, it could ultimately affect decentralization (i.e., the ability of the average user to operate a node).

Censorship

Due to the state bloat effect on the network and the general introduction of new asset types, some members of the Bitcoin community see Inscriptions as spam and an attack on Bitcoin. Not all Bitcoin spam (i.e., fun) is built the same, but it is similarly rejected by certain users. The OCEAN mining pool raised money and announced that it’s filtering/censoring Inscriptions transactions. However, other transaction types, such as coinjoins, also fit their criteria and are excluded by the pool.

The pool has only created a couple of blocks, but it represents how divided the community is on Inscriptions. The Monero community had already successfully implemented a patch back in Q2 to reduce the amount of space available and effectively disable the minting of NFTs on its own network. Other networks faced their own ‘issues’ with BRC-20-inspired tokens. Avalanche, NEAR, Solana, and others have experienced major activity spikes, and Toncoin and Arbitrum even had outages. BRC-20s on Bitcoin can be filtered out, front-run, or forked away, but the majority of the Bitcoin community appears to be interested in keeping the asset class around. This sentiment is evidenced by network activity metrics, community sentiment, and miner fees accepted.

Historically, Bitcoin has seen many versions of censorship, not just OP_Return debates. Major mining pools have been found to comply with OFAC sanctions many times. However, there is an important difference between a miner not including certain transactions in their own block and one miner refusing to build on another miner’s block that included the “banned” transactions. In Q4, OFAC-censored transactions have been missing or had the blocks containing them orphaned by some of the largest miners, which poses a more serious concern for Bitcoin’s neutrality.

Ecosystem Analysis

Inscriptions, Ordinals, and NFTs

Bitcoin saw new innovation in 2023, leveraging the SegWit and Taproot upgrades, called Inscriptions. Inscription-based projects, such as Ordinals, revealed a serious appetite for NFTs, meme coins, and overall added functionality in the Bitcoin ecosystem. The excitement in the ecosystem extended past these meta-protocols and even into the world of modular networks, i.e., Bitcoin L2s.

Ordinals are the Inscription type that popularized the sector. They enable arbitrary data (images, text, etc.) to be inscribed on an individual satoshi (sat), effectively creating entirely onchain NFTs. Alternative BTC-derivative asset types, either based on Ordinals or inspired by them, came quickly after. BRC-20s are semi-fungible Ordinals. Although they’re meant to be fungible, they are actually semi-fungible and similar to ERC-1155 tokens in architecture due to the inherent nonfungible nature of sats.

Average daily Inscription transactions decreased 13.6% QoQ. Alternative asset types, such as Stamps, Runes, and recursive Inscriptions, do contribute to activity, but BRC-20s have been the primary driver of overall Inscription activity. Their dominance was lightly challenged in Q4, as BRC-20 transactions decreased 23.3% QoQ and other Inscription transactions increased 145.1% QoQ. As of the end of Q4, ORDI was the largest BRC-20 token by market cap, breaking into the top 50 of all tokens by market cap and ending the year with a circulating market cap of $1.57 billion. Several marketplaces exist for Ordinals (both NFTs and BRC-20s) such as Unisat, ALEX’s B20 DEX, and MagicEden — with many more in development.

The urgency around BRC-20 token launches has created high-fee environments as users seek to outbid each other. While certain Inscription types, such as images, are disproportionately expensive (relative to text), BRC-20s are still the Inscription type that contributes most to total Inscription fees, due to their higher volume and mint behavior.

In terms of daily transaction volume, Bitcoin NFTs (i.e., Inscriptions) are already competing with, and even exceeding, the established NFT ecosystems on Ethereum and Solana. Bitcoin’s December 2023 NFT sales volume of $881 million is greater than any single-month sales volume for either Ethereum or Solana in 2023, and it is greater than the combined sales volume of both networks during the same period ($687 million). Bitcoin has yet to challenge these other networks in other NFT metrics, such as daily transactions (~10,000 on Bitcoin versus ~25,000 on Ethereum and ~75,000 on Solana in Q4) or unique buyers/sellers (~5,000 on Bitcoin versus ~10,000 on Ethereum/Solana in Q4).

