Exploring Bitcoin

In this report we dive deep into the Bitcoin ecosystem and the associated demands for BTC utility. We explore the catalysts for and potential of growth within the ecosystem, and evaluate whether Bitcoin can eventually compete with established dApp ecosystems such as Ethereum’s.

Key Takeaways

• There are growing development efforts and initiatives centred towards scaling Bitcoin and supporting Bitcoin-based decentralized apps (dApps).
• Bitcoin wrapping showcases a clear demand for Bitcoin utility but comes with risks that may deter potential users.
• Ordinals hype highlights a demand for Bitcoin-native tokens, and a necessity for scaling through Layer-2s to match capacity with said demand.
• The Bitcoin ecosystem UX and product diversity is currently lacklustre, but EVM-compatible Layer-2s, growing capital interest, and a dedicated developer base all indicate a positive future for the ecosystem.

Bitcoin Ecosystem Background

Bitcoin was envisioned in 2009 as a peer-to-peer payment network. With the introduction of smart contract technology to compatible blockchains like that of Ethereum in 2015, the scope of applicability of digital ledger technology (DLT) widened massively. This paved the way for the wide range of financial, social, and technological applications of blockchain-derived technology that we enjoy today. Bitcoin as a base layer was not suited for hosting smart contract-derived applications and thus lagged in attracting developer interest; to date the dollar inflows into these applications have largely focused on purpose-built chains while Bitcoin has taken the shape of an index largely governing the wider price movements and valuations of other cryptocurrencies.

One of the first signs of change to this paradigm arrived in 2015 with the introduction of Rootstock, a Bitcoin scaling solution that aimed to increase transaction throughput while introducing smart contract functionality compatible with BTC pegged from the base chain. Several years of development followed, with the mainnet release of Rootstock being introduced in 2018. Since then, Rootstock has become home to a diverse range of applications and houses a passionate developer community, continuing to attract interest as the most viable Bitcoin Layer for supporting a competitive dApp ecosystem.

With increased interest in the digital asset sector the idea of Bitcoin as a payment infrastructure quickly became obsolete, as transferral fees started to number in the dollars as the network compensated for increased block space demand. A solution to this arrived with a 2015 proposal by Thaddeus Dryja for the creation of the Lightning Network, a trustless and scalable Layer-2 that could settle BTC payments off-chain instantaneously with near-zero fees through novel payment channel designs. The Lightning Network required minor alterations to Bitcoins core protocol to function, which were implemented by Bitcoin core developers in 2017 and lead to the launch of the Lightning Network alpha in the same year.

The need for major core modifications to the Bitcoin protocol architecture is what hindered the development of key application categories such as DeFi and NFTs on Bitcoin; it quickly became apparent that Layer-2 scaling solutions were necessary to expand the use cases and ecosystem for Bitcoin. Other attempts to overcome the limitations of the Bitcoin protocol led to hard forks such as that of Bitcoin SV in 2018 (which forked from Bitcoin Cash) which allowed for the execution of smart contracts, a necessary component of most DLT applications. However, forked chains like BSV have failed to attract staying power or capital interest rivalling that of Bitcoin, supporting the idea that Bitcoin-based Layer-2s are a necessity to fully tap into the vast value stored within the chain.

Bitcoin Cross-Chain Utility Demand

A demand for the use of Bitcoin in applications other than payments became apparent with the launch of Wrapped Bitcoin (wBTC) in 2019, which allowed users to bridge BTC 1:1 to the ERC-20 native wBTC. This allowed Bitcoin holders to participate in the large suite of financial applications native to Ethereum, with wBTC and other Bitcoin wrapping solutions attracting 0.85% of the total Bitcoin supply ($4.5 billion in BTC) to date.

The proportion of Bitcoin on Ethereum as a percentage of the total supply peaked at 1.8% in Q1 22 and has declined steadily since. This reduced demand was partially compounded by the failures of Celsius and Three Arrows Capital, both of which redeemed large amounts of wBTC in Q2 2022 to meet their obligations to creditors. Aside from centralised failures, it is likely that a large contributor to reduced appetite for Bitcoin bridging derives from the massive wave of exploits on cross-chain bridges in the 21/22 bull run, which saw approximately $2.5 billion drained from popular protocols such as Wormhole and Nomad, raising legitimate concerns about security in cross-chain bridging.

