Understanding Runes: A Breakthrough for Fungible Tokens on Bitcoin

On the eve of January 9th, 2009, Satoshi Nakamoto published the version 0.1 code for Bitcoin software on Sourceforge and launched the network by defining the genesis block of Bitcoin (block 0). I’d like to think that anyone who understood this technology early on would have bought into the hype train pretty quickly. I mean, who wouldn’t be intrigued by the idea of digital money? By promising to empower true peer-to-peer interactions—no middlemen, no banks, no “big brother”—Satoshi’s open-source design welcomed everyone to be part of a network that no single person or entity could own or control.

When we view this technology over the long run, it has lived up to its seemingly lofty promises. At the risk of sounding too passionate,

it is restorative, reconstructive, and even revolutionary.

This technology has led to countless innovations. From the smart contracts and the proof-of-stake functionality of Ethereum to the proof-of-stake mechanism on Solana, to newer blockchains in the Cosmos ecosystem (including Injective, Atom, Celestia, etc.) all growing rapidly and becoming more interconnected. Built on these different blockchains are several products, including games, DeFi (Decentralized Finance), lending and borrowing protocols, NFTs (Non-Fungible Tokens), RWAs (Real World Assets), and many more.

One of the latest protocols to launch on the Bitcoin ecosystem, and one that has quickly made waves across the entire crypto space, is the Rune Protocol. The foundation for Rune’s development is closely tied to the rise of the Ordinals protocol. Since Ordinals was introduced, the DeFi ecosystem on Bitcoin has experienced marked growth, paving the way for fungible tokens.

What are Runes?

Casey Rodarmor, driven by his passion for innovation, was the force behind the creation of the Ordinals protocol. In September 2023, he took his vision further by developing Rune. His goal was to revolutionize the way fungible tokens were issued and controlled directly on the Bitcoin blockchain. In an interview on the Bankless YouTube channel, Casey highlighted that establishing a robust fungible token protocol for Bitcoin could greatly expand its user base, attract more developers, and boost transaction fee revenue.

DeFi revolves around fungible tokens. Fungible tokens are digital assets that can be exchanged for other digital assets. They are used to facilitate lending, borrowing, and decentralized exchanges. Although Bitcoin provides a safe, decentralized base for the development of DeFi applications, Ethereum leads in the DeFi department due to its flexibility in the creation of tokens. For fungible tokens, however, the core architecture of Bitcoin poses a problem (taking Omni Layer as an example where the complicated structure of the system is increased by the system’s reliance on extra layers constructed on top of Bitcoin). With Runes, on the other hand, there’s a significant shift as they enhance direct token operations by leveraging the Bitcoin blockchain itself. The Runes protocol is built on a UTXO-based (Unspent Transaction Outputs) foundation that facilitates a more minute transaction management and is consistent with Bitcoin’s original design.

How does the Rune Protocol work?

Runes are the basic units representing fungible tokens at the center of the protocol. In solid contrast to Ethereum’s ERC-20 standard, the Bitcoin UTXO system comes with Runes built in. Each Rune can be uniquely identified by its Rune ID, which also contains data regarding its value and current output.

Three (3) concepts establish the framework of the Runes protocol, namely;

1. UTXOs

2. Runestones

3. OP_RETURN

The protocol functions using a mechanism in which each transaction output represents unspent Bitcoin that can be used as input for a new transaction. The protocol utilizes this model to embed data about token creation and transfers directly within Bitcoin transactions. It is totally unlike Ethereum’s account-based system; that’s where the UTXO model comes in.

The OP_RETURN function is a Bitcoin opcode that makes it possible to include data in a transaction without compromising its legitimacy. This data, which is just 80 bytes long, contains details regarding the etching and transfer of tokens as well as other features.

In contrast to standard Bitcoin transactions, which involve sending currency, OP_RETURN is intended to attach additional data. It is not possible to spend the coins within this output normally. The use case for the OP_RETURN function is wide and cannot be streamlined to runes protocol alone, developers use it to;

- Timestamp documents

- Store small bits of game data

- Embed messages, and of course

- Create tokens on Bitcoin

Although the main objective of Bitcoin is safe financial transactions, OP_RETURN adds a little flexibility to the platform as it enables the permanent recording of minute amounts of data on the blockchain without obstructing its primary function.

The messages that are encoded within transactions using OP_RETURN are called Runestones. These encoded messages include information on the precise operations being carried out with a Rune token, including; adding new units, moving current ones, or destroying them.

There are three types of these encoded messages (Runestones) namely;

• Etching: This describes the origin of a new Rune token. It includes specifications such as the initial supply, divisibility, token name, and symbol.
• Transfer:  This type of Runestone carries the Rune ID, output number, and the amount to be transferred.
• Burn: This type of runestone deliberately destroys a certain number of Runes. It is very helpful in controlling the supply of the token.

Runestones are key components in the Rune lifecycle—from its creation to validation.

Etching is described as a process of creating a fungible token using the Runes protocol. This major step involves designing a Bitcoin transaction with a special message (encoded using the OP_RETURN opcode). This Runestone serves as an origin for the new token, outlining its salient attributes that include;

- A unique name

- A recognizable Symbol

- Divisibility

- Initial Supply

After miners have validated and processed a transaction containing etched Runestone, a new Rune token is created and stored in the transaction’s allocated output. Also, another thing to note about the etching process is its permission and compatibility for pre-mining process in which a certain number of the Runes are allocated to the creator’s wallet before they are minted.

The transfer of a freshly etched Rune token is carried out by a specialized Runestone known as the transfer Runestone. The message stored in the transfer Runestone for a new Bitcoin transaction highlights the specifics of the move. The attributes that are stored in transfer Runestone include;

- The Rune's identity - It helps to identify the exact Rune token being transferred by including its unique ID.

- The Current location on the Bitcoin blockchain where the Runes currently reside

- The New destination for the Rune token (usually a destination Bitcoin address)

- The amount of Rune tokens being transferred

The specified quantity of Runes travels to the destination Bitcoin address automatically as soon as miners approve this transaction.

The Runes protocol prides itself in its security and this makes it beautiful, and like any working system, the protocol has inbuilt check and balance system to ensure everything runs smoothly. The gatekeepers in the Bitcoin network are the miners and the nodes, who verify every transaction including Runestones. They guarantee that;

- Runes aren’t duplicated

- Runes aren’t unexpectedly destroyed

- Runes follow their designated path

In the case of any mishap of a Runestone, for example, an invalid encoding or a missed output, the transaction would get flagged as invalid. To sort this out, Cenotaphs are required. Cenotaphs basically burn/destroy Runes. They act as a deterrent for sloppy UTXO management. This mechanism encourages the conscious and meticulous use of Runes.

In conclusion, the introduction of the Runes protocol has upgraded DeFi in the Bitcoin ecosystem and has significantly reduced the entire blockchain bloat. Unlike other token solutions that create tiny, unspendable outputs, Runes focuses on integration with Bitcoin’s UTXO system, and by the reduction of these unspendable outputs, it keeps the blockchain leaner.

The Runes protocol represents a major shift in the interaction possibilities of fungible tokens and the Bitcoin network. It also represents how far we have come from Satoshi’s first line of code- Which will undoubtedly bring a smile to his face.