As BRC-20s and other text-based Inscriptions/Ordinals are also technically non-fungible, they’re included in NFT metrics. However, BRC-20s are perceived and treated by many users as fungible and therefore may be more accurately compared to DEX volumes. Bitcoin’s NFT sales volume would rank 10th among all networks’ DEX volumes in December.

The Open Ordinals Institute was launched to finance and support Ordinals developers. Additionally, Inscriptions-related projects are being supported through development programs/incubators, such as the Bitcoin Startup Lab. Communities such as Taproot Wizards are pioneering the exploration of onchain programmability.

Bitcoin L2s

Bitcoin has seen a vibrant “L2” ecosystem emerge this year, led by Stacks, which can read and respond to Bitcoin L1 transactions. Stacks’ upcoming sBTC and Nakamoto Release should provide access to BTC liquidity with fewer trust assumptions; its integrated consensus mechanism is unique in leveraging the full hash power of Bitcoin to secure transactions. While there are other sidechains with BTC bridges enshrined in their consensus mechanisms (e.g., Liquid, Rootstock, and Internet Computer), Stacks is the most ambitious in terms of Bitcoin modularity and integration.

There are also several teams exploring sovereign rollups on Bitcoin — like Chainway, ZeroSync, Rollkit, and Kasar Labs. The proposed sovereign rollups would not require any new opcode or soft fork to Bitcoin. New rollups built with this format can extend certain aspects of Bitcoin’s security to more expressive execution environments.

Other rollup models, such as validity rollups, would require a specific VM to be enshrined into Bitcoin through a new opcode. Any Turing-complete VM — such as WASM, Risc Zero, or CairoVM — could replicate all other VMs. However, by enshrining any single VM, the ecosystem would be locked into that one VM — and its performance — indefinitely. As it stands, zkVMs are in a nascent stage of development, harboring unknowns about the performance of current VMs and their implementations. As such, it’d be difficult to convince the entire Bitcoin community to enshrine a specific VM. Drivechains are another recently discussed concept that requires a new opcode and soft fork.

BitVM offers arbitrary functionality on Bitcoin without adding any new opcode or soft fork. Unlike Drivechains and most validity rollup ideas about enshrining a specific zkVM, BitVM is more like an optimistic or fraud-proof setup. Rather than verifying directly on Bitcoin with a zk-verifying opcode, BitVM relies on a hashlock-enabled challenge period. This setup is still enforceable onchain but not locked into a specific proving/verifying scheme. Concerns for practical implementations include two-party restraints, offchain data management costs, and the sheer complexity of building complex transactions with binary bits.

While BitVM is impractical for supporting rollups at this current time, it’s being explored extensively by creator Robin Linus of ZeroSync and other developers, such as Super Testnet. So far, builders have detailed or built an 8-bit CPU, 2-way peg sidechains, atomic swaps with Lightning, and more using BitVM. Babylon is already timestamping on Bitcoin from 30+ Cosmos testnets and Chainway already posted the first EVM transaction on Bitcoin. Bitcoin L2s and Bitcoin programmability are coming.

ETFs

The SEC’s recent actions with ETF issuers suggest that the decision for ARK and 21Shares’ application (final deadline on January 10, 2024) may apply to several other applications. Issuers have recently had tens of meetings with the SEC, mostly in Q4, to adjust their filings. Several issuers have even posted estimates for Q1 2024 inflows from these ETFs that do not yet exist, showing their confidence in prompt approvals. Notably, almost all ETF applications list Coinbase as the custodian.

The number of BTC on exchanges decreased 1.0% QoQ. However, the percentage of BTC being held reached an all-time high in Q4 2023. As of the end of 2023, 13.74 out of 19.59 million BTC had not moved in the past year. The hold rates for BTC on other time frames — from 180 days through 10 years — have all also peaked in Q4 2023. While supply on exchanges is not at unusual levels, this peak HODLing suggests that BTC is relatively illiquid heading into 2024 events such as spot ETF approvals and the halving.