Another important consideration for some potential bridge users is inherent to the centralised entities that facilitate the majority of wrapping and unwrapping of Bitcoin. As an example, the sole custodian that oversees wBTC mints and burns is the NYC-headquartered Bitgo. This centralisation aspect raises a risk in the form of sanctions from entities such as the US Treasury or OFAC in the same manner that befell Tornado Cash.

As a centralised entity, custodians like Bitgo must also comply with regulatory obligations. This may dissuade or prohibit certain users from interacting with wrapping protocols; as an example of how this can affect the guarantees offered by these protocols, an Alameda employee burned 3000 wBTC in an attempt to stave off bankruptcy but failed Bitgo’s mandatory security check. Alameda was not granted the equivalent in BTC until post-bankruptcy trustees took over.

Decentralized approaches to Bitcoin wrapping have been attempted, of which the most notable is renBTC. For now, these protocols have failed to maintain momentum in the face of their centralised cousins and have even demonstrated equal vulnerability to centralised failures. Ren Protocol, the entity that manages the renBTC bridge, was acquired by the FTX debtors in February 2022 and subsequently liquidated as FTX entered bankruptcy. This caused the renBTC supply to crash to 304 from a peak of 26,477 in October 2020. While more insulated from regulatory requirements and interjections, decentralised alternatives can still be affected by centralised contagions and fail to address concerns surrounding their vulnerability to exploits, a risk inherent to bridging protocols.

The popularity of and value locked within wrapping solutions may be on the decline for now, but they do soundly demonstrate a broader demand for BTC utility and subsequent market-fit for Bitcoin native applications. This market-fit may very well transform into adoption as the wider Bitcoin ecosystem scales to provide a comparable user experience and product diversity to those of other Layer-1s.

Ordinals, BRC-20s, and the Block Space War

A more recent sign of demand for Bitcoin-native applications came after the introduction of Ordinals in January 2023 by Casey Rodarmor. This innovation followed on the heels of the Bitcoin Taproot upgrade in November 2021, which created the opportunity for rudimentary smart contracts to be deployed on Bitcoin’s core layer. Ordinals allow users to inscribe digital content onto satoshis (a subunit of Bitcoin), storing them on-chain as a basic form of NFT. To date over 11.1 million inscriptions have been stored natively on Bitcoin, netting miners $45 million in related fees.

In early March of 2023, a pseudonymous developer named Domo built on the innovations of Ordinals to create the BRC-20 token standard and launched ‘ordi’, a Bitcoin-native fungible token based on the Bitcoin Request for Comment (BRC) protocol. This was the first truly Bitcoin-native token standard and has resulted in over 2,000 deployments of other BRC-20 tokens to date. The demand for these tokens climaxed in the first two weeks of May 2023 when the total market cap of BRC-20s peaked above $1 billion, clearly showing an appetite for Bitcoin-native tokens.

While deployed BRC-20 assets largely consist of memecoins, developers in the Bitcoin ecosystem quickly moved towards exploring the potential for BRC-20 native DeFi applications. As an example, the Stacks-native Alex DEX launched an unrivalled BRC-20 DEX to solve the liquidity issues facing BRC-20s trading outside of CEXs. Another example of this is OSHI: a BRC-20 that serves as a governance token for Oshi Finance, the first liquidity pool and ERC-20 -> BRC-20 bridging protocol native to BRC-20. As one of the most innovative players within BRC-20, Oshi’s lead developer Merlin announced the development of Smart Inscriptions in the first week of June 2023. This technology relies on a system called BOSS (Bitcoin O-Perational Standard System) to improve on simple inscriptions by providing decentralised applications on BRC-20 with more operational versatility, interoperability, and complexity.

Another development following on the heels of Ordinals lies in Bitcoin Stamps, which also allows for data storage directly on the Bitcoin chain. As opposed to Ordinal inscriptions which are stored in transaction witness data, Stamps are stored directly on Bitcoin’s unspent transaction outputs (UTXOs). While allowing for less user friction in minting large quantities of inscriptions, the cost of minting an inscription using Stamps is approximately 4x that of Ordinals as the witness data discount is not applied. Additionally, image data being stored in UTXOs makes Stamps less prunable than Ordinals, increasing hardware requirement for users running Bitcoin nodes.

