Welcome to the inaugural edition of Primal Capital’s research newsletter, the first in a series of articles and research papers we will be sharing over the coming months. As cryptocurrency and blockchain technology once again step into the limelight, poised on the verge of the next bull run, our dedicated research team is thrilled to bring to you in-depth analyses and discussions on topics we believe are both relevant and timely. This edition focuses on the untapped potential within the Bitcoin ecosystem, a subject of significant interest and debate among enthusiasts and experts in the field. Our aim is to offer comprehensive insights that not only enrich your understanding of the current landscape but also highlight the possibilities that lie ahead.

TLDR;

Bitcoin remains the largest blockchain by market cap but has not developed a large Decentralised Finance (DeFi) ecosystem like Ethereum. Despite having the tools and infrastructure for a native ecosystem, Bitcoin’s DeFi foray is modest compared to Ethereum’s. But as the interest in Bitcoin grows, we may see Bitcoin emerge as much more than ‘digital gold’. This article explores the challenges and potential strategies for growing Bitcoin’s ecosystem, including layer 2 solutions, community engagement and institutional adoption, highlighting the untapped potential for Bitcoin in the DeFi space.

Below is a basic flywheel of the Bitcoin ecosystem:

Introduction

Bitcoin is and has always been the lead in the blockchain theatre, taking centre stage from the opening act. Like a pioneer planting a flag on uncharted lands, Satoshi Nakamoto staked his claim on the genesis of an entirely new technology; blockchain. Indeed Bitcoin is the forerunner of all blockchain technology and continues to be the largest blockchain by market cap today. Given its preeminence, the emergence of a large and vibrant Bitcoin ecosystem would appear inevitable. However, this has not occurred, leaving us with one question: why?

As the blockchain movement gained traction, many other networks emerged, offering the ecosystem and financial infrastructure that Bitcoin lacked. Among them, Ethereum was the first to do so and emerged as the platform championing the decentralised finance (DeFi) space. Given Bitcoin’s stature and reputation, it seemed poised to enter and dominate the DeFi arena. But, in contrast to expectations, Bitcoin’s foray into DeFi remained relatively muted. For instance, Bitcoin’s largest layer 2, the Lightning Network, possesses a comparatively modest US $277M total value locked (TVL) while Ethereum’s largest layer 2, Arbitrum holds a sizable US $3.3B TVL at the time of writing.

Some may explain this away as Bitcoin simply lacking the programmability of blockchains such as Ethereum. However, the emergence of layer 2 networks built on Bitcoin put to rest this mistaken assumption, leaving users with the tools and infrastructure necessary to grow a large and diverse native ecosystem. Now all that is left to do is sway the massive community of Bitcoin users and holders to build out a comprehensive ecosystem. Bridging the gap between the immense value harboured by Bitcoin and the world of DeFi may bring with it a myriad of possibilities for Web3. The roadmap ahead involves embracing more layered solutions and fostering a more collaborative developer community to leverage Bitcoin’s unparalleled security.

Current State of the Bitcoin Ecosystem

Having found its origins in the cypherpunk community, Bitcoin has grown precipitously since 2008. Despite this, the core code of the Bitcoin protocol itself has undergone minimal changes and its role has remained primarily limited to that of a transactional medium. Indeed, the true value of the Bitcoin network remains as the arbiter of digital gold; Bitcoin itself. But even in this role the Bitcoin network has faced challenges associated with scalability, transaction speeds, and costs which hindered even its ability to process transactions, let alone support a comprehensive DeFi ecosystem.

Presently, the Bitcoin network consists of a tapestry of miners, nodes, stakeholders, developers and a somewhat sizable ecosystem of layer 2’s, sidechains and other decentralised applications (DApps). The miners and nodes uphold the network by validating transactions and maintaining consensus for the stakeholders. This is done using a Proof of Work consensus mechanism, which may have contributed to the slower ecosystem growth compared to other Layer 1 protocols using Proof of Stake mechanisms. Meanwhile the developer community helps expand the native ecosystem and introduces occasional updates to the core protocol. Reaching consensus for an upgrade within the developer community is difficult, hence the lack of change. For instance, Taproot was introduced in 2021 as Bitcoin’s first significant update since SegWit in 2017. Here’s a quick look at the ecosystem:

Source: Coin360

Due to the infrequency of updates, Bitcoin has suffered from several issues, particularly with regards to scalability and programmability. Therefore, a prerequisite for the creation of a DApp ecosystem on Bitcoin are scaling solutions with smart contract capabilities. Hence the development of layer 2 networks and sidechains on the Bitcoin network to facilitate its native ecosystem.

