December 10, 2021 - 11 min read
On November 14, 2021, Bitcoin became capable of basic smart contract functionality with its new Taproot overhaul and soft fork of the network, meaning the new upgrades are backward compatible with the longest chain of blocks. This is the first upgrade since the 2017 implementation of SegWit version 0, which paved the way for the Lightning Network, the faster layer 2 solution built upon Bitcoin’s base layer blockchain.
SegWit, or Segregated Witness, was an optimization of Bitcoin signatures which freed up space to fit more transactions in each block. Now Taproot has gone on to advance SegWit to its next iteration, version 1, further refining transaction output scripts and optimizing the assignment of fees.
The recent Taproot upgrade, voted on by network miners, gave the blockchain two major software changes to its back-end code: changes to the network’s cryptography in the form of Schnorr signatures, as well as support for a compact and private data storage solution, Merkelized Alternative Syntax Tree (MAST) script.
These novel additions to Bitcoin’s code will improve efficiencies, become less data-intensive, and improve the privacy of users over the long term. The Schnorr signatures even provide the potential for Bitcoin to host simple smart contracts.
Privacy is becoming a louder and more pronounced part of the Bitcoin conversation, with governments around the world already showing signs of discomfort if not banning it along with other cryptocurrencies outright. Prior to Taproot, Bitcoin blockchain analysts have been able to track and trace transactions across Bitcoin’s network, often being able to identify individuals based on wallet addresses and various patterns of on-chain behavior.
This would be particularly true when analyzing the type of transaction, which can be given away by unique patterns produced by Bitcoin’s code following transactions. Following the Taproot update, a new address type is introduced, P2TR (Pay-to-Taproot), which essentially hides the nature of transactions more effectively. However, that is not to compare it to privacy coins with deliberate anonymizing obfuscations such as Monero.
Due to Bitcoin’s data-heaviness and thus scalability and throughput limitations, smart contracts could not be deployed on the network. In fact, the narrative surrounding the coin has been to compare BTC to gold for several years now due to its solid and proven security model, but its limited scalability and spending limitations of its signature scripts. However, that narrative may see a shift as Bitcoin’s network becomes leaner and faster, making way for more complex smart contracts and decentralized applications (dApps) than previously possible.
The Taproot upgrade took three Bitcoin Improvement Proposals (BIPs 340, 341, & 342) and activated all of them simultaneously. The umbrella term for the upgrade, Taproot, makes three fundamental changes to Bitcoin’s code: Taproot, Tapscript, and Schnorr signatures. The update includes a new payment script type called Pay-to-Taproot (P2TR) and makes possible new kinds of multi-signature (MuSig2) public keys for spending Bitcoin, unlocking new potential for the network’s smart contract complexity. These upgrades will be summarized for their pragmatic improvements before considering implications for Bitcoin’s future developments and price action.
The first major overhaul came in the form of Schnorr signatures, which essentially increases the bandwidth capabilities of each Bitcoin block without any increase in size. A Schnorr signature is a method of cryptography known for its simplicity, which is used to aggregate and compress signature data for blockchain transactions.
Broadly speaking, it provides users a greater level of privacy while also compressing file sizes, or ‘minimizing the paperwork.’ That is, Bitcoin transactions will become leaner, and will not leave behind unique signature footprints, often used by on-chain analysts to track transactions and identity wallet-holders, not to mention other nefarious motivations.
The new and improved script makes use of Schnorr signatures to improve the speed and security of the status quo signature script called ECDSA (Elliptic Curve Digital Signature Algorithm). The Schnorr signature scheme has been demonstrated to be more secure and non-malleable in comparison to the ECDSA script.
Moreover, Schnorr signatures take less time to verify as well. Finally, Schnorr signatures and public keys can be aggregated and compressed, meaning that several parties with unique private keys can sign the same request with greater efficiency and with a less distinguishable footprint for on-chain analysts to identify.
The other significant improvement to Bitcoin’s protocol introduced new scalability potential in the form of Merklized Alternative Script Trees (MASTs), which compress various types of Bitcoin transactions into a single hash, making them harder to distinguish from other transactions. Of course, on-chain analysis is quite interesting when used for determining things like miner spending behavior or fear indices. On the other hand, when real-world identities are targeted through wallet addresses and transaction histories is where the action is. MASTs help minimize privacy erosion by on-chain analysts since transactions appear similar with the new Taproot addresses.
Previously, a Bitcoin transaction had included the sender’s script along with the other possible scripts that were not used in a transaction. This made the network much more data heavy than necessary, and made more complex transactions easily identifiable once written on the blockchain. MASTs, then, create compressed summaries, removing unnecessary data and thus reducing the footprint of each transaction per block.
Since the new Taproot-upgraded blocks may now contain Merkle roots instead of unused code, Bitcoin users may now write more complex smart contracts without reaching bandwidth limitations. Compressed and simplified code also reduces transaction fees and memory usage, thus increasing the network’s throughput capabilities, typically measured in transactions per second (TPS).
As mentioned, Tapscript defined the updated scripting language which allows for transactions to take place using the new Schnorr signatures and MASTs. These upgrades make Bitcoin’s network more composable, meaning it can be more easily built upon from a developer’s standpoint. Going forward, users may now transact with P2TR, giving users the option of using Schnorr public keys or Merkle roots, allowing the Bitcoin to be spent in more ways.
