Original author: Michael Zhao, grayscale
Original translation: Kate, Mars Finance
The launch of a Bitcoin spot ETF in the U.S. market has sparked new interest in the largest public blockchain among traditional investors. For crypto-native investors, attention to Bitcoin has also heated up, but for a different reason: a resurgence in developer activity and investment.
Unlike Ethereum, Bitcoin’s programming language does not support complex functions. However, the success of Ordinal Inscriptions has spawned a new wave of developments aimed at introducing smart contracts to blockchains and increasing transaction throughput.
While Bitcoin's primary use case today is as a store of value and a digital alternative to gold, the network can also be used for other purposes, including payments, data storage, and computation. If development activity leads to new use cases and greater adoption, we expect it to increase Bitcoin's total potential market value.
In the future, we expect to see increasing use of decentralized finance (DeFi) applications on Bitcoin, more Bitcoin miner partnerships to secure these new extended chains, and increased competition as Bitcoin becomes a viable smart contract platform.
Grayscale Research has noted that much of the excitement over the past few months has been focused on the Bitcoin developer space. Today, the Bitcoin builder community resembles the embryonic stages of Ethereum in early 2017, when decentralized applications were just emerging. As of May 2024, Bitcoin is the largest public blockchain by market cap and the oldest blockchain in existence, and has so far served primarily as a money transfer platform, in keeping with its original purpose. Unlike smart contract platforms such as Ethereum, which use a richer programming language that can facilitate decentralized finance and other advanced applications, Bitcoin Script has traditionally been limited to facilitating straightforward transactions without supporting complex functionality.
Despite many efforts to enhance the network in the past, value transfer remained the primary function of Bitcoin for more than a decade until the launch of Ordinals in late 2022. Ordinals introduce NFTs (non-fungible tokens) to Bitcoin, marking a major shift in the perspective of users and developers. With the successful integration of Ordinals, more and more users and developers now view Bitcoin as fertile ground for experimentation. This manifests itself in two key ways. First, it broadens Bitcoin's functionality. The growing ecosystem of Bitcoin's second-layer solutions has prompted people to explore other possibilities of the Bitcoin network. Second, given the escalating activity on the main chain and rising transaction fees, people are working to increase the transaction throughput of the main chain.
Figure 1: Bitcoin NFT transaction volume continues to dominate
Scaling Bitcoin
The idea that Bitcoin would need additional scaling solutions has been known since the beginning, as cryptographer and early Bitcoin adopter Hal Finney emphasized:
“Bitcoin itself cannot scale to broadcast every financial transaction in the world to everyone and include it in the blockchain. We need a secondary payment system that is lighter weight and more efficient.” — Hal Finney (December 30, 2010)
We see two main ways to scale Bitcoin:
Functional diversity involves expanding the range of activities and applications that are feasible within the Bitcoin network. This includes exploring and implementing new features, protocols, and technologies that extend Bitcoin’s utility beyond simple value transfer, potentially including smart contracts, decentralized financial applications, and NFTs.
Transaction throughput focuses on increasing the total number of transactions processed on the Bitcoin blockchain. This includes optimizing the network protocol, improving block size, and implementing scalability solutions to facilitate a greater volume of transactions in a given time frame.
Prior to the introduction of ordinals, several Bitcoin scaling solutions already existed:
Lightning Network: Considered one of the most popular Bitcoin scaling solutions in terms of historical adoption and funding, the Lightning Network functions as a protocol designed to facilitate fast and cost-effective peer-to-peer payment transactions.
Stacks: As a sidechain running parallel to the Bitcoin mainchain, Stacks can execute more complex applications such as DeFi and NFT. With the Nakamoto upgrade expected to be completed in the coming months, Stacks will be secured by Bitcoin’s hash rate.
Rootstock: An Ethereum Virtual Machine (EVM)-compatible sidechain, Rootstock allows developers to use Ethereum-compatible smart contracts on a network secured by a portion of Bitcoin’s hash power through a process called merged mining.
