Written by Jay Han(Investment Team Lead), Victor Cha(Investment Analyst), Kevin Min(Research Assistant) from Alphanonce
Despite holding a substantial majority, accounting for over 50% of the total crypto market cap, Bitcoin had, until recently, largely refrained from participating in web3 innovation. This reluctance was primarily attributed to technical constraints and the steadfast ethos of the Bitcoin OG community. However, the introduction of Ordinals and the BRC20 standard has ushered in a new era for Bitcoin, expanding its functionality beyond the confines of its digital gold narrative to embrace a more extensive financial ecosystem and culture. We believe this evolution mirrors the early stages of Ethereum and other blockchain platforms dedicated to smart contracts, encompassing areas such as DeFi, NFTs, games, and more. We are optimistic about the burgeoning innovation within the Bitcoin ecosystem, and this report provides an in-depth analysis of these transformative developments.
Fifteen years since its inception, Bitcoin has transcended its original functionality as sound money. Although initially conceived as a P2P digital currency, Bitcoin has now evolved into a complex ecosystem encompassing a variety of financial and non-financial applications. Bitcoin-based projects facilitate intricate financial products and even venture into non-financial domains such as NFTs and gaming. This evolution has been marked by the recent changes in Bitcoin network activity, particularly spikes in last April and sustained increases from last October. Last December, the number of Bitcoin transactions reached its all time high with over 700 thousand daily transactions, and building on Bitcoin is becoming a strong theme.
However, as the Bitcoin ecosystem continues to grow, so does the complexity of its network, necessitating a deeper exploration into the implications of this expansion. We`ll commence 1) examining Bitcoin network trends and the factors contributing to the sustained increase in network activity, and continue on with investigating the 2) change in profitability of mining activities and 3) development of Layer 2(L2) solutions to address Bitcoin’s new scalability and economic challenges and 4) controversies within Bitcoin community.
1. Bitcoin Network Activity and its Implications
Ordinals and BRC20: Emergence of a new Bitcoin-based asset class
Bitcoin network activity surged after Bitcoin’s Taproot update introduced technological novelties, namely Ordinals, to the Bitcoin ecosystem. Ordinals revolutionized the way text, images, audio, video, and code are stored on the Bitcoin blockchain, drawing parallels to the early Ethereum ecosystem.
Furthermore, introduction of the experimental token standard BRC-20, inspired by the ERC-20 token standard and realized with the Ordinals protocol, enabled the launch of Bitcoin-based fungible tokens, leading to significant market traction. Although functionality of BRC-20 is still limited compared to ERC-20, it supports basic transfer and ownership; this enabled creation of popular meme-coins like $ORDI and $SATS, which are currently listed on major exchanges.
<Fig 1. Bitcoin Transaction fees. Source: reportbly @ Dune >
The Financialization of Bitcoin
The financial ecosystem of Bitcoin is becoming increasingly sophisticated, resembling the early days of Ethereum’s DeFi summer. The successful structures and business models pioneered in Ethereum's DeFi ecosystem are now gaining traction and finding success in the realm of Bitcoin.
Bridges such as MultiBit($MUBI, website), OrdBridge(website), and SoBit($SOBB, website) facilitate interoperability between Bitcoin, BRC20 and EVM networks or other blockchains. Recently, MultiBit introduced the BTC-ETH NFT bridge, enabling access to Bitcoin NFTs via Ethereum platforms and increasing interoperability(source). $SOBB successfully completed its IDO, and is currently at $26.8M FDV as of January 3rd, 2024.
Wrapped Bitcoin solutions such as the incumbent wBTC(Market Cap(MC) $7.14B; website), Rootstock’s rBTC(MC $143.4M; website), Threshold’s tBTC(MC $60.9M; website), Avalanche’s BTC.b(MC unknown; website), Stack’s sBTC(to be released; website), and others enable Bitcoin use across various blockchains.
These financial advancements not only unlock unused Bitcoin capital and enhance Bitcoin’s liquidity but also signify Bitcoin’s shift from a mere digital gold to a versatile financial platform capable of supporting a wide range of complex financial products and services.
