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The Dawn of BRC-20 Tokens
The cryptocurrency landscape has been invigorated by the advent of the BRC-20 token standard, a Bitcoin-based protocol inspired by Ethereum's renowned ERC-20. Memecoins, such as Pepe (PEPE) and Memetic (MEME), have been instrumental in the BRC-20 surge, a development that has led to the minting of thousands of unique tokens.
Understanding the BRC-20 Standard
BRC-20, although similar in many respects to the ERC-20 protocol, diverges in several critical areas. Notably, BRC-20 tokens are minted and transacted through the Ordinals protocol, which does not rely on Ethereum's smart contract system. This distinction necessitates the use of a Bitcoin wallet for the minting and exchange of BRC-20 tokens.
The BRC-20 standard's influence is evidenced by the market capitalization explosion of BRC-20 tokens, which recently reached $120 million. The BRC-20 protocol leverages Ordinal inscriptions of JSON data to create a collection that operates much like fungible NFTs. While the BRC-20 has demonstrated its potential to mimic ERC-20's fungibility, its practical applications are presently quite limited.
In comparison to ERC-20 tokens, which can be employed as collateral across Ethereum's myriad decentralized applications, BRC-20 tokens are largely confined to minting and transfer functions. However, asset sales can still be performed on-chain using escrow or emblem vault functions due to the lack of native Bitcoin decentralized exchange solutions.
The Birth of BRC-20 Tokens
The BRC-20 standard allows any individual to mint tokens for free (excluding transaction fees) in amounts specified by the token contract during deployment. The protocol precludes the pre-mining of asset issuances.
Over the course of Q2 2023, the total market cap of BRC-20 tokens has skyrocketed, rising to ~$620M on May 9th. This meteoric growth has been accompanied by a massive increase in individual BRC-20 tokens. In an unprecedented development, BRC-20 token transactions have exceeded the original volume of Bitcoin transactions on the blockchain. From April 29 to May 2, BRC-20 transactions accounted for over half of the Bitcoin blockchain's activity, surpassing standard BTC transactions.
The Implications of High Transaction Fees
The surge in BRC-20 transactions has also led to a rise in transaction fees and congested mempool due to the increased token activity. Since its inception in late April, the network has yielded an additional ~120 BTC in transaction fees for miners.
Source
Source: mempool.joenicke.de
Bitcoin's Taproot upgrade, ironically, is the reason for this increase in fees. This upgrade inadvertently created a new design space that allowed users to inscribe arbitrary content on the blockchain. Although the creation of BRC-20, which utilizes an unconventional distribution method, has been the immediate trigger for this surge, the Ordinals (Image NFTs) have largely dominated the discourse.
The "proof of burned fee" mechanic, where users must forfeit transaction fees to generate new tokens, has driven transaction fees to prohibitive levels in the short term, pushing out other forms of conventional usage.
The Future of BRC-20
The current fervor for minting BRC-20 tokens will likely subside relatively soon. The situation appears to be a passing event, akin to the Otherside mint on Ethereum, rather than a long-lasting phenomenon. Nevertheless, it is undeniable that Ordinals and Inscriptions have unveiled a significant latent demand for Bitcoin blockspace, launching us into a higher fee regime, even if this immediate spike will dissipate in due course.
Certain critics have expressed concern about the high fees obstructing the introduction of newcomers to Bitcoin. However, this viewpoint represents a misunderstanding of the network's nature. Base layer settlements are a finite resource and cannot be expected to remain inexpensive indefinitely. The settlement assurances sought should align with the transaction's nature. For instance, you don't need a bank wire level of assurance to buy a coffee, and you don't need a base layer transaction to settle a $5 test payment to a friend.
Embracing the High Fee Environment
Those Bitcoiners who are frustrated by the high fees should instead focus on the slow development of Layer 2 solutions in the Bitcoin space. The rise in fees should not come as a surprise: data shows that fees have exceeded $50 per transaction at certain points in both 2021 and 2017. Fees will always mirror the market's demand for Bitcoin blockspace, and if your desired usage mode is priced out, that simply means that base layer Bitcoin isn't the right network for you.
The increased fee pressure should be viewed positively by those small blockers who have remained intellectually consistent from 2017 to today. It acts as a catalyst for the further adoption of established L2 networks like Lightning, and where Lightning falls short, alternative L2 systems. As is true with all commodities, high prices are the solution to high prices. As a venture capitalist, I am heartened by the entrepreneurs I have been meeting recently who have started designing novel L2s that explore alternative design spaces. In particular, I am optimistic about the potential addition of rollups, which have demonstrated a clear product-market fit on Ethereum, to Bitcoin.
Lightning the Solution?
Lightning is best suited for high-frequency, low-value payments – which certainly doesn't satisfy all types of Bitcoin transactional demand. There are many ways to move dollars around – we have wires, ACH, credit and debit networks, Fednow, physical cash, remittances, money orders, and more. Each has its own set of trade-offs and offers different transactional speeds and settlement assurances, as does Lightning. Let's take a look.
What Is the Lightning Network (LN)?
