Hello readers,
In our last report, we covered a small-cap liquid staking provider on the Solana network as a special opportunity report.
This week we’re pivoting back to the big daddy: Bitcoin. Honestly, I didn’t expect to be writing this report. But here we are. As ever, things are evolving. Bitcoin is back in the limelight.
Disclaimer: Views expressed are the author's personal views and should not be taken as investment or legal advice.
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The DeFi Report is an exploration of the emerging web3 tech stack and an ongoing analysis of where value could accrue.
Let’s go.
It’s finally happening. People are building on Bitcoin. We’ve got new utility. Increasing demand for block space. New users. And more fees.
And not surprisingly, it’s CoNtRoVeRsIaL. One thing we’ve learned over the years in crypto is that when something is controversial, *pay attention.* When people are having visceral reactions to something, it usually matters.
We can observe this playing out on Crypto Twitter over the last few weeks (supplanted by the Ledger debacle last week). You could also check out my recent LinkedIn post on the topic. Some interesting comments in there.
Seriously though. There are small pockets of folks within the Bitcoin community that are very upset about the recent developments. It appears that some of the same people that champion free markets and permissionless access to finance want to censor Bitcoin innovation and/or change the protocol.
This is fascinating to see.
One needs to be pretty open-minded to be into Bitcoin. You need to be a creative thinker. A little bit outside the box.
But a small subset of Bitcoiners appear to be quite closed-minded. Bitcoin is a radical innovation. Yet some of its most loyal evangelists seem to despise innovation. A paradox for the ages.
I can see where they are coming from so we shouldn’t harp on this too much. Many of these folks helped to bootstrap Bitcoin into existence and we are grateful for that.
What’s happening is new innovations on Bitcoin are creating net new demand for block space. This is backing up the mempool. Which is driving up transaction fees.
Traffic jams in the mempool can crowd out those who simply want to use the network for payments. But that’s exactly what Bitcoins L2 (Lightning) and other scaling solutions such as Side Chains solve for.
Ultimately, what matters is utility, value proposition, technical capabilities, and market opportunities.
The inability to accept new, reasonable ideas should be avoided at all costs. Dogmatic thinking is precisely what this space is trying to disrupt.
We think base-layer Bitcoin transactions should be expensive. Bitcoin is the most decentralized and secure public blockchain ledger. The base layer is akin to Fedwire. Nobody pays for a coffee with a wire. Same with BTC. If you want to anchor data to Bitcoin at the base layer or send a large, cross-border, peer-to-peer payment, this should cost something. Want to buy a coffee or send a remittance payment? That should cost less than a penny. This is how the network is set up today.
If the mempool is clogged because of user demand, this is a good thing. It will likely be solved with further innovation on layer 2 — which is how Bitcoin is designed to scale in the first place.
So it’s unclear why some people are so upset. We think it’s an emotional, knee-jerk reaction to “NFTs and tokens on Bitcoin” and not much more.
Some hardcore Bitcoiners have bonded over mocking everything about Ethereum. And now “their chain” is starting to look like Ethereum.
Ultimately, we think the free market will decide the best use of Bitcoins block space, with the miners and nodes having the final say via network consensus. Does anyone really think that the miners will want to change Bitcoin to make their business model less profitable??
Healthy debates are a good thing. But the controversy here is mostly noise.
Bitcoin miners — who invest land, labor, and capital to secure the network — are finally benefitting from developers creating net new demand for block space. On Monday, May 8th, Bitcoin did $17.7 million in fees. This was more than the network did on any single day during the frenzied bull market of 2021. Miners are finally having a moment after 18 months of pain.
So, what’s this new innovation all about? Let’s get into it.
We’re going to keep this high level in an effort to stay out of the technical weeds. Ordinals is a new protocol built on Bitcoin. Historically, Bitcoin has not had any other tokens on the network outside of BTC, the native asset. This is in stark contrast to Ethereum, which has introduced many standards including ERC-20 (fungible tokens), as well as the ERC-721 and ERC-1151 standards (non-fungible). These token standards sparked the ICO craze in 2017, and continue to drive new innovations and demand for block space on the Ethereum Network. Ethereum is profitable today because of this (block space fees exceed new token issuance).
Ordinals is a new protocol that is suddenly introducing a similar concept to Bitcoin.
It’s all made possible by the Taproot upgrade, which went into effect on the Bitcoin network in 2021.