While this may not seem significant superficially, it makes Bitcoin’s capabilities more reminiscent to Ethereum’s than ever before, though Ethereum is still leagues ahead in its ability to handle complex smart contracts. Nevertheless, now that complex signatures, scalability, and throughput have become streamlined, the door has been opened for Bitcoin to compete as more than a clunky P2P payments system or merely a store of value.
Though increased flexibility in Bitcoin transactions may open the doors for innovation, the user experience, aside from cheaper fees, following the new upgrades will not be immediately obvious if only using the network for P2P payments. While Taproot does make significant incremental progress in Bitcoin’s speed and scalability, the network remains limited to conserve the decentralization and security of the blockchain. That is, the blockchain must still only produce one 1MB block per 10 minutes, with the network confirming each new block of transactions in lockstep.
However, for companies and advanced users who make use of multi-signature transactions or plan to use smart contract functionality, they will find that their on-chain activities remain private and the potential to develop sophisticated applications to offer end-users greatly expanded. For instance, Cash App made announcements right away to its users of its plans to implement the Taproot upgrades from December 2021. Not only are transactions verified more quickly, but more precisely as well. Security threats are reduced as well, such as crash bugs which malicious miners could use in a DDoS attack.
That being said, because the coding script and data packet size has been compressed, the ledger will be easier for miners to maintain over time, lowering the barrier for the entry of new players. For example. Public keys using Schnorr signatures are only 33 bytes long compared with ECDSA’s 33-byte public keys, whereas the Schnorr signatures themselves are only 65 bytes long contrasting the longer 71-72 bytes for ECDSA signatures, which must also include a sighash flag. This size reduction translated to a direct reduction in transaction fees, since the upgrades minimize data footprints of network users.
As the base layer of Bitcoin’s code has been optimized to a certain extent, the development of layer 2 and 3 solutions are accelerating and surely on the way. For instance, Bitcoin’s Lightning Network was made possible after the 2017 SegWit adoption; now after Taproot, dApps such as SatoshiStream for podcasters will spread to wherever there is a demand for Bitcoin. Bitcoin visionaries will begin picking winners as developers take advantage of Bitcoin’s new possibilities.
For the average Bitcoin user, the main improvements following Taproot adoption will be speed, contract optionality, privacy, and fee reductions. While these will not be dramatic, they will be incremental and meaningful. Perhaps up to 20% of Bitcoin’s mined supply has already been lost, while another significant portion of BTC HODLers have left their wallets dormant for years.
Consequently, these users may be reluctant to update wallet addresses unless a good reason compels them to do so. On the contrary, if Bitcoin is precipitating a major parabolic adoption curve by new users, then it could be expected that newly created BTC addresses will favor the most contemporary and sleek version of BTC, not to mention Bitcoin dApps.
One concern relating to the adoption of Taproot is that the pool of initial users transacting using the new P2TR addresses were small, leading to privacy concerns until these addresses make up a larger share of transactions on Bitcoin’s network. For example, if only 10% of Bitcoin transactions took place using the new Taproot addresses, then it would be much easier for analysts to track relevant and potentially sensitive data. However, this problem was temporary and is altogether mitigated now that enough users have begun making use of the new features.
After all, transactions on the Bitcoin Lightning Network consistently reach new all time highs, and the amount of Lightning nodes grew throughout 2021. As mentioned, the tendency towards the new P2TR addresses may also be accelerated by dApps use of more highly complex smart contract functionalities and new users simply opting to use the most recent versions of Bitcoin’s protocol. As far as BTC’s price goes, Taproot may increase demand in the short term, but Bitcoin’s scarcity and demand as the ultimate store of value may still play the primary role in driving market prices.
Resulting from these upgrades, Bitcoin’s narrative will shift to include not only the ultimate store of value, but also Bitcoin as a means to pay network fees for using dApps. Of course, the narrative of BTC as a medium of exchange has mostly been limited to simple peer-to-peer payments thus far due to the aforementioned limitations. That being said, the complexity of dApps found on Ethereum, Solana, or Cardano should not be expected as the base layer still requires lockstep consensus with its 10-minute block times.
As the MASTs and Schnorr signatures reduce BTC’s footprint, lower fees for users, and bring smart contract functionality, demand for Bitcoin will be driven even higher. In addition to its increasing usefulness and popularity with retail, institutional, and even sovereign entities, the supply of Bitcoin will diminish over time as we pass through each inevitable halving cycle. That is, the moment at which mining rewards are halved every four years (currently at 6.25 halved to 3.125 in 2024).
These two forces should create conditions for absolutely stunning increases in the price, though profit-taking will create alpha for investors for quite some time. Though this volatility should increasingly diminish as the market cap becomes large enough to sustain significant capital flows without double-digit daily candles.
Though Taproot is inarguably an improvement to the network, it is nevertheless an incremental step. Thus, it is unlikely to have an immediate impact on Bitcoin’s price, as it is not well understood yet, but will eventually be priced in once dApps begin deploying on Bitcoin’s blockchain. The rise of Bitcoin on the world stage may still be in a more premature phase than most investors currently realize.
Think of nostalgic television shows from the late 90’s, full of jokes about computers and the Internet, as if it were a big joke. We have not even reached the stage at which Bitcoin is in the public lexicon, but those days may soon arrive. Perhaps looking back historians will write that the days before Taproot were rudimentary ‘warm-up rounds’ before the games had really begun.
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