Recently, Bitcoin layer-two (L2) payments network developer Lightning Labs shared some exciting news for crypto users.
According to the organization, it raised $70 million through a Series B round and this will help the team expand the development of open-source Bitcoin and Lightning Network software.
One of the most interesting projects of Lightning Labs is Taro. This upcoming protocol leverages the Taproot upgrade rolled out on Bitcoin in November 2021 to introduce stablecoins, NFTs, and other assets to BTC and Lightning Network users.
In this article, we will take a look at Taro and what it will mean for Bitcoin and the Lightning Network. But before that, let’s first see a quick recap of Taproot.
What is Taproot?
Despite some myths and urban legends, Bitcoin transactions are not anonymous or fully private, as anyone can audit the public chain and analyze all transfers within the network.
In fact, there are multiple blockchain analytics firms specializing in monitoring the distributed ledgers of BTC and other cryptocurrencies for suspicious and illicit transactions.
However, let’s compare Bitcoin and fiat currency transactions. Bitcoin offers much more privacy for users due to the lack of KYC/AML to initiate peer-to-peer transfers. Additionally, there is no central authority like a bank overseeing and controlling the ecosystem.
That said, there is always room for improvement in this field. And that’s what Bitcoin developers thought when they spotted an inefficiency, which the Taproot upgrade was designed to fix.
Before the Taproot soft fork, the pay to script hash (P2SH) transaction and address type introduced in 2012 contained a privacy caveat for complex transactions, which are powered by smart contracts.
As a result, while P2SH hid the scripts containing the conditions to spend BTC in timelocks and multi-signature transactions, their publicly-visible hash revealed the script and its data when the sender met the requirement to spend the funds.
In addition to showing data like the conditions for the transactions and the wallet type the user utilized for the transfer via P2SH, there has also been an efficiency-related issue with the ECDSA digital signature algorithm the Bitcoin network used before Taproot. As the Elliptic Curve Digital Signature Algorithm required each and every signature related to a transaction to be included individually, it significantly increased the size and cost of complex transactions.
And this problem doesn’t only come with inefficiency, but it can also lead to further privacy-related issues as it makes it easier to spot the smart contracts and multisig transactions utilized by different service providers.
To fix these issues, the Taproot upgrade replaced the ECDSA algorithm with Schnorr digital signatures that only require a single public key and signature to be included for a multisig transaction, which effectively decreases its cost and tackles its predecessor’s privacy caveat. Furthermore, as they look identical, Schnorr makes it nearly impossible to distinguish signatures for normal and complex transfers.
At the same time, Taproot leverages the Merkelized Abstract Syntax Tree (MAST) structure that only reveals the condition that has been met after spending the BTC in a multisig transaction.
Taking this a bit further, Taproot includes a “cooperative close” in every transaction that, along with Schnorr, won’t reveal any information (not even the condition that has been met) included inside in case its conditions are met by participants.
However, in case participants are unable to reach an agreement, Taproot reveals only the threshold public key – that aggregates all public keys in a complex transaction – and the script that was used to modify it as proof for spending the coins in the transaction.
To learn more about Taproot, we highly recommend checking this article out on AAX Academy.
It’s Time to Meet Taro
Simply put, Taro will allow assets other than BTC to be issued on the Bitcoin main blockchain, with the ability to transfer and use them via the layer-two Lightning Network (LN).
Taproot has officially set the groundwork for Taro. Interestingly, the latter was already submitted for peer review as a Bitcoin Improvement Proposal (BIP) by Lightning Labs.
Without diving too deeply into the technical details, Taro will leverage Taproot’s new tree structure – using a modified version called the Merkle-Sum Sparse Merkle tree (MS-SMT) – to enhance scalability and privacy for coin issuance and usage.
It’s important to note that assets issued on Bitcoin via Taro work differently than, for example, fungible ERC-20 tokens or ERC-721 NFTs created via Ethereum’s token standard. Unlike Ethereum, which is a Turing complete chain -its codebase can perform virtually any task as long as it has the necessary computing power-, Bitcoin’s smart contract functionality is limited.
For that reason, Lightning Labs developers decided to base Taro on Bitcoin’s UTXO model instead of an accounting model Ethereum, Solana, Binance Smart Chain, and other smart contract chains utilize for token issuance. This architecture enables increased scalability and compatibility with light clients (an app, such as a wallet that interacts with the BTC blockchain but doesn’t store the blockchain like a full node). At the same time, as balances are not revealed and keys are not reused, it is also more secure and private.
In short, UTXO refers to unspent transaction output, which is a model Bitcoin and other blockchains utilize to define where each transaction on the distributed ledger starts and finishes.
Simply put, each transaction on the Bitcoin network has an input and an output. To make a transaction, a user has to spend one or more UTXOs serving as the input. While the same UTXOs can’t be spent more than once, the new transaction will create new outputs for the user to be utilized later on.