Scaling Solutions

Scaling solutions are protocols built atop a blockchain’s base layer, designed to enhance its efficiency by processing transactions off the primary blockchain. By processing transactions off the main blockchain, they offer improved scalability, reduced transaction costs, and faster confirmation times. In addition to scalability, layer 2s and sidechains can also introduce functionalities like complex smart contract capabilities.

The first of these scaling solutions to emerge on the Bitcoin network was the Lightning Network. This platform was specifically designed to increase the speed and decrease the costs associated with transactions on the Bitcoin network. Although the Lightning Network performed well in this task and attracted a sizable total value locked (TVL) of more than US $277M, it failed to deliver the smart contract capabilities necessary for a complex native ecosystem of DApps to emerge.

Fortunately, several other scaling solutions have emerged, designed specifically to enable smart contracts. Some of these solutions include:

• Counterparty — Launched in 2014, Counterparty is Bitcoin’s pioneering smart contract platform with its native token, XCP. It allows token creation, crowdfunding, and is multi-sig compatible. Despite a decline in popularity, it has seen a revival with innovations like Ordinals on Bitcoin.
• Stacks — Stacks functions as a smart contract and DApp layer for Bitcoin with its own blockchain using Proof of Transfer (PoT). This mechanism leverages Bitcoin’s PoW for security. It enhances Bitcoin’s functionality with DApps, DeFi, and a growing ecosystem.
• Rootstock/RSK — RSK is a merge-mined Bitcoin sidechain with Turing-complete smart contracts and EVM compatibility. It uses a native coin, RBTC, with a 1:1 peg to Bitcoin through a two-way mechanism. Projects such as Sovryn and Money On Chain operate on RSK.
• Liquid Network — Liquid is Blockstream’s Bitcoin sidechain featuring a native token, LBTC, via a two-way peg mechanism. It offers tools for decentralised trades, asset issuance, and confidential transactions. Liquid supports the creation of various digital assets like NFTs, stablecoins, and tokens.
• Mintlayer — Mintlayer is a Bitcoin sidechain using Dynamic Slot Allocation (DSA) consensus, blending PoS and Bitcoin’s PoW. It supports smart contracts, asset issuance, and Lightning Network compatibility. Mintlayer’s protocol also allows cross-blockchain transfers and peg-in/out capabilities.
• RGB — RGB is an off-chain smart contract layer for Bitcoin, enabling the creation of digital assets like tokens and NFTs. It uses Bitcoin’s UTXOs as single-use seals and offers full Lightning Network compatibility, ensuring quick settlement and scalability.
• Omni Layer — Omni Layer is a foundational smart contract and asset platform for Bitcoin, enabling token minting and DEX. Tether (USDt) originally launched on Omni. Omni Bolt, its upgrade, adds Lightning Network compatibility, allowing faster and more scalable Omni token trades.

Prominent Projects

With the rise of a variety of scaling solutions on the Bitcoin network, a number of projects have emerged, serving as the foundation for a bustling DeFi ecosystem. Beyond the basic transactional capabilities of the Bitcoin network, these projects have opened doors to more complex financial applications and instruments, many of which were once thought to be exclusive to more flexible platforms like Ethereum. From tokens created on Bitcoin to platforms allowing decentralised trade such as DEXs, the ecosystem is dynamic and constantly evolving.

Platforms like Zest Protocol and Atomic Finance introduce peer-to-peer decentralised lending backed by Bitcoin. Zest — a portfolio company of Primal Capital — specifically aims to tackle the counterparty risk in lending on the Bitcoin network. Bisq Network and Alex Labs, are Bitcoin DEXs, providing a platform for P2P trading, running autonomously under a Decentralised Autonomous Organization (DAO). Liquality Wallet offers a multi-chain Web3 wallet with support for multiple assets. These are just a few of the numerous DApps catering toward the Bitcoin network. Each brings unique DeFi solutions and trading platforms, catering to different user needs and emphasising different aspects of the DeFi experience.

But the Bitcoin ecosystem is not limited to DApps. Using the fundamental unit of Bitcoin, the Satoshi (or Sats), Ordinals have brought about unique mechanisms to create NFTs on Bitcoin. Ordinals essentially add value to individual Satoshis, allowing them to be “inscribed” with unique content. BRC-20 tokens build on this, using JSON inscriptions to create primitive token contracts. The more advanced ORC-20 tokens further this idea, utilising Segwit witness data and JSON to issue tokens with more capabilities. Stamps & SRC-20 tokens, on the other hand, create native Bitcoin digital artefacts using the blockchain to insert arbitrary data. Ordinals have quickly gained popularity and grew exponentially, reaching 60M inscriptions (mints) since launch in January 2023, just over a year ago.