Bitcoin venturing into Non-financial territory
Introduction of Ordinals has been a pivotal moment for Bitcoin's non-financial ecosystem, catalyzing a diversification into various sectors beyond its original monetary use. Ordinals have allowed for the creation and storage of text, images, audio, and video directly on the Bitcoin blockchain, leading to the emergence of blue-chip NFTs in Bitcoin.
Notable Ordinal collections include Bitcoin Frogs, NodeMonkes, Taproot Wizards, Ordinals Maxi Biz, MNCHRMS and others. This expansion into NFTs signifies a broadening of Bitcoin's utility, attracting both creators and collectors to the space and contributing to a vibrant market for digital assets. As evident in the data below, from last November, Bitcoin NFT trade volume exceeded that of Ethereum and Solana. According to Amb Crypto, Bitcoin NFT sales totaled $869 million in December 2023 and more than doubled Ethereum’ sales of $343 million(source). According to CryptoSlam, top 10 NFT collections by sales volume in December 2023 were also dominated by Bitcoin based collections - 6 out of 10 collections were Bitcoin Ordinals collections, and Bitcoin Frogs was the #1 PFP(source).
<Fig 2.NFT Trade Volume by Chain, weekly. Source: The Block, Cryptoslam>
Beyond NFTs, Ordinals have paved the way for Bitcoin's foray into gaming, metaverse and social finance realms. Selected examples include metaverse projects such as Bitmap(website) and Life Beyond(website), gaming projects such as Bitcoin Cats(website) and Darewise(website), and Social Finance(SocialFi) project New Bitcoin City(website).
Furthermore, BitVM(source), introduced by Robin Linus, is gaining interest for its potential to enable smart contract functionalities within the Bitcoin network without necessitating a soft fork of the network. This feature positions BitVM as a significant player in the expansion of Bitcoin's capabilities; if BitVM is implemented, Bitcoin would be able to host a wider array of projects and applications. These developments underscore a significant shift in Bitcoin's journey, marking its evolution from a purely financial tool to a versatile platform supporting a diverse array of financial and non-financial applications.
Building on Bitcoin
Increased Bitcoin-based projects support the rising "Building on Bitcoin" trend. This trend is likely to continue on in 2024 as well; major institutions also prospect on the expansion of Bitcoin beyond its original role as electronic cash. Analyzing 2024 outlook reports from key crypto institutions like Nansen, Pantera, and Hashed, there's a clear bullish sentiment towards increased Bitcoin's use cases and expansion of its ecosystem.
Nansen regards Bitcoin as the flagship token of the crypto industry and the most reliable asset. Nansen further suggests a strong foundation for developing various Bitcoin-based solutions is needed (source). Similarly, Pantera predicts an increase in Bitcoin's scalability through the rise of Bitcoin Layer 2 solutions and anticipates that Bitcoin's total value locked (TVL) in DeFi could grow from the current 0.05% of Bitcoin’s market cap to 1-2%(source). Hashed believes that a wave of innovation and activity is taking place on the Bitcoin network and envisions that projects scaling the Bitcoin ecosystem could have a huge impact in 2024(source).