Figure 2: Bitcoin’s existing second-layer ecosystem continues to grow
While these solutions have been around for years, the introduction of ordinals in late 2022 can be seen as a catalyst for the development of the latest generation of Bitcoin. Ordinals were facilitated by two upgrades to the Bitcoin Core software: SegWit (July 2017), which increased the theoretical block size from 1 MB to 4 MB, and Taproot (November 2021), which enables users to more easily embed arbitrary data into the witness data portion of a Bitcoin block.
Ordinals are essentially a way to introduce non-fungibility by assigning a unique number to each Satoshi (i.e., the smallest unit of Bitcoin). By referencing these numbers, pictures, music, or other arbitrary data can be linked to the witness portion of a transaction. By the end of 2023, Bitcoin becomes the largest NFT platform compared to all other chains (based on the data from Allium that we use in Table 1).
While the initial user experience lags behind chains like Ethereum and Solana, users may be attracted to NFTs on Bitcoin in part due to the scarcity of block space relative to other layer 1 solutions, most of which do not store files directly on the main chain. Coupled with the novelty, the popularity of ordinals has prompted participants—both users and developers—to think: “What else can Bitcoin achieve?”
The next generation of Bitcoin applications
In the Bitcoin ecosystem, there are several innovative projects currently under development:
BitVM: One of the most anticipated developments is BitVM, which enables optimistic Bitcoin rollups using only Bitcoin script, something that was previously thought to be impossible. Similar to Ethereum's optimistic rollup, Bitcoin's rollup moves transaction execution off-chain, allowing for faster and cheaper transactions. While still in its early stages, projects like Build on Bitcoin aim to incorporate BitVM into future settlements.
Spiderchains (Botanix Labs): Spiderchains refers to second-layer chains that use staked Bitcoin in decentralized multi-signature wallets, providing a different security standard than solutions such as Stacks and Rootstock. For example, Botanix Labs is developing an EVM-compatible Spiderchain to facilitate the bridging of Bitcoin from Bitcoin's first layer to Botanix's second layer.
Bitcoin Restaking Solution (Babylon): Babylon, similar to Eigenlayer, leverages the security of the underlying Bitcoin network for other validated services. Given Bitcoin’s high hash rate as of May 9, 2024, it can provide strong security for applications seeking to leverage Bitcoin’s security budget.
Bitcoin-specific applications/DeFi: Projects focused on Bitcoin-backed stablecoins, lending, and other DeFi applications aim to replicate functionality on Ethereum within the Bitcoin ecosystem.
Taproot Assets: Formerly known as Taro, Taproot Assets is a Bitcoin layer developed by Lightning Labs for issuing assets on Bitcoin. Taproot Assets uses the Taproot upgrade to embed metadata into Bitcoin's unspent transaction outputs. With major players such as Coinbase activating Lightning transactions, Taproot Assets is likely to gain traction.
While these developments are promising, it’s worth noting that there isn’t a clear frontrunner in terms of attention. According to DefiLlama, as of May 9, 2024, the total value locked in these new projects accounts for just 0.2% of Bitcoin’s total market cap.
With so many projects competing for attention and liquidity simultaneously, the Pareto principle suggests that only a few projects will emerge as successful ones in the coming years, similar to the patterns observed on other smart contract platforms. The Grayscale Research team will continue to monitor these developments closely to understand emerging trends and opportunities in the Bitcoin ecosystem.
Bitcoin’s Larger Potential Market
So, what does all this mean for Bitcoin?
If we take a step back, Bitcoin’s total potential market relies on various narratives: store of value, medium of exchange, settlement layer, alternative monetary system, etc. This has been discussed in depth through past research.
We believe that faster transaction speeds and greater programmability on top of Bitcoin are additive to this potential market equation. Increased transaction throughput will strengthen the settlement layer narrative, while increased programmability will enable Bitcoin to enter a new market as a smart contract platform layer.
Given that Bitcoin is a relatively new entrant into the smart contract platform market, one way to chart Bitcoin’s opportunity is to compare Bitcoin’s utilization and market cap ratio to other smart contract platforms. Despite being the largest cryptocurrency by market cap, Bitcoin’s total value locked (TVL) is still relatively small, which we can use as a proxy for utilization. When comparing Bitcoin’s TVL to market cap ratio to smaller chains, it is lower both relatively and absolutely.