The Ordinals Protocol introduces the concept of inscriptions. Inscriptions are similar to NFTs. They represent digital artifacts (text, images, video, mp3, etc) inscribed directly into a sat — Bitcoins smallest denomination (100,000,000 sats in 1 BTC).
The key takeaway here is that the data is inscribed *directly into a sat.* This means the data is stored on-chain. Which makes it immutable and auditable. This is an important distinction from how NFTs work on Ethereum. On Ethereum, you own some bits of data on-chain that point to other bits of metadata (images, mp3, video, etc), which is held within another database off-chain (typically IPFS or in the cloud).
We think this distinction might be a big deal.
Bitcoin is the most decentralized and secure public blockchain. And so if we can inscribe valuable digital artifacts (or digital representations of physical things) directly into the blockchain, it would make sense to have this on Bitcoin.
Below we can see the growth in Bitcoin inscriptions over the last few months.
Each inscription requires a *one-time block space fee* for recording the data in an immutable and auditable fashion on Bitcoin.
This activity is driving more utility and economic value creation to Bitcoin.
A few potential use cases for on-chain inscriptions on Bitcoin:
If you can inscribe data from the off-chain world directly onto Bitcoin, this could potentially open up a commercial layer directly on Bitcoin. Since Bitcoin is the most decentralized and secure blockchain, wouldn’t we want to store documents such as deeds, trusts, titles, contracts, etc. on Bitcoin??
What’s stopping the registry of deeds in your local community from moving their public registry onto Bitcoin? Bitcoin is a public network where legal documents can be stored immutably, transparently, and accessed from anywhere on the planet. Bitcoin becomes the “golden copy” and a single source of truth for these records. Wouldn’t this also be more efficient while reducing the overhead of storing physical copies at the county clerk’s office? Hmm.
Keep in mind that we’ll need to create consensus around shared standards and processes prior to implementing something like this. But it’s food for thought nonetheless. When we see monkey pictures going onto Bitcoin, we should be thinking about what that potentially means going forward, rather than having a visceral reaction to what we see in the present. Who’s going to build something useful? I’m sure there are people out there already working on it as I write this.
Of course, we should acknowledge that we already have web3 data services today such as Filecoin and Arweave. But these solutions are less secure than Bitcoin. So, there could be a distinction and a best practice on where to store the most sensitive and important documents in the future, with alternative, cheaper solutions for everything else.
Is anyone else sick of spam? Sick of phishing attacks?
And are these trends getting better or worse as time goes on? I’d argue it’s getting worse. Hackers and cybercriminals continue to get more sophisticated, with AI driving more and more malicious bots.
What if we could introduce an email protocol that requires the inscription of a Sat to share information? By imposing a monetary cost, we could reduce or eliminate email spam and phishing attacks, while securing the bits of data (information) immutably via Proof of Work.
Is the most secure and decentralized blockchain the right place to build a protocol like this? Time will tell.
We saw the birth of a number of tokenization firms in the 2017-2018 period. Most of these companies are seeking to provide services involving the tokenization of commercial/residential real estate, private/public debt, private equity, etc. [An area that I was deeply involved with as Director of Ecosystem Strategy at Inveniam from 2021 through 2022]
Almost every major financial institution is moving in this direction. There seems to be a clear consensus amongst the largest asset managers globally that the future is tokenized. But we do not have a consensus as to how to actually execute that just yet. One of the many challenges pertains to data. Things like legal docs. Financial statements. Valuation docs. Subscription docs. Capital table docs. Corporate actions, etc.
There is no clear consensus or solution on how to tie these documents to tokenized representations of real-world assets and smart contracts just yet. Most solutions today are storing documents off-chain in traditional cloud-based data stores (Amazon S3, Dropbox, Box, etc) and hashing the documents using a blockchain such as Ethereum, Avalanche, or Polygon. Is this “V1 tech?” We think it’s a fair question given the nascent stage and lack of adoption/execution to date. We’re likely to see solutions evolve — with less friction and true immutability of the underlying data being the goal.
Again, we need a “golden copy” of these documents and a place to store them in an immutable and auditable fashion.
Are Bitcoin inscriptions and storing the data directly on-chain the solution? Could we store the data on Bitcoin and also have a decentralized protocol for trading the assets on the network? It’s unclear at this point. This is complicated stuff and the devil is in the details (privacy, scalability, etc.). Furthermore, DeFi and smart contracts are extremely nascent on Bitcoin today. But there might be something here.