By leveraging the UTXO model, Taro will introduce Bitcoin-based assets through the “leaves” of Taproot’s Merkle tree. As each leaf on this tree is completely independent and can be selectively revealed, Taro will function like a layer built on top of the main BTC chain.
As a result, transactions with instruments created via Taro will look just like regular Bitcoin transfers. While only limited information will be revealed on the main blockchain during a Taproot output, this data will enable proof of the movement of assets via the transaction graph.
Leveraging Taproot’s efficiency in terms of storing keys and signatures for complex transactions, Taro allows the issuance, usage, and transfer of digital assets via the main chain and the Lightning Network without burdening the entire Bitcoin network with unnecessary data.
At the same time, while Taro will basically function as an “overlay layer” on top of the main chain, everything will work as on Bitcoin with a few small tweaks, further commitments, and validation. According to the creators of the proposal, this will make things a bit easier for developers.
Lightning Labs also stated that increased user demand for stablecoins, NFTs, and other Taro-based assets will eventually lead to the expansion of Lightning Network capacity and the growth of productive network activity. As a result, more routing fees will go to the nodes.
Developers have also added that this could come in handy for enhancing the Bitcoin ecosystem’s long-term sustainability after the maximum BTC supply cap (21 million coins) is reached, as it boosts revenue through transaction fees. However, this won’t happen any time soon, as the last unmined BTC is expected to come into circulation by 2140.
One exciting feature of Taro is that Taproot’s script tree allows an unlimited number of assets to be represented in a single Taproot UTXO (thus, issued on the main BTC blockchain). Developers can create Taro instruments via Script, the standard scripting system used by Bitcoin. However, it is possible to expand the list of existing functionalities in the future that would only exist on the protocol’s level.
As discussed earlier, Taro can be leveraged to issue both fungible and non-fungible assets on the Bitcoin ledger. After creation, these instruments can be transferred to the Lightning Network via low-cost multi-hop transactions – LN payments where the sender and recipient transfer coins by hopping through intermediate nodes instead of a direct transaction.
Increased Stablecoin Demand on the Lightning Network
One of the key focuses among the new Bitcoin-based digital assets are stablecoins, which the upgrade will enable both on the main chain and the Lightning Network.
According to the creators of the proposal, stablecoins were among the top requests of Lightning Network developers, startups, and end-users. Stable asset integration will likely expand financial access for these communities.
In terms of Bitcoin adoption, the LN has been gradually playing a greater role in emerging nations. As the main BTC chain sacrifices scalability for state-of-the-art resilience and decentralization, transactions are too slow and expensive. As a result, the first layer is an inefficient solution to process everyday payments on a global scale.
And this is the exact reason why the Lightning Network was built on top of Bitcoin. While it leverages the excellent security and decentralization of the main blockchain, Lightning Network facilitates inexpensive and instantaneous payments on the second layer.
For that reason, the demand for Lightning Network-based BTC payments has surged rapidly in the past few months.
According to Arcane Research’s The State of Lightning report, the year-over-year USD denominated payment volume on the LN grew by 410% between Q1 2021 and Q1 2022. At the same time, users with access to lightning payments have surged from up to 150,000 in August 2021 to over 80 million by March 2022, thanks to new app integrations.
A special mention goes to El Salvador here, where the potential integration of stablecoins would very likely come in handy for citizens. Since September 2021, when the state has made Bitcoin legal tender alongside the USD, the Latin American nation’s citizens and businesses are getting more used to crypto. Featuring integrations with custodial solutions like Strike and the government’s Chivo Wallet, along with many non-custodial wallets, the Lightning Network offers a cost-efficient and convenient way for Salvadorians to settle their everyday payments.
However, Bitcoin’s high volatility compared to major fiat currencies presents increased risks for both individuals and enterprises.
For that reason, there is a high demand in emerging nations like El Salvador to introduce stablecoins over the LN. Integrating them directly to the Lightning Network offers the ability for users to minimize their digital assets’ volatility and hedge against market risks without relying on the traditional banking system or a custodial wallet solution.
Taro: Supercharging Bitcoin With New Assets
Taro is a fascinating proposal for Bitcoin that has excellent potential in boosting Lightning Network activity and the speed at which the off-chain payment network’s infrastructure is developing.
While enjoying the rock-solid security of the main chain and the increased privacy and efficiency of the latest Taproot upgrade, Taro will enable the issuance of stablecoins, NFTs, and other Bitcoin-based assets on a layered protocol to avoid burdening the network with unnecessary data. Furthermore, by moving Taro instruments to the Lightning Network, users can benefit from the enhanced speed and scalability of the layer-two payments solution.
At the same time, increased security, simplicity, privacy, and scalability can be achieved by utilizing UTXO instead of an accounting model like in the case of ERC-20 tokens on Ethereum.
That said, as Taro’s proposal is still waiting for a peer review from members of the Bitcoin community, we don’t exactly know whether and when it will actually get implemented. In case it is, it will have great potential to boost the Lightning Network’s activity and adoption.