2. Bitcoin Mining Profitability and Economic Implications
Recent trends in Bitcoin mining
Recent trends in Bitcoin mining rewards and fee structures also reveal significant shifts in the economy of the Bitcoin network. According to [Fig. 3], daily mining rewards have been on a steady rise since last October, with miners earning 40 million dollars on average per day. Notably, on December 17th, miners received more than 80 million dollars in a single day. Although historically most of the Bitcoin mining rewards originated from the creation of new blocks, with the increase in Bitcoin transaction volume, now transaction fee revenue has become a substantial component of the total mining rewards. This change is evident in the "Fee-to-Reward Ratio" in [Fig. 4] which has recently exceeded 10%, and occasionally even surpassing 20%. This trend suggests that if Bitcoin's price remains relatively stable and the halving event occurs, the proportion of transaction fees in miners' rewards is likely to increase further, and Building on Bitcoin could create a significant impact to the economic system of Bitcoin mining. <Fig 3. Daily Miner Revenue (in red), and Bitcoin Price(in black) from Jul 2020, Source: reportbly @ Dune>
<Fig 4. Bitcoin Block’s Fee-to-Reward Ratio(orange) from Jul 2020, Source: reportbly @ Dune>
Performance of Bitcoin's transaction fees relative to Ethereum's is another noteworthy aspect. According to Will Clemente, co-founder of Reflexivity Research, Bitcoin's monthly transaction fees in December 2023 have outperformed those of Ethereum, serving as a strong incentive for miners to maintain the Bitcoin network(source). This development has caught the attention of Web2 investors, leading to significant investments in stocks that provide exposure to Bitcoin mining. For instance, Valkyrie's Bitcoin Mining ETF ($WGMI, website) saw a YoY increase of over 300% in 2023, and was one of the best performing ETFs in 2023. On December 28th, the trading volume of a Bitcoin mining company, Marathon Digital, surpassed Web2 giants like Tesla and Apple within a 24-hour period(source). This sustained investor interest underscores the growing recognition of Bitcoin's expanding utility and the role of fees in ensuring network security.
Fees as a Security Budget for Bitcoin
Increase in transaction fees represents more than just additional revenue for miners; it is a crucial component supporting the scalability and security of the Bitcoin network. Numerous industry figures agree with this point of view, including Messari’s CEO Ryan Selkis(source). This ongoing diversification of miner’s fees addresses concerns raised by Ethereum proponents regarding Bitcoin's security budget; if this trend continues, the Bitcoin network could effectively self adapt to meet its security needs. Thus, as the Bitcoin ecosystem evolves, financial incentives to miners play a vital role in maintaining its stability and integrity and demonstrate Bitcoin's resilience and adaptability in the face of changing market dynamics.
3. Emergence of Bitcoin Layer 2 Solutions
As the Building on Bitcoin trend continues to grow, Bitcoin - the base layer for this trend - has faced increasing challenges related to scalability, efficiency, and transaction costs. In response, a variety of Bitcoin Layer 2 solutions have been developed to address these issues. These solutions, which include a smart contract L2 Stacks, payment focused L2 Lightning Network, and federated side chains Liquid, aim to increase transaction throughput, reduce costs, and improve overall network performance while minimally compromising the security or decentralization of the base layer. This section provides an overview of these L2 solutions, discussing their technical workings, advantages, and trade-offs.
Bitcoin Layer 2 Trilemma
The Bitcoin Layer 2 (L2) trilemma presents a unique challenge to Bitcoin L2 solutions. According to Muneeb, co-creator of Stacks, as developers and investors navigate this landscape, they face a trade-off between choosing the three desirable properties for Bitcoin L2 solutions as it is currently technically challenging to achieve all three simultaneously(source). The three properties of the Bitcoin L2 Trilemma are:
1) an open network,
2) the absence of a new token, and
3) a full/global Virtual Machine(VM).
<Fig. 5: Bitcoin L2 Trilemma. Source: Bitcoin Magazine>
The builder’s choices shape the fundamental architecture and characteristics of Bitcoin L2 solutions. The Bitcoin community's 1) skepticism of introducing new tokens on top of Bitcoin and 2) the focus on maintaining a decentralized, open network adds complexity to developing L2 solutions that meet these stringent criteria.
Bitcoin Layer 2 Solutions
Current Bitcoin Layer 2 solutions could be classified into three major categories: 1) Off-chain Networks, 2) Decentralized side chains with new tokens on top, and 3) Federated sidechains.
Off-chain networks store data off-chain without a public ledger, significantly enhancing scalability and privacy. However, they require users to run their own nodes, which can be a barrier to accessibility. While these networks offer significant improvements in transaction speed and privacy, they lack the universal accessibility of a public blockchain, making them more suited for specific use cases such as payment scaling. Off-chain network solutions include Lightning Network(website), RGB(source), and Taproot Assets(formally known as Taro, website) .
