Grayscale: Bitcoin Renaissance — The Evolution of the World’s First Public Blockchain

Author: Michael Zhao, Grayscale; Compiler: Tao Zhu, Golden Finance

Abstract

• The launch of a spot Bitcoin ETF in the U.S. market has sparked new interest in the largest public chain among traditional investors. For crypto-native investors, attention to Bitcoin has also increased, 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 catalyzed a new wave of development aimed at introducing smart contracts to the blockchain and increasing transaction throughput.

• While Bitcoin's primary use today is as a store of value asset and a digital alternative to gold, the network can also be used for other purposes, including payments, data storage, and computing. If development activity leads to new use cases and greater adoption, we expect it to increase Bitcoin's total potential market and its 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 scaling 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 in the Bitcoin developer space. Today, the Bitcoin builder community resembles the embryonic stages of Ethereum in early 2017, when decentralized applications were just beginning to take off. Bitcoin, the largest and oldest public blockchain by market cap as of May 2024, has so far primarily served as a money transfer platform, in keeping with its original intended purpose. Unlike smart contract platforms such as Ethereum, which use richer programming languages ​​that can facilitate decentralized finance and other advanced applications, Bitcoin Script has traditionally been limited to facilitating simple 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 brings NFTs (non-fungible tokens) to Bitcoin, marking a major change for Bitcoin. A shift in user and developer perspectives. With the successful integration of Ordinals, more and more users and developers now view Bitcoin as fertile ground for experimentation. This is reflected in two key aspects. First, it expands Bitcoin's functionality. The evolving ecosystem of Bitcoin Layer 2 solutions is prompting people to explore more possibilities of the Bitcoin network. Second, given the escalating activity on the main chain and rising transaction fees, efforts are underway to increase the main chain's transaction throughput.

Figure 1: Bitcoin NFT transaction volume continues to dominate

Scaling Bitcoin

The idea that Bitcoin would need additional scaling solutions has been well known from the beginning, as cryptographer and early Bitcoin adopter Hal Finney emphasized:

“Bitcoin itself cannot scale to the point where every financial transaction in the world is broadcast to everyone and included in the blockchain. There needs to be a lighter, more efficient secondary payment system.” - 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 transfer of value, potentially including smart contracts, decentralized finance applications, and NFTs.

• Transaction throughput focuses on increasing the total number of transactions processed on the Bitcoin blockchain. This involves optimizing the network protocol, increasing the block size, and implementing scalability solutions to facilitate a greater number of transactions in a given time frame.

Before the introduction of Ordinals, several Bitcoin scaling solutions already existed:

• Lightning Network:Considered one of the most popular Bitcoin scaling solutions based on historical adoption and funding, the Lightning Network is a protocol designed to facilitate fast and cost-effective peer-to-peer payment transactions.

• Stacks:Stacks runs as a sidechain running in parallel to the Bitcoin mainchain, enabling more complex applications such as DeFi and NFTs. With the Nakamoto upgrade expected to be completed in the coming months, Stacks will be secured by Bitcoin’s hashrate.

• Rootstock:Rootstock is an Ethereum Virtual Machine (EVM) compatible sidechain that allows developers to utilize Ethereum-compatible smart contracts on a network secured by a portion of Bitcoin’s hashrate through a process called merged mining.

Chart 2: Bitcoin’s existing Layer 2 ecosystem has been evolving

While these solutions have been available for years, the launch of Ordinals in late 2022 can be seen as a catalyst for the development of the latest generation of Bitcoin. Ordinals were advanced by two upgrades to the Bitcoin Core software: SegWit (July 2017), which increased the theoretical block size from 1MB to 4MB, and Taproot (November 2021), which enabled 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, the smallest unit of Bitcoin. By referencing these numbers, one can link pictures, music, or other arbitrary data to the witness portion of a transaction. By the end of 2023, Bitcoin has become the largest NFT platform by transaction volume compared to all other blockchains (based on the Allium data we used in Exhibit 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 their main chain. Coupled with the sense of novelty, the explosion of Ordinals has prompted participants (both users and developers) to think: “What else can Bitcoin achieve?” The Next Generation of Bitcoin Applications There are several innovative projects currently being developed in the Bitcoin ecosystem: BitVM: One of the most anticipated developments is BitVM, which enables optimistic Bitcoin Rollups using only Bitcoin Script, a feat previously thought to be impossible. Similar to Ethereum’s optimistic rollup, Bitcoin Rollup moves transaction execution off-chain, enabling faster and cheaper transactions. While still in its early stages, projects like Build on Bitcoin aim to incorporate the BitVM into future settlements.

