United States: How Ordinals Make Bitcoin Both Fungible And Non-Fungible

Katten's Daniel Davis and Alexander Kim break down the impact of Bitcoin Ordinals on fungible and non-fungible tokens. They say their rising popularity sparks new regulatory considerations as developers rush to replicate its features in blockchains.

Bitcoin is generally understood to be a fungible virtual currency—each unit of bitcoin is exactly the same as any other unit of bitcoin and can be exchanged or transacted over the Bitcoin protocol on a like-kind basis.

In contrast, non-fungible tokens refer to a subset of digital assets that represent ownership of unique pieces of intangible digital content such as digital art, avatars, or even music. NFTs are typically minted or issued independently of a fungible base-layer digital asset such as Bitcoin or Ether. The underlying blockchain network recognizes each NFT as different from one another. In other words, one NFT cannot be exchanged for another NFT on a like-kind basis.

However, the fungible and non-fungible worlds of digital assets have collided with the recent emergence of Bitcoin Ordinals—also known as Ordinal Inscriptions. Bitcoin Ordinals, enabled by a 2021 upgrade to the Bitcoin protocol named Taproot, allow Bitcoin holders to "inscribe" permanently the smallest unit of Bitcoin, or satoshis, with unique digital content of up to 4 megabytes.

Despite continued regulatory uncertainty surrounding digital assets, Bitcoin Ordinals have generated significant interest in recent months, contributing to a surge in Bitcoin transaction fees in early 2023. According to recent media reports, more than 500,000 Bitcoin Ordinals have been "minted" or issued on the Bitcoin blockchain to date. The rising popularity of Bitcoin Ordinals even reportedly sparked developers of other virtual currencies to incorporate similar features on their respective blockchain protocols.

Simultaneously Fungible and Non-Fungible

Unlike traditional NFTs, Bitcoin Ordinals give Bitcoin both fungible and non-fungible properties.

For instance, unlike an NFT issued on the Ethereum blockchain, the Bitcoin protocol does not recognize a satoshi inscribed with unique content as being different from any other satoshi. A holder of a Bitcoin Ordinal therefore is free to exchange their satoshi for another, and may even spend the inscribed satoshi to pay for transaction fees on the Bitcoin network. In this way, Bitcoin Ordinals preserve the fungible nature of Bitcoin and behave as any freely exchangeable virtual currency would.

On the other hand, Bitcoin Ordinals can also behave much like NFTs as digital collectibles, as they may be bought or sold for their unique inscribed content—which has included in one instance a fully functional video game. This attribute gives the Bitcoin Ordinals value independent of the Bitcoin virtual currency. Several third-party NFT marketplaces have reportedly launched platforms to facilitate the trading of Bitcoin Ordinals.

Because digital content inscribed on a satoshi is permanent, Bitcoin Ordinals may be used as a virtual currency in one transaction and as an NFT in another, forever fluctuating between the two use cases. Whether a Bitcoin Ordinal makes the underlying satoshi fungible or non-fungible therefore depends on how the holder decides to use it.

Regulatory Implications Are Unclear

The duality of a digital asset that is simultaneously fungible and non-fungible potentially raises challenging regulatory questions surrounding the characterization of the digital asset under the federal securities laws. No US regulator has to date formally addressed the ability of a historically fungible digital asset to morph into an NFT and vice versa.

For example, it is unclear whether a unit of a digital asset that was once issued as a security ceases to be a security if the same unit of the digital asset is later sold in a non-fungible capacity as a digital collectible. Such a scenario may be akin to a decades-old rare coin being sold at an auction as a valuable piece of memorabilia, where the utility and the market value of the rare coin is completely divorced from its face value.

Conversely, it is also unclear how regulators might characterize the morphing digital asset if it is subsequently redeemed as a fungible token in the secondary market. To continue the rare coin analogy, this would be akin to the rare coin being put back into general circulation for its originally intended use, namely for purchase of goods and services.

While the regulatory treatment of an instrument may change over time depending on the relevant facts and circumstances, it is unclear how such an approach would practically apply to a digital asset that continuously morphs between a fungible token, and one that is as unique as a piece artwork such as the Mona Lisa.

It may be too early to tell whether this latest trend in the world of digital assets will stick for good. However, innovations in the digital asset space continue apace, often pushing the boundaries of existing regulatory frameworks and challenging regulators to devise creative solutions to adapt.

Originally published by Bloomberg Law.

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