Contrary to popular belief, Bitcoin is a settlement network—not a payment network. The blockchain acts as an immutable ledger, but the sending and receiving of micropayments is unrealistic due to fees. To overcome this scalability blockade, Joseph Poon and Thaddeus Dryja wrote their 2015 white paper, “The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments,” as they aimed to create a second-layer solution without compromising the security of the base layer. In simple terms, the Lightning Network’s goal is to allow for quick and low-cost peer-to-peer microtransactions occurring on a payment channel that’s not a part of Bitcoin’s base layer until settlement. The most commonly used analogy is the idea of a bar tab. When one goes to a bar with a credit card, they open a tab if they intend to have multiple drinks. This customer and the drinking establishment open a payment channel through the credit card. The patron (responsibly) buys drinks throughout the night and closes the payment channel by paying the final check. The only transactions that the bank sees is for the total amount of drinks, not each individual drink. Lightning works similarly.
The LN lets users open multi-signature payment channels with each other in which they can send fractions of BTC back and forth without paying transaction fees each time. A Lightning channel is bidirectional, meaning both parties can send/receive payments. If one party wants to exit the channel or settle their transactions at any point, they can close the channel and settle back on the base layer. This means users can fit numerous transactions into one large fee-driven settlement. As an L2 to Bitcoin, the Lightning Network is not its own blockchain or token. It maintains its reliance on Bitcoin for its security. The Bitcoin mainchain acts as the final arbiter to any disputes on this secondary layer.
Moreover, an individual doesn’t need to have an open channel with the exact person with which they’re trying to transact. They only need to have a clear path from node-to-node-to-node that eventually links to said person. Routing is what enables transactions between two unconnected nodes to occur through pre-existing linked channels. Routing between otherwise unconnected nodes is enabled by Hashed Time Locked Contracts (HTLCs). An HTLC is a special type of smart contract transaction and is used to allow one party to guarantee payment to another through a shared node connection. Separate individual nodes have the ability to allocate their Bitcoin liquidity to help route payments between two parties that are otherwise not directly connected.
The first Lightning Network implementation was launched in March 2018 and wasn’t possible until the implementation of another Bitcoin enhancement, SegWit. Although Poon and Dryja were not the first to discuss and promote off-chain scalability solutions, their white paper inspired multiple development teams (such as Lightning Labs, Blockstream, and ACINQ) to work on the Lightning Network with the goal of making it the most robust payment layer built on top of Bitcoin.
Use cases and the status of Lightning today
The LN has grown drastically since its inception. Currently, the Lightning channel capacity has crossed $110 million and continues to hit all-time highs as measured by BTC locked in public Lightning channels. Roughly 30% of channels are private, meaning the true value of the network is likely to be understated by current metrics.
With 17,000+ active nodes and over 5,000 BTC deposited into the network, the network’s trajectory is promising. Using the LN becomes easier as the network grows, and since the start of 2021, the number of LN channels has increased from about 12,000 to 90,000. What’s even more encouraging is the amount of companies and services building upon the LN.
Bitcoiners have a copious amount of options when it comes to interacting on the Lightning Network. Companies like Casa, Lightning Labs, and Umbrel allow users to run their own Lightning node. Users can also choose from a full range of Lightning wallet solutions, such as Muun, Bluewallet, and Strike. Widely considered to be the most popular LN service, Strike is a mobile app that lets users transact on the Lightning Network with a USD bank account. With Strike, you could pay in bitcoin without being exposed to volatility/tax liabilities or in fiat without taking exposure to BTC. This results in faster settlement times and lower fees. Strike has shown strong signs of growth over the years given their partnerships with big names, such as Shopify, NCR, BitPay, and Robinhood.
The latest improvement to the Lightning technology stack is the proposed Taro upgrade, made possible by the Taproot soft fork. Introduced by Lightning Labs in April 2022, Taro aims to allow Lightning users to send stablecoins and other assets over the LN at virtually zero cost. As of Q3 2022, Taro is still in the implementation process. So far, analysis conducted on Taro and the LN as a whole has concluded that Taro will effectively serve as a tool to remove taxable events from Lightning Network transactions. By leveraging the fiat-to-bitcoin-to-fiat payment railway, those in developing nations with high inflationary pressures or inefficient banking resources could use Taro to facilitate global payments with no tax implications.
So, how does Taro work? Taro doesn’t have its own blockchain as it’s a protocol that’s tied down to Bitcoin’s base layer. Taro assets can be considered Bitcoin UTXOs that exist within a Bitcoin Taproot UTXO. However, a lot of the data that make up a Taro asset is off-chain; only the hash of this data is committed to the Bitcoin base layer. Bitcoin essentially acts as a publication system enabling an embedded consensus for the Taro protocol. The off-chain data that makes up a Taro asset consists of the Taro signature, the Taro sparse-Merkle sum tree, and the Taproot tree. To create one or more Taro assets, a single on-chain transaction is required. All off-chain data is signed and only the Taproot script tree’s root is committed onto the blockchain. This on-chain root can be verified by relevant parties that are involved in the asset exchange against the root’s off-chain data for the Taro asset in question. This is how one can establish proof that off-chain Taro data/specifications are correct.