Remember that the open-source nature of public blockchains leads to innovation compounding on itself. 1 breakthrough can lead to 10. Which can lead to 100 more. That’s why it’s important to consider where things are heading, rather than specifically what we see today.
It seems clear that almost anything of physical value will be tokenized in the coming years, with a digital twin represented on blockchain rails. Not just financial assets. Again, this introduces the challenge of where to store the data that gives the token value. Should it be stored in IPFS? Amazon S3? Dropbox? Arweave?
Or should it be stored on Bitcoin?
We think there will likely be a number of on-chain options to store the data. Public data is likely to lead the charge, with privacy and scaling solutions creating further use cases later. Higher-value items are likely to be stored on the most secure and decentralized blockchains. Bitcoin appears to be the right blockchain for important public data today. Lower-value items could be stored on alternative options, where the block space fee is cheaper.
NFTs have many, many potential use cases. At the end of the day, the market will ultimately decide if Bitcoin is the right place for high-value data and digital goods.
Related to Ordinals, we’ve seen the introduction of the BRC-20 token standard in a nascent, but explosive stage. While Ordinals is a protocol that allows for non-fungible tokens or “digital artifacts” via inscriptions, the BRC-20 token standard utilizes Ordinal inscriptions to deploy token contracts, mint tokens, and transfer tokens — a fungible standard similar to Ethereum’s ERC-20 standard.
Does this make sense on Bitcoin? Again, it’s not perfectly clear.
We think it will make sense if demand for Bitcoin DeFi surges as a result of the new innovation on-chain. Does 1 innovation quickly lead to 10 more? We’ll see.
Don’t forget that there are some well-funded, smart folks that have been quietly building DeFi on Bitcoin, such as the team over at Stacks Protocol.
We’re looking to see a new stablecoin project similar to MakerDAO on Bitcoin to bootstrap TVL and the DeFi ecosystem. A project like this could potentially use a BRC-20 token to bootstrap.
Same idea for a DEX. Or for a lend/borrow protocol. Or for a new protocol for on-chain security tokens.
The market and technical capabilities will ultimately decide if Bitcoin is the right blockchain for these new use cases.
Bitcoin can only survive in the long run if there is a persistent demand for its product — block space. Secure, decentralized block space can be used for many things. Sales are up on Bitcoin due to recent innovations.
Today the security budget of the network is primarily supported by block subsidies/ new issuance of BTC to compensate miners. Up until the recent flurry of innovation, transaction fees represented just 2% of miner revenues.
Fees are over 21.7% of miner revenues so far in May and reached as high as 75% on May 8th.
Remember that every 4 years, new issuance (miner subsidies) drops. All things being equal, if the price of BTC does not double every 4 years, miners will not be economically incentivized to continue to provide services to secure the network.
Therefore, new use cases for Bitcoin that drive demand for block space are critical for long-term security and economic viability. Simply put, organic block space fees need to increase sustainably in the coming years.
It would appear that Bitcoin is undergoing a paradigm shift. For the first time in 14 years, we are seeing some real innovation on the network, creating net new demand for block space.
I’ll be the first to raise my hand as I did not see this coming. I’ve always viewed Bitcoin as a monetary/store of value and a global, peer-to-peer payment network.
But Bitcoin could actually be much more than this. And that doesn’t mean its utility as a long-term store of value or payment network is diminished in any way.
If I asked you to define the internet in 1998, 2005, 2013, and today, you'd likely provide a different answer at each stage. The internet is many, many things. And its utility has changed over time.
We think this applies to Bitcoin, and crypto at large due to the open-source nature of the innovation.
At the end of the day, Bitcoin’s monetary policy can remain immutable. It can remain a long-term store of value and a global payment network. But Bitcoin’s block space can still serve additional use cases.
From first principles, Bitcoin is the first computer network that allows humans to physically secure information (bits of data) with energy via Proof of Work. A revolutionary concept.
Naturally, the first use case has been monetary. But what other information do we want to secure?
That’s the critical question.
And this is why we should stay open-minded as to where we go from here.
Some people are struggling with this. Which creates some *noise.* We think this is par for the course. It’s healthy to have the debate.
But at the end of the day, the folks opposing innovation on Bitcoin appear to be rooted in ideology and identity (anti-Ethereum groupthink).
And that’s ok.
The market will ultimately decide the best use of Bitcoin’s block space.
Thanks for reading.
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Disclaimer: Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.