in Bitcoin (BTC), Decentralized Finance (DeFi), Ethereum (ETH)
Bitcoin has a scaling problem. Currently the cryptocurrency network can clear about 7 TPS (Transactions Per Second) which, while slow, is typically OK when there is not a lot of traffic. The real problem is what happens to Bitcoin during times of above average use. Fees quickly increase such that sending a transaction may cost $5 or more. This effectively prices out all smaller transactions and brings the fee to use Bitcoin up to the point where it’s about as expensive as the traditional financial system.
During times of extremely high demand, as can happen every couple of years, fees can skyrocket to $50 or more. Bitcoin users who don’t adjust their fee spend in their Bitcoin Wallet may find that their transaction gets stuck for days. All of this happened in the 2017 bull market and it created a good deal of frustration among Bitcoin users. A solution was needed and several were proposed.In this article
Bitcoin Scaling Attempts
One of the simplest ways to scale Bitcoin would be to allow for larger blocks. A larger block size would allow more transactions to clear at the same time, hence reducing network congestion. Bitcoiners found themselves unable to agree on this change, however, and so a subset of the Bitcoin community, led by Roger Ver, forked Bitcoin and created Bitcoin Cash with it’s larger blocks. That’s fine for Bitcoin Cash BCH but it doesn’t solve any of Bitcoin BTC’s scaling problems.
The solution the Bitcoin community eventually agreed upon was the lightning network; an off-chain network of users and financial relayers that is not entirely dissimilar from the correspondent banking system. Lightning promised near-instant payments that would cost so little that the fee would be negligible.
Unfortunately, Lightning has some drawbacks. It’s buggy and has led to depositors losing money. Lightning payments are also just not accepted in very many places. But perhaps the largest factor that’s held lightning back is that it’s complex and difficult to use. Although Bitcoin and cryptocurrency holders, in general, are technologically sophisticated, even hodlers have found Lightning hard to use. All of this has led to stagnation and the value locked in Lightning in the fall of 2020 is about equal to the value locked in the spring of 2019. There has been no growth.
So Bitcoin is at an impasse. Big blocks were rejected and the Lightning network has failed to catch on. It appears that Bitcoin may be heading into a new bull market, and without a scaling solution, it’s likely that the same problems will arise again. $50 or $100 fees (or more!) and long wait times for users who don’t want to pay the high fees.
Against this backdrop there is Ethereum. The Ethereum team, as well as numerous side projects, have been working on scaling and some really interesting solutions are in the works. At the same time, the amount of Bitcoin locked up in the Ethereum network has been growing exponentially. This all leads us to ask: could Ethereum be the solution to Bitcoin’s scaling problem? Before we answer that question we’ll need to cover a few basics about how BTC on Ethereum works, and how Ethereum plans to scale in the future.
What is Bitcoin on Ethereum?
There are a couple of different ways to migrate BTC to Ethereum but the general idea is relatively straightforward. An organization has a Bitcoin address that users can send their BTC to. Once the organization receives the BTC they mint a token on the Ethereum blockchain which acts as a claim on that BTC. This is often referred to as tokenized Bitcoin.
So in simplest terms, a Bitcoin token on Ethereum is really just a promise that whoever is holding that token can redeem it for Bitcoin at any time. This is the same idea as USDC. With USDC, Coinbase holds dollars in a bank account. Any USDC holder can redeem their tokens for dollars at any time, which is what gives the USDC token value and keeps it at the $1 peg.
There are a couple of varieties of tokenized Bitcoin. The most popular version is WBTC which is minted by a centralized company, however, there are also decentralized Bitcoin tokens that are gaining in popularity. Overall the entire market has been growing exponentially.
How Ethereum Plans to Scale
So lots of Bitcoin is getting locked up on Ethereum, which is interesting, but it doesn’t do much good if Ethereum can’t scale either. Arguably right now it can’t, as we’ve seen a massive explosion in Ethereum fees as demand has outstripped supply (more demand for transactions than there is supply of space in the blocks). However, this won’t be the case for long as Ethereum has a couple of interesting scaling solutions in the works.
ZK-Rollups make use of math that 999 out of 1,000 people will never understand. However, the premise is relatively simple. A ZK-Rollup exists on a sidechain. If we use a highway analogy, a sidechain is like the country road the runs alongside the highway (the highway being the Ethereum mainchain). The side chain connects to the highway at certain intervals but it is not in constant communication with the highway. The advantage is that traffic can be delegated to the sidechain in order to reduce fees and speed up transaction times.
What a ZK-Rollup does is batch groups of transactions together and then validate them on the Ethereum mainchain. So for example, a person could complete dozens of tokenized Bitcoin transactions via a ZK-Rollup and only sporadically validate those transactions by publishing them in one large group to the mainchain. The transactions happening in the ZK-Rollup are cheap, fast, and unaffected by heavy congestion on the Ethereum mainchain.
Sharding will split the Ethereum blockchain into 64 individual chains. The advantage is a massive increase in transaction capacity. By having dozens of chains instead of just one, throughput can be significantly increased. The disadvantage is that interoperability becomes more cumbersome. For example, if there is a dapp on chain 10 that wants to communicate with a smart contract on chain 38, that communication can be slower than if all the dapps were on a single chain.
What some people have predicted is that related dapps and smart contracts may exist on the same chain. For example, all of the smart contracts and dapps related to tokenized BTC could exist on the same shard of Ethereum. This would enable extremely fast transactions and decrease the chance of congestion even when transaction demand is high.
Can Ethereum Scale Bitcoin
So if the amount of Bitcoin locked up in Ethereum is growing, and Ethereum has scaling solutions that they’ll be implementing in the future, can Ethereum scale Bitcoin? The answer is yes, and also no.
Ethereum will be able to scale Bitcoin in the technical sense of enabling a high number of tokenized Bitcoin transactions to take place every second. Users who want to trade tokenized Bitcoin, or send it to someone else, will be able to do so quickly and without paying a high fee.
In fact, an entire ecosystem may form around tokenized Bitcoin, including merchants who accept it, exchanges that support it, lending platforms that pay interest on it, etc. We’re already seeing pieces of that now but the size of the ecosystem may grow much larger in the future. However, no matter how large it grows it’s likely to always remain small compared to the size of the Bitcoin network.
This is where the “no” part of the answer comes in. The heart of the matter is that a cryptocurrency’s value comes from its network effect. Bitcoin is the most valuable cryptocurrency because it has,
- The most users
- The most exchanges that support it
- The most name recognition
- The largest number of wallets
- The largest number of merchants that accept it
People want to use Bitcoin because other people are using it. It’s the same thing as Facebook, email, or a telephone. The more people using a technology, the more valuable it becomes. Bitcoin is valuable because so many other people, businesses and organizations use and accept it. So while Ethereum may be able to technically scale Bitcoin, it will not be able to replicate this massive network effect. Even if tokenized Bitcoin can be sent instantly for free, if there are not many people to send it to compared to the normal Bitcoin network, then there’s not going to be a huge demand for it.
Negative prognostications aside, tokenized Bitcoin is already proving useful within its niche. For instance, tokenized Bitocin is likely to remain quite popular in the DeFi movement, where users can earn interest on their tokenized Bitcoin or swap it for other Ethereum assets.
At this point, it’s hard to say whether tokenized Bitcoin will remain a fringe asset with a dedicated but small group of supporters, or if it will take off and offer a truly robust scaling solution for Bitcoin. One thing is clear though, something is going to need to scale Bitcoin. Seven transactions per second just aren’t going to cut it for a financial asset that’s billing itself as digital gold.
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This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.