Bitcoin’s Taproot Upgrade and the Possibility of DeFi on Bitcoin
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Bitcoin’s Taproot Upgrade and the Possibility of DeFi on Bitcoin

Created 2mo ago, last updated 2mo ago

Taproot went live in November last year, promising greater transaction privacy by redefining how the network handles complex transactions. But what does that mean for DeFi on Bitcoin?

Bitcoin’s Taproot Upgrade and the Possibility of DeFi on Bitcoin

Table of Contents

The Taproot upgrade to the Bitcoin network is the first in four years, and it went live on Nov. 14, 2021. It aims to address scalability and privacy challenges that were plaguing the network.
This is true…to an extent. Bitcoin’s Taproot upgrade primarily focuses on transaction privacy (and hence the visibility of on-chain transactions) as well as redefines how the network handles complex transactions. An important component is the possibility of supporting smart contracts — and DeFi on Bitcoin.

But there’s more than what meets the eye.

At its core, it is merely a mathematical implementation of how signatures are used to approve transactions. But on the surface, there are several implications that we need to consider. While there are already several resources available that detail what the upgrade is and how it works, there is little information on the implications that it might have on the users.

In this article, that is exactly what we’ll explore. Let’s dive in.

What on Earth Is Taproot?

To understand how Taproot and its implementations actually work, it is crucial for us to know that in the Bitcoin network, your coins are locked in scripts. This script is nothing but an embedded code that clearly outlines how your coins can be spent within the next few transactions.

Obviously, to enable these transactions, certain conditions need to be fulfilled, one of them being the signature that you provide. Furthermore, complex conditions like the presence of more than one signature, or the criteria of certain time before the coins can be transferred can also be added. All of these conditions decide how the coins are actually spent and how the transactions are carried out.

The scripts that we referenced earlier are not visible to the entire public. In fact, they are only made visible when the transaction is complete. This happens when the owner of a particular set of coins reveals their script, the hash of which is already present on the blockchain. The hash is then cross-checked with the script to ensure that all the prespecified conditions were met before the transaction was carried out.

But why do these scripts matter?

Because they are data-heavy and not privacy-focused. When the transaction is executed, anyone is able to see what the conditions of the transaction were.

To tackle this, the Taproot upgrade was first proposed by Greg Maxwell in 2018 where he talked about making a transaction with a normal “one-party signature” indistinguishable from complex signatures.
Previously, the network used the “Elliptic Curve Digital Signature Algorithm (ECDSA),” where a signature is created from the private key that controls the wallet. After Taproot, it adopts something called Schnorr signatures too, which makes multi-signature transactions unreadable.
This was the birth of the idea of making all transactions appearing on the Bitcoin network all the same. The original idea was called Taproot, which was further merged into Bitcoin core in September 2020. At the core of this merge were three core Bitcoin Improvement Proposals, BIP 340, 341 and 342.

While it would be helpful to explore these in detail, we’ll only briefly go over them here to understand the core improvements that the Taproot upgrade entailed.

Understanding BIP 340

The major argument for the implementation of BIP 340 was that of security of the type of signatures (ECDSA) that Bitcoin was using prior to its implementation. Schnorr signatures, which were posed as an alternative, were found to be much more resilient to being forged.

In addition to this, the ECDSA signatures are considered to be more malleable than Schnorr, which means that anyone can modify an existing signature for a public key into another one. And lastly, the multi-signature transactions are made more efficient so as to enable complex transactions within the network.

Understanding BIP 341

BIP 341 was aimed at breaking down the complexity of proposals that Taproot entailed. This consisted of some ground-level feature upgrades.

One of the key highlights of this proposal was key aggregation, which was essentially aggregating all multi-party keys into one public key such that it would appear similar to the public key of an individual. This goes back to creating a mechanism which ensures that the public keys would seem similar for both multi-sig and individual-initiated transactions.

Furthermore, Schnorr signatures were emphasized as they allow for a combined validation of multiple signatures at once making multisig transactions more efficient.

Understanding BIP 342

BIP 342 was aimed at better implementation of the previous two proposals by making sure that the ground-level infrastructure was made compatible with the proposed changes. Overall, these proposals (and several connected proposals) led to the final merging of the Taproot implementation.

Ever since its implementation, a majority — roughly 70% of the nodes on Bitcoin — have decided to adopt Taproot, while the rest are either against it (and a fraction are unsure).

Source

How Do the New Signatures Help in Bitcoin’s Taproot Upgrade?

Prior to the Taproot upgrade, Bitcoin utilized the ECDSA type signatures, which had certain downsides that affected the privacy of transactions and efficiency of the network.

Taproot addresses, on the other hand, utilize the Schnorr signatures that follow a linear math which facilitates in “simplifying” the complex transactions in the network. In addition to this, these signatures are relatively smaller and faster, enabling much faster transactions in the network.

Naturally, because of the Schnorr implementation, users get to benefit from the reduced transaction fees as the transaction size reduces. This is made possible by the signature aggregation that allows breaking down a complex transaction into several pieces and makes a multisig transaction look similar to that initiated by a single user.

What Implications will the Taproot Upgrade Have on Bitcoin?

The Taproot upgrade for Bitcoin aims to create a completely new address type for the transactions. This helps make a single individual-initiated transaction indistinguishable from that of a multi-signature one. As a result, transactions on the Bitcoin network are a bit more private and efficient.

