More Than Digital Gold: Why the Bitcoin Ecosystem Has Upside Potential [Part 1]

TLDR 

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Bitcoin’s institutional era is here. In 2024, the advent of the first spot ETFs tied to BTC has defined the current crypto market cycle. While BTC first started to attract attention from TradFi giants in 2020, it’s now indisputable that the top crypto is gaining mainstream acceptance.

BTC’s “digital gold” narrative has driven much of this institutional interest. While BTC’s scarcity is its biggest selling point, recent innovations in Bitcoin have proven that there’s a world of untapped potential beyond holding its underlying asset.

In recent years, blockchain’s L1 space has become saturated with projects looking to compete with Ethereum and its various L2s on speed, cost, and scalability. At the same time, innovation has flourished on crypto’s original blockchain and many talented teams have turned to it to bring their ideas to life. 

As more and more builders look to innovate on Bitcoin, its ecosystem is showing that it could have a bright future ahead, presenting exciting opportunities from an investment perspective. Many L2s have emerged on Bitcoin, while dApps focusing on areas like DeFi have given BTC holders new ways to use their assets. 

While the Bitcoin ecosystem faces challenges around user onboarding and centralization, the recent growth hints that it has a bright future ahead. We can look to the Ethereum ecosystem’s development for an idea of how this space could grow over the coming years. 

In this report, we go deep on the state of the Bitcoin ecosystem in 2024 and explain why we believe this space could have huge upside potential. 

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Our investment thesis in the Bitcoin ecosystem

While the Bitcoin ecosystem is still nascent, many promising projects have emerged, including L2 scaling solutions and other pioneering innovations. This presents a compelling investment opportunity for early believers. Additionally, the current market landscape illustrates the Bitcoin ecosystem’s significant potential:

The Bitcoin ecosystem offers huge promise as an investment: Sophisticated financial products and services tied to Bitcoin are emerging, proving that this young space is poised for growth. There are a few key reasons these products are launching. 

• Attractive comparative valuation between BTC and its ecosystem: The Ethereum ecosystem is crypto’s largest and most active today. But Bitcoin looks set to spawn an Ethereum-like application layer given that there is substantial capital in BTC seeking productive use. BTC’s $1T market capitalization is around three times that of ETH’s. The Bitcoin ecosystem’s valuation is around $10B, while Ethereum’s sits closer to $300B (based on the broader ecosystem and TVL). This hints at a discrepancy between the amount of capital stored in BTC relative to its market valuation. Our investment strategy is built on the thesis that the BTC ecosystem has huge upside potential given BTC’s market capitalization. 
• Preferences among BTC holders are changing: BTC holders have historically been divided on prioritizing earning yield on BTC (at the cost of decentralization) or trustless self-custody (at the cost of yield opportunities). This division should fade as self-custodial capital management solutions emerge, albeit with certain trade-offs. This niche is still underexplored despite the demand for yield on BTC, hinting at opportunities ahead. 
• A layer is forming on top of Bitcoin: We are seeing signs of a middle ground forming on top of Bitcoin’s base layer. Early Bitcoin ecosystem followers have focused on L2s, suggesting that infrastructure investments could yield returns. We have found that investors and builders alike are prioritizing Bitcoin L2s in 2024, with attention likely to shift to applications on a longer time horizon. 
• BTC is an institutional asset: BTC is becoming more widely adopted in institutional investment portfolios, which means the demand for secure ways to earn yield will increase. Platforms that prove their credibility and security should attract significant interest from the institutional market. 

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While Asian projects have moved fast to build out the Bitcoin ecosystem, sentiment surrounding Western projects is strong: We have noticed that Western teams building Bitcoin L2s have gained greater interest from investors than Asian teams focused on similar goals. There are several reasons for this. 

• Asian Bitcoin L2s are underperforming: While Asian projects building in the ecosystem often have a first-mover advantage with early CEX listings, most have underperformed. Some teams have been criticized for focusing on the short term without offering real tech or innovation. 
• Western Bitcoin L2s have a valuation premium: Western Bitcoin L2s like Stacks (STX) and CORE (CORE) are often valued at a premium. Coinbase recently listed CORE, a sign of the market’s inclination towards Western projects. 
• Bitcoin L2s are attracting global interest: Top-tier VCs worldwide are increasingly paying attention to the Bitcoin L2 space. As more established institutions join the ecosystem, projects are likely to adopt a longer-term vision with serious technological breakthroughs.

Bitcoin L2’s success depends on several crucial factors: Balancing technological feasibility, user engagement, and trust-building is key to creating a sustainable ecosystem for Bitcoin L2s to thrive. There are a few vital steps in this process. 

