Why DeFi will force BTC to exceed its supply cap of 21 million

2020 was clearly the year of decentralized funding. With growing interest and surprising advances, the DeFi protocols accelerated financial innovation while reshaping the blockchain landscape.. Due to innovations in cross-chain asset gateways and DeFi protocols, Ethereum has attracted a significant amount of Bitcoin (BTC) assets, cutting off the transmission of Bitcoin in the chain.

Going forward, this trend will pose major challenges for the security of the Bitcoin network, especially as BTC continues to eliminate block rewards and miners are increasingly unable to generate revenue. Before the DeFi explosion, BTC backers were confident they could generate income from the platform’s transaction fees. However, this no longer appears to be the case. In the future, I’d like to explore the future of BTC and its impact on the blockchain sector.

When the blockchain introduction enters a new phase, Decentralized funding facilitates an irreversible shift away from centralized funding as the users take over self-management. Since the start of liquidity farming in July 2020, large crypto assets such as Ether (ETH) have increasingly shifted to decentralized platforms in the last four months. The decentralized exchange trading volume now accounts for 10% of the total trading volume of the market, compared to just 1% in the same period last year, while MetaMask’s user base topped a million this year. Aside from CeFi’s ongoing problems with security and regulatory pressure, users are relying on self-custody solutions despite expensive gas rates, network congestion and emerging products.. In short, 2020 was marked by the triumph of an open source approach to blockchain, with users taking advantage of both the unique risks and benefits of DeFi.

Why DeFi will force BTC to exceed its supply cap of 21 million
Why DeFi will force BTC to exceed its supply cap of 21 million

From March 2020, the volume of transactions on the centralized exchanges decreased, while the number of newly registered Ether wallet addresses rose rapidly. In summary, Ethereum has fundamentally changed the use of cryptocurrency exchanges. Users are now storing and trading more and more assets in escrow accounts and driving more platforms to develop DeFi products.

Ethereum beats Bitcoin with DeFi advantage

Perhaps one of the most notable shocks in 2020 was Ethereum outperforming Bitcoin as the leading DeFi protocol infrastructure and general settlement network. Ethereum is now expected to exceed Bitcoin’s transaction volume for the first time and become the first blockchain to record transactions valued at more than $ 1 trillion.. In addition, the cumulative fees of the Ethereum network have surpassed those of Bitcoin this year, indicating that the former may offer higher returns to users.

Bitcoin and the rise of DeFi

Bitcoin will face a decrease in activity in the chain as well as a decrease in transaction fees due to the rise in DeFi. With Ethereum overtaking Bitcoin as a settlement network, there is now a very real possibility that Bitcoin-based transactions will disappear in the future.

Recently, the daily trading volume of BTC on decentralized exchanges in Ethereum exceeded $ 100 million, which is more than 1% of the total BTC trading volume, although only 0.71% of the 21 million volume. BTC is traded on Ethereum.

In short, Ethereum’s BTC sales are higher than vice versa. Likewise, The volume of BTC assets traded on Ethereum has grown exponentially. Now, more than 4% of the total volume of BTC is expected to be deposited in the Ethereum ecosystem over the next year if this trend continues.

With the increasing number of Ethereum use cases and advances in cross-chain protocols, BTC is now migrating to Ethereum as Ethereum steals Bitcoin’s on-chain transactions.

Hence, the path for Bitcoin is complicated. As Bitcoin continues to halve, miners increasingly rely on transaction fees, but the fees make less and less revenue over time.. Currently, it is estimated that transaction fees only cover 30% of mining costs, an insufficient amount, especially if the halving continues and block rewards drop.

In the future, The value of bitcoin mining can drop to tens of thousands per hour, an amount that may not be compatible with a network that holds hundreds of billions in assets.

Faced with this challenge, the Bitcoin community has three options for moving forward: increasing network fees, introducing Bitcoin-based DeFi, or implementing moderate inflationary policies. Let’s discuss each method in more detail.

Maintaining network security and moving forward for BTC

Now I would like to discuss the future market size of BTC, the model and cost of maintaining the BTC network, as well as the expiry of the block rewards. First, let me point out that maintaining network security comes at a price. This price is deducted from miners’ income (including block rewards and network fees), which in turn is used to pay for hardware, electricity, operations, and labor costs. This deduction effectively acts as a “tax” that works much like a country’s military and security spending. In summary, it can be said that although the amount can fluctuate to a certain extent depending on environmental factors, it remains relatively stable in the long term.

Below are two charts that compare military spending as a percentage of GDP to Bitcoin’s annual network security spending for BTC’s market cap.

As the graphs show, global defense spending as part of gross domestic product has stabilized after a sharp decline after the 1960s. Likewise, as the scope of the BTC consensus expands, the amount expands and what is invested in network security also decreases annually, a trend line that will ultimately test the platform.