This reduction in transaction size leads to two prime benefits for users on the network:

It helps reduce the transaction fees that users have to pay as the transaction size reduces.

It helps facilitate more complex transaction types (like the multi-signature transactions we referenced earlier) on the network.

It also aids the Lightning Network and makes the transaction on this “Layer-2” for Bitcoin more scalable and efficient whilst keeping the transaction costs low. Since both complex and simple transactions on the network will now no longer be indistinguishable, there are more chances that both senders and receivers (and even miners) don’t distinguish between the type of transaction that is happening. This will enhance the usage of BTC as a mode of payment in many cases. There is also a lot of talk about how the potential of DeFi could be unlocked on Bitcoin.
The Lightning Network utilizes hash time-locked contracts (HTLCs) which help facilitate transactions on the network. However, with the implementation of Schnorr signatures, the network will now include point time-lock contracts that  will create a more efficient transaction experience on the Lightning network for all users.

Will There Be DeFi on Bitcoin Now?

While there are currently a few DeFi protocols on Bitcoin, the emergence of a vibrant DeFi ecosystem on Bitcoin has been a pipedream for several Bitcoin maximalists. While Taproot does aid in enabling more complex smart contract-based transactions on the network, no major DeFi developments have happened on the network so far.

However, one project has been attempting to build the ecosystem on Bitcoin, RSK Finance. It promises a new world of DeFi on Bitcoin where you are able to lend, borrow and earn interest on your Bitcoin.
RSK has its “own” sidechain which is parallel to that of Bitcoin. The only difference is that it does not have its own native token. The inception of the protocol happened in 2015 when several developers thought there was a need to look for and find ways to implement smart contract functionality on Bitcoin.
Similar to Bitcoin, the protocol utilizes proof-of-work (PoW) as its consensus mechanism for executing transactions and draws a lot of its functionality from Ethereum making it compatible with most Ethereum dApps. The RSK sidechain has a two-way peg with Bitcoin, which allows Bitcoins from the original chain to flow into the RSK chain. When they do, they are known as Smart Bitcoins. Since most of these coins are sourced from the Bitcoin chain itself, RSK itself does not issue any Smart Bitcoins of its own.
Since RSK offers Turing-complete smart contracts, the applications can be largely compatible with the Ethereum Virtual Machine (EVM) and in fact most of the applications can also be similar to the ones that EVM supports.
If you’d like to know the extensive list of applications that RSK promises for Bitcoin, you can refer to their updated whitepaper here.

Micropayment Channels

These channels help users transact amongst themselves several times without having to pay exorbitant transaction fees every time. This is aimed at creating a fair,inclusive yet decentralized financial ecosystem on Bitcoin.

Decentralized Exchanges

While RSK does support the creation of decentralized exchanges (DEXes), most of them are order-book based. These types of exchanges are in contrast to the automated market maker algorithm that several DEXes on Ethereum and other chains have.

Efficient Transaction Speeds

One of the primary reasons why PoW-based cryptocurrencies (like Bitcoin and Ethereum 1.0) are not used as mediums of exchange is because of the high transaction confirmation time. RSK aims to change that by offering confirmation in less than a minute and higher transaction speeds.

But what is the cost of this increased efficiency of transactions? They claim to use DECOR+ as their consensus protocol to avoid centralization of mining. To put simply, DECOR+ aims to set the right economic incentives for miners without needing further interactions between miners. You can find out more about DECOR+ in the whitepaper here.

Bitcoin Token Offerings (BTOs)

Remember Initial Coin Offerings (ICOs) that were all the craze back in 2016 and 2017 on Ethereum? Bitcoin Token Offerings (BTOs) are similar in that you can buy new projects’ tokens using Bitcoin as the base token. Thus, these emerging projects get crowdfunded in Bitcoin. And the promise that RSK gives here is that the crowdfunding is made possible in Bitcoin, which again is one of the most secure cryptocurrencies.

Lending

Lending is one of the most popular (and possibly one of the oldest) ways of generating yield in DeFi (on Ethereum, at-least). When the DeFi summer was underway back in 2020, the prime drivers were lending protocols that were offering huge returns to liquidity providers (lenders).

The same is said to be possible in Bitcoin, where millions of users can borrow Bitcoin as the base asset. While RSK claims in their whitepaper that this is a possibility, it is unclear how this implementation will pan out given the performance of the lending pools will depend on Bitcoin’s liquidity on RSK.

There are several other applications that RSK references in their whitepaper. The promise of creating an entirely new DeFil ecosystem on Bitcoin is certainly appealing. However, it would all depend on the liquidity that RSK has for Bitcoins. It cannot establish the peg in such a way that all the coins are transferred to RSK as this could lead to centralization. At the same time, the complexity of Bitcoin’s transactions and the underlying infrastructure makes it hard for it to facilitate an entire financial ecosystem.

Closing Thoughts

While Bitcoin Taproot is many things, it is hard to tell if an entire DeFi ecosystem can be created on top of it. We have already seen some countries embracing Bitcoin as a legal tender. But that doesn’t render it a reliable blockchain for creating financial products on top. In fact, one may argue that Bitcoin’s value comes from it being the first cryptocurrency ever launched, and being one of the most secure ways of sending payments across the world.

While the Taproot upgrade offers scalability and efficiency to transactions on the Bitcoin network, its primary focus is just that. DeFi is native to Ethereum primarily, and it’s hard to tell if such ground-level changes to the Bitcoin network will possibly change that.coin

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