introduce
For many investors, bitcoin represents a new and exciting store of value ambition. Bitcoin’s potential as a store of value has earned it the labels “gold 2.0” and “digital gold.”
In some ways, Bitcoin is an upgrade from gold as a store of value. For example, #bitcoin's scarcity is provable, and the cost of storing huge value in bitcoin is a fraction of that of gold. On the other hand, gold has a 5-millennium head start to bitcoin and is much less volatile. Additionally, gold has industrial use cases and demand for its perceived beauty.
Bitcoin is nothing like gold. The Bitcoin network is an upgradeable technology. Gold in a vault will remain gold. It is unlikely that gold will turn into lead, silver, or some improved version of gold. Instead, the Bitcoin network is subject to change.
Bitcoin is an upgradeable technology that can adapt over time to the changing needs of users, miners, and developers. On June 12, 2021, enough Bitcoin miners expressed support for a technology upgrade called Taproot. Taproot is a package of three upgrades that improve network security, privacy, and scalability. Taproot is the most significant upgrade to the Bitcoin network since the block capacity enhancement of Segregated Witness was activated in 2017.
Expected benefits of the upgrade include:
- Consolidates all bitcoin transaction output types into a single Taproot output, improving privacy by making different transaction types indistinguishable.
- Improved Bitcoin programmability (so-called “smart contracts”).
- Improve data efficiency using signature algorithms and more efficient transaction structure methods.
- Improved security due to the addition of a new signature scheme, making it a dual-signature blockchain.
It is not without risks, including:
- Low adoption rates indicate that Bitcoin users are not interested in using Bitcoin for anything new.
- Low adoption rates offset potential security benefits.
- New signature schemes may be less "quantum-resistant" than current schemes.
- A rift could appear in the Bitcoin community due to disagreements over the Taproot upgrade — similar to the SegWit controversy that led to Bitcoin Cash
We will expand on these benefits and risks in our report to provide a foundation for Bitcoin as a technology investment. Additionally, we will discuss how upgrades have historically been performed on the Bitcoin network.
Throughout, we capitalize blockchains (Bitcoin, Ethereum) and use lowercase letters or trading symbols (bitcoin/BTC, ether/ETH) to represent content. U.S. dollars are U.S. dollars ($USD): Nothing in this report should be considered investment advice
TAPROOT Upgrade
The Taproot upgrade consists of three separate Bitcoin Improvement Proposals (BIPs), 340, 341, and 342.
In short, Taproot aims to improve Bitcoin’s security, privacy, and efficiency
Taproot will achieve these improvements by:
- MAST changes the way spending conditions are structured by reducing the inputs required, thereby reducing the data footprint of each transaction.
- Pay-to-Taproot generates a single “Taproot” output on the Bitcoin network, regardless of transaction type, improving transaction privacy and efficiency.
- Schnorr signatures replace the current cryptographic signature scheme, called ECDSA (Elliptic Curve Digital Signature Algorithm).
These three BIPs are being rolled out together to incentivize wallets and service providers to update their software only once to maximize adoption of the entire suite, improving#Bitcoinfor as many users as possible.
Benefits of Taproot
Taproot will expand Bitcoin usability and the overall address market. It is difficult to quantify this growth, but the qualitative benefits are as follows:
Richer application development
Bitcoins are not usually associated with smart contracts, which are self-executing digital contracts whose terms and execution are written in the form of code or scripts. Instead, the Ethereum blockchain is usually associated with smart contracts and the development of blockchain-based applications that use them.
However, Bitcoin does have native smart contract capabilities. Bitcoin transactions can be programmed to time payments when certain limits are met or missed. Bitcoin smart contracts are currently used in multi-signature wallets to enable the Lightning Network.
(Lightning or LN) and “lock” Bitcoin units, ensuring they cannot be spent for a period of time.
