What it means for investors
The first Bitcoin upgrade in four years has just gone live. It’s a rare moment of consensus among stakeholders and it’s a big deal for the world’s most popular cryptocurrency.
The Taproot update means more privacy and efficiency in transactions – and most importantly, it will unlock the potential for smart contracts that can be used to eliminate middlemen from transactions.
“Taproot is important because it opens up a variety of opportunities for entrepreneurs interested in expanding the uses of Bitcoin,” said Alyse Killeen, founder and managing partner of Bitcoin-focused venture company Stillmark.
Unlike the 2017 Bitcoin upgrade – dubbed the “last civil war” due to the controversial ideological divide that separates followers – Taproot has near-universal support, in part because those changes include fairly incremental improvements to the code.
Much of the bitcoin reshaping has to do with digital signatures, which are like the fingerprint an individual leaves with every transaction.
At the moment, the cryptocurrency uses the so-called “Elliptic Curve Digital Signature Algorithm”, which creates a signature from the private key that controls a Bitcoin wallet and ensures that Bitcoin can only be issued by the rightful owner.
Taproot will add something known as Schnorr Signatures, which will make transactions with multiple signatures essentially illegible, according to Bitcoin miner Alejandro De La Torre.
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It does not lead to greater anonymity of your individual Bitcoin address in the public blockchain, but it makes simple transactions indistinguishable from those that are more complex and consist of several signatures.
In practice, this means more privacy as your keys are not exposed as much on the chain. “You can hide who you are a little better, what is good,” said Bitcoin mining engineer Brandon Arvanaghi, who now runs Meow, a company that enables companies to participate in crypto markets.
These pimped up signatures are also a tipping point for smart contracts, which are self-executing agreements that live on the blockchain. Smart contracts could in theory be used for virtually any type of transaction, from paying your rental monthly to registering your vehicle.
Taproot makes smart contracts cheaper and smaller in terms of space requirements on the blockchain. Killeen says this improved functionality and efficiency offers “overwhelming potential”.
Currently, smart contracts can be created on both Bitcoin’s core protocol layer and the Lightning Network, a Bitcoin-based payment platform that enables instant transactions. Smart contracts executed in the Lightning Network usually lead to faster and cheaper transactions.
“Lightning transactions can be fractions of a cent … while a Bitcoin transaction can be much more expensive at the core protocol level,” explained Killeen.
The developers had already started building on Lightning in anticipation of the upgrade, which will enable very specific contracts.
“The most important thing for Taproot is … smart contracts,” said Fred Thiel, CEO of cryptocurrency mining specialist Marathon Digital Holdings. “It’s already the main driver of innovation in the Ethereum network. Smart contracts essentially give you the ability to really build applications and businesses on top of the blockchain.”
As more and more programmers build smart contracts on top of Bitcoin’s blockchain, Bitcoin could become more of a player in the world of DeFi, or decentralized finance, a term used to describe financial applications designed to shut out the middleman.
Today, Ethereum dominates as the blockchain of choice for these apps, also known as “dApps”.
Why the wait
Although the Bitcoin community agreed to complete the upgrade in June, the rollout itself didn’t happen until November. The two month delay is designed to allow enough time for testing and to reduce the chance that something will go wrong during the upgrade.
“Upgrades allow the – extremely remote – possibility of a bug entering the system that destroys trust in the entire cryptocurrency system and effectively obliterates it – a ‘self-inflicted wound’ if you will,” said Jason Deane, analyst at Quantum economy.
Deane says this is why upgrade processes are so carefully tested, retested, and verified over very long periods of time.
Many users in the community also remember the catastrophic migration of 2013, when an upgrade that went wrong resulted in Bitcoin being temporarily split in half.
“You don’t want different clients or miners to be out of sync in the protocol. That’s how catastrophic things happen, ”Nic Carter, founding partner at Castle Island Ventures, told CNBC. “Because we don’t want to repeat 2013, we have these extremely long lead times.”