Source: @dgtl_assets, Dune

These are just a few of the numerous projects being built on the Bitcoin network. Together, they form the basis for a bustling decentralised financial system. Nevertheless, in spite of a sizable DeFi ecosystem, the network still lags behind its counterparts, especially Ethereum, in terms of DeFi development. This underdevelopment stands in sharp contrast to the magnitude and enthusiasm of its global community, making it a peculiar juxtaposition in the crypto world.

Native Community

When it comes to the native community of users for this ecosystem, Bitcoin has many to choose from. The size, fervour, and dedication of the Bitcoin community are undeniable. With a global base of users, miners, developers, and evangelists, Bitcoin has arguably the most influential and passionate community in the cryptocurrency world. This community is characterised by its open-source ethos, where principles such as decentralisation, collaboration, security and transparency are paramount. From online forums like BitcoinTalk to global conferences, the community thrives on shared knowledge and the collective pursuit of financial sovereignty.

The majority of Bitcoin users are holders, viewing it as a store of value or a form of digital gold. Bitcoin maximalists are a large subset of this community of holders. They believe that Bitcoin is the only cryptocurrency that will stand the test of time. They argue that Bitcoin’s decentralised nature, security, and first-mover advantage make it superior to all other digital currencies. Maximalists often critique altcoins (alternative cryptocurrencies) and view them as distractions or even potential threats to the purity and mission of Bitcoin. Since Bitcoin Maximalists are opposed to alternative blockchains, they are a primary potential audience for a native Bitcoin ecosystem.

Bitcoin also possesses a large network of entities and users that use Bitcoin for its intended purpose — as a decentralised peer-to-peer electronic cash system. These users range from merchants accepting Bitcoin for goods and services, to individuals using it for remittances, investments, or as a hedge against economic instability. Alongside these entities are groups of developers and educators that play a crucial role in bridging the knowledge gap, offering resources, conducting workshops, and dispelling myths about the cryptocurrency. They are often the first point of contact for newcomers and play a pivotal role in shaping perceptions and understanding of Bitcoin.

These groups, each of which frequently overlap, form the core of Bitcoin’s native community. Each of them bring their own perspective, expertise, and passion with regards to the future of the network. Collectively they are the core component of the Bitcoin ecosystem.

Growing the Bitcoin Ecosystem

In light of the exorbitant value secured within the Bitcoin network, growing Bitcoin’s native ecosystem will not be a matter of attracting new users. Instead, projects will need to capitalise on the vast reservoir of users, developers, and capital already on the network. Many of these stakeholders are committed to the Bitcoin network, they represent a valuable resource for any initiative looking to grow the ecosystem.

The sheer volume of funds lying dormant on the Bitcoin network is substantial at roughly 70% of the total supply. Were just 10% of that value put to work within the Bitcoin ecosystem, it would equate to US $122B TVL at the time of writing. To put this into perspective, the present day TVL in all DeFi protocols is estimated to be US $91B. The potential of this ecosystem is undeniable, should the proper measures be taken to attract new users.

The groundwork for this ecosystem has already been laid, now it is a matter of bringing in more of the community, attracting greater investment and building better tooling. This trifecta of challenges will require a comprehensive and coordinated approach, as each of these aspects plays a critical role in the future growth and sustainability of the Bitcoin native ecosystem.

Changing Community Perceptions

The preservation of the core principles and values of the Bitcoin protocol can be attributed in large part to the community’s resistance to change. However, this attitude is a double edge sword as it slows down the integration of new features and adoption within the network’s native ecosystem. To break free from this paradox, a concerted effort is needed to entice users and enhance the user experience. This could involve a myriad of initiatives, from social media campaigns, to designing more intuitive and user-friendly wallet interfaces to launching educational campaigns that demystify the complexities of Bitcoin transactions, smart contracts, and network security.

For the Bitcoin purists in particular, it will be a matter of offering opportunity without sacrificing their core values such as decentralisation and security. In particular, proper infrastructure and tooling alongside educational resources will be needed to cultivate their trust in the integrity of these systems. Think decentralised scaling solutions with robust smart contract frameworks, all tied to the security of the Bitcoin network. Projects that deliver on this promise may welcome an influx of maximalists looking to capitalise on their holdings without violating their principles.

Building Better Infrastructure and Tooling

The current pace of gradual changes is insufficient to catalyse any significant growth within the Bitcoin ecosystem. Rather than these incremental upgrades; we’re envisioning a seismic shift that encompasses next-generation scalability solutions, state-of-the-art smart contract frameworks, and fluid bridges to other blockchain networks. In their current state, many of the existing Bitcoin based scaling solutions are insufficient. The Counterparty protocol for instance has suffered from issues associated with the rigidity of its smart contract framework as well as the necessity of its currency, XCP, for certain features, which could dissuade purists from using the platform.