Currently, creating these specialized Bitcoin contracts is cumbersome and expensive. Furthermore, if users want to send complex Bitcoin transactions, they must
Scripts in each transaction input. When these scripts are subsequently executed, all conditions, including those that are not met, will be revealed. As a result, the amount of transaction data involving Bitcoin contracts is large, which is not conducive to privacy. Taproot will make on-chain smart contracts more feasible by breaking down the execution of Bitcoin scripts so that only the executed scripts are displayed.
Taproot also improves the usability of so-called Discreet Log Contracts (DLCs), which can be used to build Bitcoin smart contracts. Somewhat infamously, two of Bitcoin Inc.’s founders, Nicolas Dorier of BTCPay Server and Chris Stewart of Suredbits, entered a DLC in 2020 to bet on the outcome of the U.S. presidential election. With Taproot, DLCs will have a smaller on-chain footprint, thereby encouraging smart contracts on Bitcoin.
In summary, smart contracts, which are touted by many as flexible and revolutionary, are currently difficult to implement on Bitcoin and therefore cannot become popular. Therefore, while Taproot will make Bitcoin smart contracts possible, we will not see the rise of Bitcoin decentralized applications (dapps) and decentralized autonomous organization centers (DAOs) that feature the Ethereum blockchain in the near future. Instead, we are more likely to see the rise of simple Bitcoin smart contracts in insurance payments, residential real estate transactions, or financial annuity products, representing meaningful growth opportunities, such as:
- Life insurance payments can be programmed upon receipt of a satisfactory death certificate or similar documentation — more than $760 billion in payments were made in the U.S. in 2019.
- A residential real estate transaction can trigger final settlement when the seller’s bank confirms receipt of payment on the mortgage balance - During the seasonally adjusted annual period of May 2021, 5.8 million residential real estate units were sold in the United States at a median price of approximately $350,000.
- Programmable financial annuities for a certain period of time - In 2020, the assets of annuities in the United States exceeded $3TN.
The path Bitcoin takes to these markets is unclear. The most obvious factor may be that customers demand that all or part of their earnings be paid in bitcoin.
Finally, insurance companies that issue life insurance and sell annuities represent some of the most conservative risk profiles in the financial world, as they were founded in the mid-1800s with a philosophy of “forever.” If these companies don’t succumb to any demands from their customers to tap into the blockchain and digital asset markets, it will likely come in a related form. About Bitcoin. Compared to Ethereum, Bitcoin is a more conservative blockchain that is predictable from a technical perspective (see “Triggering Upgrades” below). It is more like gold and money than any of its competitors, and therefore captures its value proposition more clearly. Not to mention, insurance company MassMutual has invested in Bitcoin and Bitcoin companies.
Data efficiency
Schnorr signatures will increase the efficiency of single-signer transactions. Schnorr signatures are 64 bytes (units of digital information) while ECDSA signatures are 71-73 bytes, making each transaction about 11% more efficient. There is no guarantee that Taproot-enabled transactions will be accepted by the network: users will remain free to stick with Bitcoin’s legacy transaction technology. However, if Taproot transactions go through, fewer resources will be required to run one of the full nodes that validate transactions and maintain the network. This would incentivize users to run their own full nodes, thereby increasing Bitcoin’s decentralization. Bitcoin’s decentralization allows it to be permissionless and censorship-resistant, two important features of its value proposition. A decrease in decentralization would weaken Bitcoin and most likely hurt its value.
A reduction in the number of nodes may not be a problem for the network, as long as enough nodes are still active. This number is not really knowable, but in practice the number itself is not important. What is important is that users who are transacting meaningfully on the Bitcoin network are reviewing transactions against their own nodes, and that there are enough nodes providing chain download services for new nodes. This is similar to the mining hash rate of the Bitcoin network, where higher hash rates are "better", but lower hash rates are not necessarily "worse", until a certain threshold is reached. Determined, unspecified.
Additionally, because Schnorr signatures are a data-light signature scheme, Taproot can increase the average number of transactions that can be included in each block. This can reduce transaction fees for users.