With estimates for spot BTC ETF inflows as high as $65 billion (1.5 million BTC), the amount of BTC available on exchanges will have a large impact on the price action resulting from ETF buy pressure. While a spot ETF would actually require issuers to buy and hold the actual BTC asset in real-time, unlike futures ETFs, there are still some pending questions around the actual process. Distinctions such as cash versus in-kind creation/redemption may affect how investors use these new investment vehicles as the tax implications differ.

Cross-Chain BTC

Cross-chain BTC exists on most smart contract networks, including Ethereum, BNB, XRP Ledger, Solana, Cardano, and others. It also exists in various forms, such as the centralized-custodian-issued WBTC, decentralized-network-issued tBTC, trusted-hardware-issued renBTC, or as an overcollateralized synthetic asset. The largest of which is WBTC, a top 20 token by market cap. WBTC supply on Ethereum declined 2% QoQ, down to 160,240.

Wrapped/bridged BTC requires additional trust assumptions due to Bitcoin’s limited scripting capabilities. It is backed 1:1 with real BTC as opposed to synthetic BTC, which is secured by an algorithmic peg. As a result, facilitating BTC bridging requires a third party, in addition to the Bitcoin network and the destination network. Implementing said third party is a universal challenge for Bitcoin layers.

With centralized versions of wrapped BTC, the centralized custodian is the trusted third party. With decentralized versions of wrapped BTC, there is typically a network of nodes that are the custodians. The peg-in — moving BTC from Bitcoin to a wrapped version on another network — on smart contract-enabled networks is straightforward, as it can be facilitated by a smart contract. In other words, there can be no additional trust assumptions outside of the destination chain and Bitcoin.

However, the peg-out — moving from wrapped BTC on the destination chain back to BTC on Bitcoin — comes with additional trust assumptions. There is an economic trust assumption on the third party for the peg-out, unlike the cryptographic trust assumption (i.e., trusting the smart contract on the destination chain) on the initial peg-in.

Lightning Network

First introduced in 2015, Lightning Network’s state-channel-based scaling approach has gradually become the most popular scaling solution. Lightning uses built-in features on Bitcoin L1, such as multisigs and hashed timelocked contracts (HTLCs), to facilitate the locking and unlocking of BTC.

Lightning has seen increased adoption from custodians in 2023. Coinbase announced in Q3 that it will integrate Lightning, joining Binance and other exchanges. While this event increases accessibility to users, it also contributes to the already-high centralization of Lightning. Over 90% of transfers and addresses are facilitated through centralized solutions, with self-custody and self-hosting proving to be too cumbersome for many users. Lightning exists at the top of the “Bitcoin L2 Trilemma,” as an offchain network. On offchain networks, the risk of self-custody and self-hosting is that users would lose funds if they go offline.

A class of vulnerabilities referred to as replacement cycle attacks was disclosed by a Bitcoin/Lightning developer in October. A soft fork would be required to fix these vulnerabilities, which is a historically difficult action to coordinate on Bitcoin. Even without the additional functionalities (e.g., privacy or smart contracts) that most other Bitcoin layers aspire to deliver, Lightning has protocol issues of its own to deal with.

Closing Summary

Spot ETFs for Bitcoin made for a strong financial narrative in H2 2023 and will potentially be realized in Q1 2024. They mark a significant milestone in the legitimacy of BTC in the eyes of both regulators and TradFi. Once the ETF applications are approved, it will be worth watching which issuers attract the inflows and how BTC events such as the halving in April will affect markets with these new players involved.

Regarding onchain activity, the main narrative in 2023 was programmability on both the base layer and external layers. This narrative will continue in 2024, as basic base-layer infrastructure is just now being built out and most L2s have yet to launch. Bitcoin L2s, the Ordinals ecosystem, and novel base-layer programmability solutions like BitVM will be areas to watch through 2024.

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