Decentralized side chains represent another approach to L2 solutions, and introduces new tokens to incentivize miners’ consensus participation. New tokens create a competitive marketplace of miners and aim to enhance the network effect by leveraging the token's demand. This approach can foster community building and support extensive R&D, but it complicates the user experience by adding an additional token and often faces skepticism from Bitcoin purists who prefer to avoid additional layers to Bitcoin's original token model. Decentralized sidechain solutions include Stacks($STX, MC:$2.42B, website) and Interlay($INTR, MC: $1.8M, website).
Federated side chains operate differently; these solutions peg bitcoin instead of issuing new tokens. This model utilizes a multisig of select validators to increase efficiency and scalability, but introduces a level of centralization and leaves open questions about validator compensation. Efforts to automate and further decentralize membership in these networks are in development. Federated side chains offer a compromise between maintaining a close relationship with Bitcoin and introducing new functionalities, but their centralization and lack of a sustainable economic model present ongoing challenges. Federated sidechain solutions include Liquid(website), Rootstock(website), and Botanix(website).
Lastly, a variety of other Bitcoin L2 solutions are emerging, addressing different aspects of the trilemma with innovative approaches. These include EVM-compatible L2s, optimistic rollup L2s, ZK L2s, Rust based L2, inscription L2s, and much more. Bitcoin L2 solutions come with unique trade-offs and contributions to the Bitcoin ecosystem. As developers continue to experiment with these solutions, the landscape of Bitcoin L2s is becoming increasingly diverse, offering a range of options for enhancing Bitcoin's scalability, privacy, and functionality. Other significant Bitcoin L2 projects are following:
1) Map Protocol($MAP, MC: $70.1M, website) backed by DWF, offers a zero-knowledge(ZK) omnichain L2.
2) BeL2 by Elastos($ELA, MC: $82.8M, website) introduces a ZK based L2 and BTC-powered EVM. BeL2 partnered with Alibaba Cloud, Tencent Cloud, and other prominent companies.
3) Dovi($DOVI, MC: $11.4M, website) backed by KuCoin, provides an EVM-compatible L2.
4) BEVM(website) is an EVM-compatible L2 based on Taproot.
5) BOB(website) by Interlay is a Rust and EVM based L2.
4. A Divided Bitcoin Community
The popularity of Ordinals has divided the Bitcoin community as well. As an example, Yat Siu, the co-founder of Animoca Brands, expressed enthusiasm for the renewed spirit of development on the Bitcoin network. He emphasized, "Culture is the biggest TVL of all economies. Before Ordinals, Bitcoin was really just used as a store of value, now you can actually store culture."
Conversely, Bitcoin Maxis such as Bitcoin core developer Luke Dashjr argues that Ordinals are spams in need of fixing, and Inscriptions are exploiting a vulnerability in Bitcoin (source). Some even took the initiative to assign the vulnerability identifier CVE-2023-50428 to Inscriptions in the United State’s National Vulnerability Database(source) and develop a Ordinals filter for censorship such as Ordisrespector(source). Several mining pools and developers also started to talk about censoring Ordinals and BRC-20(source). On the other hand, CEO of Blockstream Adam Back argues that Ordinals and JPEGs on Bitcoin are unstoppable, and high Bitcoin fees caused by Ordinals and increased network fees would promote the adoption of Bitcoin Layer 2s and force innovation.(source)
<Fig. 6: A divided Bitcoin community - in 4 pictures>
Some, such as Jimmy Song(source) even argue that a hard fork of Bitcoin may be imminent, similar to Bitcoin Cash($BCH) and Bitcoin Classic($BXC). According to Jimmy Song's perspective, the influx of venture capital into projects like Ordinals, BRC-20, and Inscriptions creates an inherent drive towards a Bitcoin fork. As these projects seek sustained growth amidst fading hype, they face a crossroads: increase revenue or reduce costs. The former requires new narratives or features, potentially leading to a fork to accommodate these changes, especially as creating them on Bitcoin as it currently stands is challenging. The latter, reducing costs, might involve increasing block sizes or frequency, again incentivizing a fork. Song argues that venture capital involvement has set this path in motion, indicating that a conflict of visions is inevitable, and a peaceful coexistence within the current Bitcoin framework is unlikely. Song’s perspective provides a view on incentives for a Bitcoin hard fork in the face of Ordinals' evolving ecosystem.