Some scaling solutions such as the Lightning Network lack smart contracting capabilities all together. These challenges highlight the need for a more holistic approach to infrastructure and tooling development within the Bitcoin ecosystem. To truly improve the Bitcoin infrastructure, a multi-pronged strategy is essential:

1. Enhance Scalability — There are already a number of scaling solutions operating on the Bitcoin network, such as the aforementioned Lightning Network. However, most fall short with regards to one or more essential criteria. What is needed are comprehensive scaling solutions offering a secure, decentralised and efficient platform for smart contracts.
2. Facilitate Smart Contracts — One of the critical strengths which propelled Ethereum to its present heights was the network’s intuitive and robust smart contract engine; Solidity and the EVM. For the Bitcoin network to build a similar ecosystem the native scaling solutions will have to adopt robust and developer friendly smart contracts with extensive educational resources behind them.
3. Foster Interoperability — Building bridges and connectors that allow seamless interaction between Bitcoin and other blockchains. This would enable users to move assets across chains effortlessly and tap into the best features of each network.
4. Integrate User Friendly Experiences — As the ecosystem grows, there’s a need for tools that simplify the development and deployment process for developers. This includes better wallets, development frameworks, and debugging tools. Beyond this, user friendliness is essential for those users who may be less technologically literate to interact and participate in the ecosystem.
5. Education and Community Building — A strong community is the backbone of any successful blockchain project. Investing in education, workshops, and community-driven initiatives can help users discover, developers build and investors connect.

While the Bitcoin ecosystem has made significant strides over the years, there’s still much work to be done. Platforms like Stacks represent the future. They have the tools to create an ecosystem that can compete with the Ethereum L2 ecosystem. By focusing on platforms like Stacks and building better infrastructure, the Bitcoin ecosystem could be brought to the forefront of the DeFi movement.

Attracting Developers, Investors and Entrepreneurs

A thriving ecosystem generates its own pull. With robust infrastructure, an active community and available opportunities, developers will naturally gravitate towards the Bitcoin network and develop new solutions for its ecosystem. But beyond the coders, investors will also seek out the growing space in search of ROI. For entrepreneurs, this will provide an opportunity to get in on the ground floor of an already sizable ecosystem teeming with opportunities. Given the growth criteria; the burgeoning user base, and the untapped potential, the possibilities for new ventures would be extensive.

Once started, this cycle can very quickly spiral into a network effect whereby each new participant, whether a developer, investor, or entrepreneur, adds value to the network, making it more attractive to future participants. The growing network then ascends into a positive feedback loop, increasing the system’s overall utility, security, and value. The cascading effects of attracting this trifecta of developers, investors, and entrepreneurs are profound. Each group feeds into the other, creating a synergistic effect that amplifies growth. All that is needed is a catalyst to begin the cycle, one which will likely come in the form of improved infrastructure and shifting community perceptions.

Institutional Adoption

Over the years, the case for adding Bitcoin to institutional balance sheets has transitioned from being a speculative gamble to a strategic necessity. In today’s world, plagued by economic uncertainties, rising inflation, and volatile markets, Bitcoin can serve as both a hedge and an investment for portfolio diversification. The recent game-changer was the approval and launch of Bitcoin ETFs in early January 2024. The success of the launch and record inflows from institutional investors is a resounding endorsement for the entire Bitcoin ecosystem.

This endorsement may open up new avenues for more direct investment from institutions directly into new projects being built on Bitcoin. Although institutional investment is dependent on the success of the effective development and growth of the Bitcoin ecosystem, its occurrence would be the final piece of the puzzle. Once institutional funds begin flowing into projects and on-chain financial products, the network will be propelled into the limelight as one of, if not the largest Web3 DeFi ecosystems.

Conclusion

Were the Bitcoin ecosystem to evolve and grow according to the criteria outlined above, the results would be profound. The wealth of stored capital available for use on the network coupled with the potential influx of new capital from off-chain could propel the Bitcoin ecosystem to exceed that of Ethereum’s. The implications of such a shift would be monumental for the entire cryptocurrency landscape. Of course this hypothetical is dependent on a multitude of factors, each of which requires a concerted effort from certain parts of the community. Nevertheless, a major catalyst could spark this evolution, whether that be a market upturn, a sudden change in community perceptions or otherwise. As history has shown, the only constant in the Web3 landscape is change, Bitcoin’s potential to grow and evolve cannot be underestimated.

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