Improved wallet functionality, usability, and privacy
Taproot aims to improve the functionality of multi-signature wallets. Multi-signature wallets are wallets that require multiple signers to unlock coins, which makes them more secure than single-signature wallets. Taproot aims to help these transactions use data more efficiently. There is also a privacy upgrade here. Taproot transactions will mask the spending conditions of multi-signature wallets. Currently, multi-signature wallets on Bitcoin are built using smart contracts. Every time a transaction occurs,
For example, a public condition of a multi-signature wallet might specify that a transaction must be signed by three of five valid signatures or a master signature. Even if the signature holder is never used, the blockchain will reveal the public address associated with the master signature in every transaction, posing a potential security threat.
Taproot fixes this in two ways:
1. The potential expenditure of funds will not be disclosed at the time of transfer.
2. Because Pay-to-Taproot makes all transaction outputs look the same, no one can tell if a company is using multi-sig.
While Taproot improves privacy, it does not mean that the Bitcoin blockchain cannot be investigated. Bitcoin will remain an anonymous network with a publicly verifiable digital file record. Bitcoin will not become a privacy coin with Taproot like Monero or Zcash, and it is not as private as cash.
The chart below (Figure 3) shows the amount of Bitcoin held in multisig wallets since 2018. This is up about 55% since 2018, but has been stagnant since reaching an all-time high in July 2019. The past two years may give us pause. If Taproot is widely adopted, we could see increased adoption of multisig solutions by privacy-conscious individuals and companies. On the other hand, the slow growth of multisig wallet balances to zero in recent years suggests there may be a lack of demand for the feature. It is worth mentioning that with Taproot, this type of analysis will not be possible in the future, as all transaction outputs will be identical.
Finally, Taproot will enable the use and construction of signature architectures and wallet solutions based on so-called “linear” Schnorr signature functionality, meaning signatures can be merged. One such example would be creating a multi-signature wallet that requires three signatures over time, but only requires two if the funds remain unchanged over time.
Progress on Layer 2 Scaling Solutions
Taproot can improve layer 2 networks such as the Lightning Network that sits on top of Bitcoin. Taproot will upgrade the functionality of the Lightning Network by replacing hashed time-lock contracts (HTLCs) with time-lock contracts (PTLCs). The Lightning Network is a trade-oriented service that allows parties to transact with Bitcoin faster and cheaper. Using PTLCs means that payments will be routed using regular public keys, providing privacy features similar to those designed for multi-signature wallets. PTLCs can also enable blockchain escrow conditions and improve the use of oracles to facilitate payments.
Lightning Network growth has been uneven since its launch in 2018. Taproot could accelerate adoption. From an investment perspective, increased Bitcoin tradability is positive because improvements to any given use case expand Bitcoin’s total addressable market and growth prospects.
Headwinds for the Lightning Network include Bitcoin adoption in El Salvador (which is using Lightning as a Bitcoin business service), as well as funding and partnership announcements from Lightning-enabled payment services like Strike, Fold, and Moon.
These headwinds, combined with improvements to Taproot, should bode well for Bitcoin as an investment. The growth of Layer 2 payment services could help set another core usage narrative for Bitcoin. Bitcoin has become as established a digital asset as gold, but its potential as a peer-to-peer digital currency remains largely unrealized.
Potential limitations and threats associated with Taproot upgrades
The acceptance rate is very low
The biggest threat associated with Taproot is that only some users and service providers can accept and perform the upgrade.
- Low adoption of the much-anticipated upgrade may indicate that most users are not interested in using Bitcoin for anything new. For new uses, Bitcoin users may prefer a different cryptocurrency or service.
- Users shying away from upgrades that make Bitcoin more resilient will reduce Bitcoin’s growth prospects because it closes the door to potential future upgrades.
- Some security features of Taproot only work in a crowd: if few users accept Taproot transactions, it will be easy to identify those addresses as belonging to entities that require multi-signature security.
- Rejecting Taproot will highlight the weakness of the Bitcoin community if the update fails with developer and vocal user support.
