Bitcoin’s Taproot Update — What Does It Mean For The Markets?

06/22/2021

The Taproot Update was first proposed in 2018 by Gregory Maxwell, a Bitcoin Core (BTC) contributor, and former chief technology officer at Blockstream, a Bitcoin and blockchain technology company. The Taproot update is expected to enhance Bitcoin’s smart contract capabilities and boost privacy. The proposed update would combine the Schnorr signature scheme with MAST (Merklized Alternative Script Tree) and leverage a new scripting language called Tapscript. It would make complex smart contracts like the ones requiring multiple signatures indistinguishable from regular bitcoin transactions, enabling greater privacy. Taproot is Bitcoin’s first update in four years, post Segwit update that led to Bitcoin Cash.

How Taproot Benefits?

To understand the benefits of Taproot, it’s necessary to have an understanding of how on-chain transactions work. In essence, a public address produces cryptographic proof that it has all the proper permissions to make a transaction. To do so, it uses its private key to provide a unique signature and prove that the transaction is truly coming from the user.

The cryptographic proof gets stored on the blockchain, which explains why we can trace every Bitcoin transaction. By deciphering the cryptographic proofs in each block, anyone can follow transactions between addresses and identify the sender and receiver from their public keys.

Smart contracts are interactions between many addresses that allow more complex transactions to take place. While smart contracts are most frequently associated with Ethereum, they can also be created on the Bitcoin network. Smart contracts are made of code that dictates the terms of each transaction and can include many different users.

In the Bitcoin network’s current form, smart contracts require an immense amount of space to be stored on the blockchain. As transaction fees are a function of the amount of space a transaction wants to occupy in a block, creating smart contracts on Bitcoin is very expensive. This is because such complex transactions have to link all public keys associated with any smart contracts, making the kind of DeFi projects found on Ethereum completely impossible.

The Taproot Solution

Taproot will combine the public keys of the users participating in a smart contract and create a new public key. That key can then create a unique signature which is only possible for that particular combination of addresses. These digital signatures are called Schnorr signatures, invented by the German mathematician Claus Schnorr in the 1970s.

These signatures have two advantages over their previous implementations.

First, they hide individual users’ public keys in any smart contract, meaning only the unique combined public key is visible on the blockchain.

Second, they drastically reduce the amount of space required in any block to create complex smart contracts. Notably, a smaller signature requires lower fees, something that many Bitcoin users would likely welcome. The cost of using the network hit new highs in April as the price of the asset surged.

Source: Ycharts.com

Effectively, Taproot will make Bitcoin's complex smart contract interactions look like simple payments between two public keys. The ability to run smart contracts potentially paves the way for Bitcoin to run similar DeFi activities to those found on Ethereum. These changes will also apply to the Lightning Network, which might the best place for smart contracts to live on the Bitcoin network. Taproot is scheduled to launch in November 2021.

Method of Implementation – Debated

Despite the unanimity among the biggest mining pools, the method of implementation is up for debate. Developers deliberated for months on the method of deployment, even as codebase for the update was merged into the Bitcoin Core library in October 2020.

After the activation discussions led to a stalemate, Bitcoin Core developers David Harding and Russell O’Connor finally decided on “Speedy Trial” as the deployment method. It was only in April 2021 that the code for Speedy Trial was merged into Bitcoin Core.

If the required threshold is reached before August 11, Taproot will be “locked in” for activation in November. If the threshold is not reached, Taproot will be up for discussion again. This is unlikely, however, since most miners have already indicated support for the update.

Miners are currently in their third signaling period which has 162 signaling blocks at the time of going to press. Taproot failed to receive 90% support from miners in the last two signaling periods. In the last difficulty epoch, some mining pools had given mixed messages, signaling with some blocks and not with others. But this was likely because adding the infrastructure to signal takes time to roll out at a large scale.

At the time of publication about 85% of mining hash power indicates support for Taproot. This is a large improvement over the 62% hash power support during the first signaling period. Late last week, Taproot signaling had reached 95% consensus. Although it was too late for the last signaling period, it means Taproot could be “locked-in” for activation during the current epoch if a similar consensus level is reached.

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