A consequence of the surge in Ordinals inscriptions post-Taproot was seen in unprecedented network congestion and high transaction fees on the Bitcoin network. This resulted in Binance suspending Bitcoin withdrawals for a short period of time as the network became unusable due to a backlog of 400,000 pending transactions, after which they decided to integrate the Lightning Network (an L2 that allows for BTC transactions while sidestepping congestion). These network inefficiencies led to uproar from certain Bitcoin developers who view Ordinals and BRC-20s as clutter that hinders Satoshi’s vision of a peer-to-peer payment network, with prominent Bitcoin developer Luke DashJr proposing extending a spam filter to sift through Taproot transactions; this would exclude and scrap inscriptions and their transferrals from related transactions across the Bitcoin network.

While extreme, this proposal is not unwarranted. Bitcoin is not designed to handle the loads associated with current levels of inscription demand for block space, let alone a heavier load in potential future periods of even higher demand. To say it sweetly, the whole network could be bricked by demand or malicious actors if the Ordinals ecosystem is allowed to continue as is. This begs the question: how will the demand for Ordinals be satiated? The non-suitability of Bitcoin in handling token standards and NFTs means that the best answer lies with Layer-2s that handle transactions outside of Bitcoin’s blocks.

In the middle of peak BRC-20 mania in mid-May 2023, Lightning Labs announced the test net of Taproot Assets Protocol (TAP), a scalable protocol that allows for asset issuance on Bitcoin and Lightning. The architecture of the TAP is designed to operate maximally off-chain, and their announced intention to integrate BRC-20 tokens would alleviate block space congestion caused by the inscriptions and transferrals of these tokens if adopted. This shows how Layer-2s can and are being used to overcome the limitations of the Bitcoin network in an adaptive and reactive manner, a testament to the rising levels of innovation within the Bitcoin ecosystem.

Exploring Bitcoin Layers

Over the last few years, progress in research and development into programmability and scalability of Bitcoin has led to a burgeoning developer community native to Bitcoin. This has led to a rapid expansion of Bitcoin’s ecosystem which now includes hundreds of projects in niches as diverse as DeFi, NFTs, and GameFi, all of which stand to benefit from Bitcoin’s security, capital, and network.

To date, development and capital expenditure have largely gravitated towards 4 Bitcoin layers, Lightning Network, Stacks, Rootstock, and Liquid Network. Stacks and Rootstock are touted as general-purpose smart contract layers enabling various types of applications such as DeFi and NFTs, Lightning Network is intended for scaling payments and more recently asset issuance, and Liquid Network focuses purely on asset issuance and swaps with integrated confidential transactions.

The proven demand for Bitcoin utility and recent surge in Ordinals activity resulted in Bitcoin Layer-2s and affiliated protocols surging in token valuations and TVL. As an example, Stacks TVL surged 75% in the second week of May, and 340% to peak from the inception of Ordinals hype in early February. This showcases a related demand and expectation of growth in the Bitcoin ecosystem.

The notable Bitcoin Layer-2s differ widely in both technology used and target service/market. A useful comparison between the technical and utilitarian features of them can be seen below, courtesy of Crypto.com Research.

Lightning Network

As aforementioned, Lightning Network is designed as a scalability solution for Bitcoin. Near-instant off-chain transaction settlements with minimal fees truly do allow for Bitcoin to be used as a payment network with Lightning, with the median fee rate sitting at 0.0029%, or 1,000 times cheaper than that of Mastercard and Visa. Since mainnet launch at the start of 2018, the transaction throughput of the Lightning Network has been growing steadily. With the advent of the Taproot Assets Protocol and its USP as a scalable home to BRC-20s, interest towards this scaling solution may increase significantly in the near future.

Liquid Network

Liquid Network is a Bitcoin sidechain that uses a two-way peg to move Bitcoin between the network without the need to worry about bridging-related security issues. Launched in 2018, it is controlled by a federated network of significant parties called the Liquid Federation and focuses on securities issuance and swaps in a manner reminiscent of Polymesh. Confidential and fast transactions are attractive for institutions and privacy-concerned individuals, and the sidechain has been seeing growth in L-BTC (native token BTC-pegged token) supply as a result. A notable Liquid-native protocol is LEND by Hodl Hodl, which allows for L-BTC collateralised lending and borrowing of other cryptocurrencies.