In the midst of the current bear market, the future use cases of Taro, the LN, and Bitcoin shine bright. The European Central Bank (ECB) has even gone as far as to identify Bitcoin and the Lightning Network as strong competitors in the global cross-border payments market in its latest Q3 2022 report on the subject. The ability to exchange stablecoins over the Lightning Network gives the entire network more utility and further solidifies the fundamental Bitcoin peer-to-peer network as usable on a global scale. As of 2022, the global cross-border payments market is valued at over $37 trillion. Cross-border payments have long been inefficient and costly, remaining a largely unsolved problem. Lightning certainly appears to have the foundation to address this striking issue on top of providing a host of DeFi solutions as a Bitcoin L2. But despite the high level of optimism surrounding its projects, there are still notable drawbacks to the network.
Identified vulnerabilities, drawbacks, and tradeoffs
Although Lightning has over 5,000 BTC (and growing) deposited into the network, there is roughly 340,000 BTC wrapped and bridged onto Ethereum. Additionally, public node capacity in USD totals less than $100 million, which also pales in comparison to the Total Value Locked (TVL) on a network like Ethereum (~$24 billion as of end-November). Both of these statistics indicate that LN’s size is still relatively small and has a long way to go to compete in the DeFi space.
As of Q1 2023, one of the most significant vulnerabilities detected on the Lightning Network is channel jamming, which is when a bad actor blocks up liquidity by making a payment to themselves via third-party channels and then never revealing the secret, such that the payment never completes. Essentially, a malicious entity or series of entities can use a denial of service attack (DOS) to prevent the routing nodes from successfully passing along the transaction in an L2 peer-to-peer engagement on LN. Because two nodes do not need to interact directly, this prevents execution, resulting in a failed payment. As failed payments build up over time, Lightning’s reliability is compromised, and the network slows down. A bigger issue with this concept is that the payments don’t technically fail, as they can’t time out after the forwarding process has begun between routing nodes. The network effectively faces congestion until it stops functioning entirely.
Source: Swan Bitcoin
This can pose serious roadblocks in terms of LN adoption and utility. Lightning is directly competing with various global cross-border payment solutions, including other blockchain networks. Even in the event of widespread stablecoin use, if there is a reasonable expectation that a transaction may fail, this might incentivize consumers to use other payment options. There have been several proposals regarding the best way in which to counteract channel-jamming attacks. One proposal is to increase the slot limit to allow more than the current allotted 483 slots in any given channel. This would make it more challenging to successfully execute a jamming attack, but not impossible. The cost of the attack would linearly scale upwards, but it wouldn’t stop it from being initiated. This solution may not justify the cost as it would require substantial effort to implement from protocol researchers.
Another possible solution is to monitor individual peer activities and implement transaction controls. In theory, this would be able to limit heavy and suspicious inbound activity like that of a DOS attack. The problem is that the privacy technology and pseudonymous nature of Lightning makes identifying individual activities purposefully more difficult. Moreover, privacy is a big appeal to LN users and curbing that benefit may be more harmful than helpful. As of Q1 2023, there’s no consensus as to the best implementations to prevent such attacks. Many proposals are simply untested at scale and could result in a greater deal of cost or difficulty for minimal impact in negating channel jamming attacks.
Another weakness of the Lightning Network is the lack of economic incentives for a router. Solutions are being worked on, such as Lightning Pool, which provides a market where LN users can lease liquidity for payment channels. This creates a financial reward/incentive for other Lightning nodes to provide routing and increase liquidity. Lightning Pool is still in its early-stage growth, however, as it’s mostly individual Lightning users creating the volume as opposed to businesses.
In terms of privacy concerns, it’s important to be cognizant of the history of UTXO(s) you’re using to open a Lightning channel. If you buy bitcoin from an exchange, send it to your wallet, and then use that UTXO to open a Lightning channel, it’s trivial for the exchange to know that you’ve opened this channel. To avoid this type of surveillance, it’s important to CoinJoin your UTXOs if you want to reap the full privacy benefits possible when transacting over Lightning. The Lightning Privacy Research team has explained some of the different ways in which you could CoinJoin before opening a channel. What’s lacking is the ability to close a Lightning channel and have your UTXO sent straight to a CoinJoin. Sadly, there’s no solution for this problem at the moment.
Looking forward
Given its high volume of growth and maturity, many spectators are optimistic about the Lightning Network. Its scalability solution of providing quick and seamless transactions is a vital step towards the goal of building a flourishing DeFi ecosystem on top of the Bitcoin base layer. Even famous BTC bulls, such as MicroStrategy CEO Michael Saylor, have expressed optimism in the establishment of “true decentralization via “LiFi” or Lightning Finance:
Other voices are skeptical regarding Lightning-based DeFi projects, such as Alex Berge, Editor of Bitcoin Development Center:
Whether or not Bitcoin-based DeFi projects will achieve success remains to be seen. But the fact is there are many Bitcoin holders that continue to crave these solutions. The Lightning Network is an important step, but only suitable for payments at the moment. To unlock activities, such as borrowing, lending, and staking, one must explore more general-purpose protocols that offer smart contract capabilities on top of Bitcoin.