For example, Ethereum currently has approximately $50 billion locked in its ecosystem as of May 2024, with an additional $7.5 billion in Layer 2 solutions for a total of $57.5 billion. Ethereum’s market cap is approximately $360 billion. This means that approximately 17% of Ethereum’s total market cap is being used in applications. In comparison, Bitcoin only has approximately $2.4 billion locked in applications and a market cap of $1.2 trillion. This means that only 0.2% of Bitcoin’s market cap is being used in applications.
Figure 3: Bitcoin’s current opportunities are still huge
From an investment perspective, we’re very excited about how things are turning out, given the combination of interested users and developers and a historically untapped market.
Development brings new risks
While greater development activity within the Bitcoin ecosystem creates opportunities, it can also create new risks. We see two main challenges. First, increased activity could lead to higher fees. One criticism of Bitcoin development comes from an aversion to high transaction fees. Recent increases in Bitcoin transaction fees due to speculative activity have made traditional Bitcoin transaction costs unacceptable to some users. The counter-argument is that fees are always meant to supplement miners’ income. The ongoing development of Bitcoin scaling solutions today should help create new solutions for users, rather than introduce a problem, and these solutions require lower transaction fees.
Second, some Bitcoin users have expressed concerns about value dilution. For example, if the Bitcoin network is used for more things, will its value as a monetary medium decrease? Does the influx of new projects represent "graffiti" on the storage value chain, or will it evolve into something more akin to jewelry?
In our view, the essence of Bitcoin lies in its decentralization and the freedom it provides users to use Bitcoin in a variety of ways, including in art or to realize stablecoins. This expansion of use cases broadens Bitcoin's appeal and brings in new markets and audiences, which is consistent with Bitcoin's fundamental purpose of empowering individuals with financial sovereignty and choice. Nevertheless, we expect the debate around the expansion of Bitcoin's use cases to continue.
Next 15 years
Bitcoin is only about 15 years old, and users and developers are still digging into its potential applications. Given the nascent state of the second-layer space, it’s too early to tell the trajectory of most projects. However, Grayscale Research has witnessed similar ecosystem expansion on other smart contract platforms and noticed the types of projects that tend to lean towards using them as primitives.
We also noticed a trend in how security is handled for most current solutions. Looking ahead, we have a few predictions for these new Bitcoin-based protocols and scaling solutions:
Expansion of DeFi primitives: We expect that the first applications to gain significant traction on Bitcoin will likely mirror Ethereum’s trajectory and provide a suite of DeFi primitives in the areas of lending/borrowing and exchange protocols. If we assume that assets other than Bitcoin will begin to be settled on the Bitcoin network, then there will be demand to use these assets. As we have seen with the development of other smart contract platforms, these applications will often receive the majority of early liquidity.
Growth of Miner Partnerships with Layer 2 Projects: The security of these scaling solutions will likely be backed by Bitcoin miners’ hash power, providing an additional revenue stream for miners. Given that there is currently no reliable solution on the market to fully utilize Bitcoin’s hash power, we believe that in the medium term, merged mining, where scaling solutions utilize a portion of the mining power, will become more common in these new projects until BitVM is implemented. We have seen this in the past with Layer 2 projects such as Rootstock and currently with BoB.
Competition in the smart contract platform space: Due to these developments, we believe Bitcoin will become a significant competitor in the smart contract platform space. Given the high demand for Bitcoin on the EVM chain, we see potential for pent-up demand for Bitcoin-based collateral projects such as Bitcoin stablecoins.
Today, Bitcoin primarily serves as a store of value and a digital alternative to physical gold. Even in this "limited" use case, it appears to have been successful in our opinion. Its market cap has grown to over $1 trillion and has spawned an entirely new asset class. But Grayscale Research believes that we are still in the early stages of Bitcoin's story.
Developers are only now discovering how to get more from the first public blockchain and how to conduct Bitcoin transactions most efficiently.
If the latest wave of development leads to greater adoption of these use cases, that would mean a larger potential market and potentially a higher market value over time.