While these developments are promising, it’s worth noting that there is no clear front-runner. As of May 9, 2024, the total value locked in these new projects represents just 0.2% of Bitcoin’s total market cap, according to DefiLlama. With so many projects competing for attention and liquidity simultaneously, the Pareto Principle suggests that only a handful will emerge as successful projects in the coming years, similar to patterns observed on other smart contract platforms. The Grayscale Research team will continue to closely monitor these developments to understand emerging trends and opportunities in the Bitcoin ecosystem.

Bitcoin’s Larger Addressable Market

So what does this mean for Bitcoin?

If we take a step back, Bitcoin’s entire addressable market rests on a variety of narratives: store of value, medium of exchange, settlement layer, alternative monetary system, etc. This has been explored in depth in past research.

We believe that the combination of faster transaction speeds and greater programmability on top of Bitcoin will be complementary to the entire addressable market equation. Increased transaction throughput will strengthen the settlement layer narrative, while increased programmability will open new markets for Bitcoin as a smart contract platform layer.

Given that Bitcoin is a relatively new entrant into the smart contract platform market, one way to frame 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), which we can use as a proxy for utilization, is still relatively small. When Bitcoin’s TVL to market cap ratio is compared to smaller blockchains, it is lower both in relative and absolute terms.

For example, Ethereum currently has ~$50 billion locked in its ecosystem as of May 2024, with another ~$7.5 billion in Layer 2 solutions for a total of ~$57.5 billion. Ethereum’s market cap is ~$360 billion. This means ~17% of Ethereum’s total market cap is in applications. In comparison, Bitcoin has only ~$2.4 billion locked in applications with a market cap of ~$1.2 trillion. This means that only 0.2% of Bitcoin’s market cap is in applications.

Figure 3: Bitcoin’s Existing Opportunities Remain Large

From an investment perspective, there is a lot of excitement about how things will eventually turn out, given the combination of interested users and developers with a historically untapped market.

Development Brings New Risks

While greater development activity within the Bitcoin ecosystem creates opportunities, it can also bring new risks. We see two main challenges. First, increased activity could lead to higher fees. One criticism of Bitcoin’s development stems from an aversion to high transaction fees. Recently, Bitcoin transaction fees have risen due to speculation, making traditional Bitcoin transaction costs prohibitive for some users. The counter-argument is that fees are always meant to supplement miners’ income. The ongoing development of Bitcoin scaling solutions should help create new solutions for users who need cheaper transaction fees, rather than introducing problems. Second, some Bitcoin users have expressed concerns about value dilution. For example, if the Bitcoin network is used for more purposes, will its value as a monetary medium decrease? Does the influx of new projects represent “graffiti” on the value chain, or help it evolve into something more akin to jewelry? We believe that the essence of Bitcoin lies in its decentralization and the freedom it provides users to use Bitcoin in a variety of ways, including introducing art or stablecoins. This expansion of use cases broadens Bitcoin's appeal and brings in new markets and audiences, which is in line with its 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.

The Next 15 Years

Bitcoin is only about 15 years old, and users and developers are still exploring its potential applications. Given the early stages of development in the Bitcoin Layer 2 space, it is too early to judge the trajectory of most projects. However, Grayscale Research has witnessed similar ecosystem expansions in other smart contract platforms and noticed the types of projects that tend to act as primitives. We also noticed a trend in the way most current solutions handle security. 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 Bitcoin applications to gain significant traction will likely follow the trajectory of Ethereum and provide a suite of DeFi primitives in the area of ​​lending and swap protocols. If we assume that assets other than Bitcoin will begin to be settled on the Bitcoin network, there will be demand to use these assets. As we have seen with the development of other smart contract platforms, these are often the applications that receive the majority of early liquidity.

• Growth of Miner Partnerships with Layer 2 Projects:The hash rate of Bitcoin miners will likely enhance the security of these scaling solutions, providing an additional revenue stream for miners. Given that there is currently no reliable solution on the market to fully utilize Bitcoin’s hashrate, we believe that in the medium term, it will be more common for these new projects to continue to merge-mine (scaling solutions utilizing part of the mining hashrate) — until BitVM is implemented. We have already seen this with Layer 2 projects, such as Rootstock in the past and BoB currently.

• Competition in the Smart Contract Platform Space:Due to these developments, we believe that Bitcoin will become a strong competitor in the smart contract platform space. Given the high demand for wBTC on the EVM chain, we see potential for latent 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 with this “limited” use case, it seems to us to be successful. Its market cap has grown to over $1 trillion and has spawned entirely new asset classes. But Grayscale Research believes that we are still in the early stages of the Bitcoin story. Developers are only now discovering how to get more out of the first public chain and how to conduct Bitcoin transactions most efficiently. If the latest wave of development leads to greater adoption of these use cases, it will mean a larger potential market and potentially a higher market value over time.