What does the lukewarm reception of Taproot mean for the future of Bitcoin? Will Bitcoin succumb to the digital gold narrative as its primary value proposition? Perhaps, and if so, Bitcoin will likely never become a reliable platform for software development or peer-to-peer digital currency. This won’t necessarily prevent Bitcoin from fulfilling its potential as “digital gold.”
Quantum resistance
Schnorr signatures may also prove to be less “quantum-resistant” than ECDSA. Quantum resistance refers to the ability of the Bitcoin protocol to resist attacks by quantum computers. Although quantum computers are not currently considered a threat, they may become a threat in the future. However, with Taproot, Bitcoin will have two types of network security signatures. If Schnorr signatures are not quantum-resistant, then users can use ECDSA. If ECDSA is not suitable, the protocol can add other quantum-resistant signature schemes.
Rifts in the Bitcoin Community
One benefit of technologies that rely on consensus to bring about change is that any perceived shortcomings are magnified and can lead to rejection of new ideas. This is another potential downside to Taproot. If Taproot activation becomes contentious, there could be a rift in the Bitcoin network, with parts of the community deciding they no longer want to use Bitcoin.
Activate Upgrade
While the details of Taproot itself are most important to investors, it’s important to mention how upgrades to Bitcoin are frequently proposed and implemented to understand the big picture regarding the current situation.
Since Bitcoin is open source, anyone can propose improvements. The improvement process was formalized early in Bitcoin's history through a process called Bitcoin Improvement Proposals (BIPs). While the finer details of the BIP process are not important because they are highly technical, we should note that BIPs are generally not very popular, especially when compared to other protocols and BIPs. They are usually minor tweaks rather than extensive upgrades.
Bitcoin is moving slowly
Since Bitcoin was created in 2009, a total of 145 BIPs have been deposited, an average of about 12 BIPs per year. In comparison, Ethereum, the second largest digital asset network by market capitalization, has submitted 342 EIPs (Ethereum Improvement Proposals) since its inception in 2015, an average of about 58 per five. Bitcoin moves slower than other cryptocurrencies from a technical perspective
The Bitcoin developer and user community emphasizes that reliability and uptime are more important aspects of Bitcoin. Of the 145 BIPs sent, only 46 (~30%) have been implemented into the protocol. Not to mention, eight of them (~6%) are informational BIPs that only describe design issues or provide general guidelines or information to the Bitcoin community, but do not propose new features. . Overall, BIPs have been implemented as soft forks, meaning that the upgrade will remain backwards compatible with outdated Bitcoin software versions. In contrast, Ethereum has had many hard forks, forcing all users to upgrade.
in conclusion
In addition to improving Bitcoin, Taproot reminds people that Bitcoin is a technology. It is capable of changing as needed to improve usability and user experience. Inspiring entrepreneurs will continue to develop their own versions of Bitcoin killers. If Taproot succeeds, it will prove that Bitcoin can adapt.
Reminding that Bitcoin is a technology, we should add that Bitcoin is a unique technology investment for the following reasons:
Venture capital and growth equity in illiquid tech companies, especially compared to Bitcoin. For reference, in the first quarter of 2021, US private equity exit value was approximately $162 billion, while Bitcoin trading volume was approximately $405 billion.
Bitcoin Transparent
Bitcoin provides full transparency about upgrades being implemented, proposed, and rejected. Enterprising investors can join and personally test the progress, code, and conversations around BIPs. If an investor doesn't like the code or the direction Bitcoin is heading, they can voice their opinions and directly propose changes. No other investment offers this level of transparency into day-to-day operations.
Bitcoin Total Addressable Market (TAM)
Investors view TAM as a proxy for the potential growth of an investment, if it can be captured. Bitcoin’s TAM is staggering, depending on whether you view Bitcoin as a payment technology, a store of value, or a global reserve currency. Even when compared to the largest public investments, Bitcoin’s TAM is larger than any other technology investment.
As Bitcoin approaches one of the biggest technological upgrades in its history to date, investors evaluating the risks and benefits of Bitcoin as a public investment technology must keep these unique characteristics in mind.