• BTC must be usable on L1 and L2: Making BTC available on L2 is a difficult challenge for teams today. While nascent technologies like RGB and zkRollups can help in addition to technical updates like the BTC Foundation’s OP_CAT, the issue is not yet solved. 
• The ecosystem must be robust: Attracting active, loyal users is critical. Establishing robust, trusted mechanisms to move between L1 and L2, leveraging community support, and capitalizing on first-mover opportunities are potential paths to achieving this goal. 
• Leading teams are emerging: The Bitcoin ecosystem is evolving fast across the technology, infrastructure, community, and fundraising verticals. But the strength of the teams in the ecosystem are pivotal to its success. We’ve identified Alpen Labs and Citrea as early leaders.
  • Security is key: Both teams are focused on building robust interop mechanisms. Demonstrating sophisticated security processes with a proven track record will be crucial to earning the trust of conservative BTC holders. 
  • Community is the focus: Both teams are building platforms that resonate with the Bitcoin community’s core values and expectations. 
  • Being early is an advantage: Securing endorsements from recognized institutions such as VC funds and Tier 1 ecosystem partners has helped both teams earn credibility and trust. 

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A timeline of the Bitcoin ecosystem 

The Bitcoin ecosystem’s early timeline has been defined by a few key moments. We track the early ecosystem’s evolution below. 

• 2021/11: The Taproot update goes live 
• 2022/12: The “Ordinals” protocol is proposed by Casey Rodarmor
  • Ordinals introduced a way to put data linked to assets such as images on the Bitcoin blockchain as “inscriptions,” giving rise to the first Bitcoin NFTs
• 2023/03: The BRC-20 token standard is proposed by anonymous developer @domodata
  • BRC-20 uses Ordinals inscription rules to provide a unified format and attributes (such as token name, total supply, and maximum single minting amount) for additional information that needs to be uploaded onchain ("transfer message")
  • “ORDI” becomes the first BRC-20 token (note: ORDI is not affiliated with Casey Rodarmor)
• 2023/09: The BRC-420 and ARC-20 standards launch
  • BRC-420 offers recursive inscriptions, which combine multiple inscriptions in repetition. This allows for the creation of complex assets such as in-game items or animations. 
  • ARC-20 is a colored coin model that uses Satoshis as the unit of account, which means that every ARC-20 token must be supported by an individual sat. 
• 2023/09: The “Runes” protocol is proposed by Casey Rodarmor
  • The Ordinals founder proposed Runes after criticizing BRC-20, saying it burdened Bitcoin nodes with data carrying. 
• 2023/11: “ORDI” secures a Binance listing 
• 2023/11-12: “Inscription Season” commences as L2s start to raise funds and build 
• 2024/03: Inscriptions get integrated into Binance’s wallet
• 2024/03: The leading Bitcoin L2s hit billions of dollars in TVL
• 2024/04: Bitcoin completes fourth halving, Bitcoin L2s launch on mainnet
  • Merlin’s MERL secures an OKX listing
  • Runes protocol goes live
• 2024/05: Bitcoin Asia in Hong Kong
  • BounceBit (BB) secures a Binance listing 
  • Omnichain Bitcoin asset FBTC launches 
  • Western Bitcoin L2s and restaking protocols start to raise funds and build 
• 2024/07: Bitcoin Conference takes place in Nashville
  • Trump pledges commitment to Bitcoin in his keynote speech, bringing attention to the ecosystem
• 2024/08: BTC staking platform Babylon launches on mainnet

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Key catalysts 

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Internal factors

• Tech improvements like Taproot have triggered new Bitcoin innovations. Taproot introduced two important Bitcoin Improvement Proposals.
  • The Schinorr signature, a signature algorithm that can generate thousands of signatures with minimal gas and storage requirements. Vitalik previously proposed Schinorr signatures for Ethereum but the chain does not yet support them. 
  • The MAST (Merklized Alternative Script Tree) contract, which allows users to insert various scripts in the tree diagram, cooperate with Schinorr signatures to create new contracts, and make interesting contract implementations. 
• With Schinorr signatures and MAST, Taproot has advanced Bitcoin’s scalability and underlying technical framework. Since Taproot, Bitcoin has five address types, with addresses commencing [bc1p] representing those created after the upgrade. Users can transfer BTC, buy inscriptions or make Lightning Network transactions with any of these address types. 

External factors

• The Ordinals protocol offers new ways to issue assets in an equitable manner, sharing similarities with the 2017-era ICO model. 
• Ordinals has revived the fair launch: As retail investors lose patience with low float, high valuation models and a drought of promising new projects, Ordinals have shone.
• Successful projects create the wealth effect: As valuations start low, participants are offered attractive MOICs. This brings more attention to the ecosystem in a reflexive manner. 
• The Bitcoin halving effect: Bitcoin’s global computing power has surged since 2020 and the fourth halving completed in April. As a result, miners are seeking new narratives to increase profitability. 
• CEXs have brought exposure to the ecosystem: New trends attract new users and offer CEXs an opportunity to scale. Binance’s ORDI listing and OKX’s Ordinals marketplace launch are examples of CEX developments that have helped the ecosystem grow. 