Stacks

Stacks as a smart contract-oriented Bitcoin Layer-2 utilises a unique consensus mechanism anchored to Bitcoin called Proof of Transfer (PoX), allowing it to leverage Bitcoin’s security while settling transactions natively on Stacks. dApps using Stacks’ smart contracts can interact with Bitcoin state to use Bitcoin as their native currency, an attractive feature for any Bitcoin holder seeking utility. It is important to note that Stacks’ uses a native programming language called Clarity, and the smart contracts used are not EVM-compatible. This may provide a significant barrier to entry for DeFi protocols wishing to deploy on Stacks, although efforts to improve compatibility are underway. While underpinned by Stacks’ native token STX for now, increased Clarity language compatibility and a native trustless two-way Bitcoin pegged sBTC (a la Liquid, Rootstock) are scheduled for implementation which will improve the security of and Bitcoin inflows into the network.

The most notable protocol on Stacks is Alex, a full-suite DeFi hub including an AMM/order book DEX, Bitcoin lending/borrowing, leveraged products like margin swaps, yield farming, and a launchpad. At the time of writing Alex has a TVL of $24.17 million and boasts a Stacks TVL dominance of 93.7%.

Rootstock

Rootstock (RSK) is the only Turing-complete and EVM-compatible smart contract Layer on Bitcoin, lending it a significant advantage in terms of product development speed as codebases can be bridged over from Ethereum with ease. Rootstock’s mainnet launched in January 2018 through RSK Labs, which was acquired by IOV Labs in 2019. IOV Labs introduced the Rootstock Infrastructure Token (RIF), akin to a utility token native to RSK. It is used to access a wide range of native integrated protocols developed by IOV Labs including storing, oracles, naming and CPU services, and currently boasts a market cap of $99 million.

RSK uses the largely decentralised Powpeg 2-way peg to bridge Bitcoin onto RSK as smartBTC (RBTC) in a secure manner. Rootstock as a sidechain is fully secured through merge mining on Bitcoin, with an average of >60% of the Bitcoin hashrate securing RSK. Currently, RSK TVL sits higher than any other Bitcoin Layer at $84.8 million.

One notable project on RSK is MoneyOnChain, a staking and stablecoin (DollarOnChain [DOC]) issuance protocol sitting at a current TVL of $42.4 million. Another project worth mentioning is Sovryn, a DeFi hub that offers yield farming, staking, a DEX with spot/margin, lending, and a stablecoin called DLLR. Sovryn has a TVL of $39.7 million at the time of writing.

Conclusions

Levels of ecosystem adoption, diversity of products and services offered, as well as UX are insofar somewhat lacklustre in the Bitcoin ecosystem when compared to that of established competitors such as Ethereum. There is still a long road ahead for Bitcoin and its sub-layers to be comparable to other Layer-1s as an ecosystem. However, there are positive catalysts that may help in driving development and adoption further.

Infrastructure development efforts by serious players are well underway. Muneeb Ali’s (Stacks co-founder) Trust Machine recently raised $150 million for expanding Bitcoin dApp infrastructure, and Jack Dorsey’s Block is looking to create a Bitcoin-oriented DEX. Development is also being supported through financial incentives allocated by larger organisations with vested interests; Stacks, GSR, DCG and others launched a $165 million grant programme for dApp developments on Bitcoin last year, and Mintlayer (upcoming Bitcoin Layer-2) launched a $4 million grant initiative for native developers.

Newer Layer-2s are also being developed for Bitcoin, with Mintlayer aiming to be a PoS anchored to Bitcoin, inheriting its security but having a rather limited connection otherwise. It aims to be largely DeFi-orientated while supporting securities issuance. StarkWare Industries-backed ZeroSync Association is aiming to bring zero-knowledge proofs to Bitcoin, which will help to increase network efficiency and participation significantly.

Bitcoin bridging solutions are likely to continue seeing usage by Bitcoin holders looking to capitalise on superior products offered by other Layer-1s. However, a degraded trust in them, significant steps forward in accelerating Bitcoin’s ecosystem development, and a renewed interest in and demand for Bitcoin-native tokens may contribute to significant future capital inflows into Bitcoin and its sublayers. As Bitcoin and related scaling solutions continue to enjoy innovations in development, there is little doubt that we will see increased adoption of Bitcoin-native decentralised applications.