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The Bitcoin market beyond BTC 

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• BTC’s market capitalization vs. the Bitcoin ecosystem’s market size: BTC’s market capitalization is over $1T, more than three times that of ETH’s. But the Bitcoin ecosystem is valued at $10B, which is significantly smaller than Ethereum’s $300B. This variance could shorten if development continues. 
• The Bitcoin ecosystem does not require large market penetration: As BTC’s market value is so large, the Bitcoin ecosystem would hit $15B in TVL if only 1% of BTC’s supply was deployed in DeFi. If 5% was deployed, it would hit $75B in TVL. 
• Ethereum’s key innovations could flourish on Bitcoin: The Bitcoin ecosystem could host the innovations that have defined Ethereum’s last two bull markets (ICO/DeFi/NFTs) within the next two years. The success of Ordinals is evidence of this. 
• Builders like Bitcoin: In a crowded L1 environment, the market is paying closer attention to the Bitcoin ecosystem and builders are pivoting to create new use cases for BTC.  
• The Bitcoin ecosystem could mirror Ethereum at a faster rate: Some Asian community members say that “Ethereum is the testnet for Bitcoin.” The blockchain industry started when Bitcoin launched and Ethereum answered to its limited application. Ethereum has taken several years to scale for applications. With recent updates like Taproot, Bitcoin can now spawn its own ecosystem. This could happen at a faster rate than on Bitcoin as many business models have been proven on Ethereum. For users, Bitcoin’s interaction logic is also familiar.  

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Potential trends and narratives to watch

While the Bitcoin ecosystem is nascent, it is evolving fast. Though it’s difficult to predict how the ecosystem sill look over the coming years, we offer our perspectives on potential trends to watch below: 

• Institutional participation could significantly increase. 
  • Institutional participation is still low in the Bitcoin ecosystem even with the huge growth seen in 2024. This leaves space for growth in the future. We believe that Bitcoin Core’s possible implementation of OP_CAT or BitVM will be key here as it would make it easier for institutions to move coins from Bitcoin L1. 
  • After discussions around the Bitcoin ecosystem with peer funds in Asia and the West, we’ve found that some teams following this space have taken specific strategies to get exposure to the ecosystem. We detail them below. 

• Restaking has huge potential. 
  • EigenLayer pioneered the concept of restaking on Ethereum, allowing users to deposit staked ETH or LSTs for increased yield. Babylon is taking a similar approach on Bitcoin in hopes of letting any PoS chain leverage Bitcoin to improve their crypto-economic security. 
  • Unlike Ethereum, Bitcoin does not offer yield on L1. Babylon launched a staking platform and has partnered with other projects. This means it has enabled applications that could launch EigenLayer AVSs to use Bitcoin collateral for crypto-economic security. 
  • Bitcoin dwarfs Ethereum in market capitalization, so BTC has huge potential in providing restaked economic security. Some first-movers have already attracted significant TVLs. We list a few examples below. 

• New innovations are still emerging. 
  • While we’ve seen many competitive products and innovations emerge, we firmly believe that there are still many entrepreneurial opportunities ahead. Below is a list of some of the key developments to date
  • FBTC, an omnichain Bitcoin asset pegged 1:1 to BTC that’s incubated by Mantle, Antalpha, and Cobo. FBTC aims to make Bitcoin more accessible and usable by reducing friction and improving interoperability. Projects like wBTC have made similar experiments in the Ethereum ecosystem. But while the TVL in the Ethereum ecosystem is about 75% of ETH’s market capitalization, the TVL in the Bitcoin ecosystem is closer to 4% of BTC’s market capitalization. This hints at growth ahead. 
  • Ethena, a synthetic dollar project that helped Ethereum users earn additional yield on ETH and now supports Bitcoin. Projects like this are giving BTC holders new opportunities to put their assets to work to capture returns. 
  • OP_CAT, a critical technical upgrade that the BTC foundation is working on. OP_CAT could improve BTC’s cross-chain capabilities and enable truly decentralized Bitcoin L2s. 
  • More native dApps that give BTC holders a reason to deposit their coins. Compared to ETH holders, BTC holders tend to be conservative, avoiding onchain strategies with heightened risk. Some projects have provided transparent solutions with occasional centralization trade-offs to cater to cautious BTC holders. Avalon Finance is one example but there are many promising CeDeFi projects focused on the Bitcoin ecosystem.

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