According to current figures, the “security tax” for BTC in 2020 is 2.42%. This benchmark also shows that BTC’s security costs correlate positively with BTC’s annual inflation rate. It follows that BTC’s annual inflation rate is falling. You will cover the security costs. While the current BTC safety and inflation rate is pretty consistent, if I look at future BTC halving, BTC should be able to maintain an average safety tax of 1.37% to ensure sustainable network growth.

To do this, I need to analyze the future growth rate of BTC by examining the annual production of mined BTC and the network value of BTC using the market capitalization of gold as a benchmark. From 2020 The total market value of gold is approximately $ 10 trillion, which brings the current market value of BTC closer to 4% of gold. Assuming that in 2040 (i.e. when BTC halves at 0.195 per block) the total value of gold will continue to grow at the same rate as GDP (both are highly correlated, with an average growth rate of 2.18% in the EU) in the past 20 years), valued at $ 13 trillion.

Now let’s examine the security cost of BTC from three different perspectives: negative, neutral and positive, or in other words, BTC’s market cap is 4%, 20% and 100% of its gold value.

Looking at the table, BTC’s security costs to maintain current levels in the “Optimistic Outlook” column could reach $ 100 billion in the future. Even in the “Negative Outlook” column, security costs will still be close to $ 1 billion. But still, With BTC production dropping and block rewards only accounting for 2.7% of miners’ sales, BTC has to rely mostly on chain transactions to cover security costs.

Influence of BTC on DeFi

Returning to our original discussion of DeFi’s impact on BTC’s economic model, BTC is currently under heavy pressure to dramatically increase transactions in the chain as long as the halving continues. Based on on-chain transactions in 2020, BTC processed 110 million transactions with an average transaction fee of $ 5. Going forward, BTC is expected to increase fees to offset stagnant growth in domestic transactions. Even based on the most conservative growth projections, transaction fees should be increased to over $ 60 (around $ 40 today), while fees in excess of $ 300 and $ 1,600, respectively, are required for a neutral and bullish outlook. . For ordinary users, these costs are just too high and lead to more Layer 2 solutions like Ethereum when users are looking for alternative transaction systems.

Alternatively, BTC could keep the current fee level, but then the native transaction volume would have to exceed $ 1 billion according to conservative estimates. Regardless of the performance, the on-chain activity of BTC should be multiplied by 12 and, depending on the neutral or positive outlook, should be between 7 and 37 billion US dollars.

Simply put, BTC is architecturally incapable of keeping up with this growth and volume. Based on the size of the 1 megabyte block of BTC, the annual transaction volume limit is approximately 190 million transactions. Additionally, the emergence of more DeFi protocols and asset bridges can result in BTC continuing to migrate to another location, making BTC’s future path even more uncertain.

Three possible solutions

Given such a situation, this is the first go for Bitcoin, that is, given the increase in transaction fees. C.As mentioned above, this measure is simply impractical because the fees would have to be multiplied a hundred times to cover the security costs.. BTC’s core challenge is not structural, but based on the native transaction volume. While the income of individual miners could increase, this approach would not solve the human problem of BTC.

The second solution is to update Bitcoin to support smart contracts and establish a native DeFi ecosystem, thereby preserving transactions within the BTC chain. This is not a new topic for discussion. Despite Ethereum’s rich DeFi ecosystem, there is a growing demand for solutions that contain Bitcoin. BTC remains the primary asset in the cryptocurrency market with a 60% market share, meaning it already has the user base required for a successful DeFi project. In addition, Bitcoin has the most robust network, the most optimal security system and the most comprehensive consensus system. Finally, With innovations such as scripting languages, sidechains or joint mining, Bitcoin could easily support intelligent contracts and thus also DeFi. However, BTC migration is already accelerating even though asset gateways are still in their infancy. While BTC is involved in open currency and financial markets, several DeFi projects are now facilitating this migration from the application layer.

Additionally, from a performance standpoint, Bitcoin is still unable to keep up with massive DeFi transaction volumes. Finally, Bitcoin’s ability to successfully integrate smart contracts into its main network remains highly questionable. Current attempts to support smart contracts have not faced the challenge of maintaining the main network’s level of security without creating a consensus difference, while the expansion plans begun five years ago have not yet paid off.. In short, the possibility that Bitcoin will be drastically transformed to be compatible with smart contracts is slim. It is much more likely that BTC will continue to circulate as a passive asset in DeFi ecosystems.

The third and most sensible solution is to increase the overall supply of BTC. Through DeFi, BTC will leave Bitcoin in various forms as a symbol of value and will circulate in other cheap and easy-to-use Bitcoin Layer 2 solutions. This method allows BTC to maintain network security while increasing the total amount of BTC to cover basic network security costs as it moves from deflation to moderate inflation. Through this method, BTC will be able to stabilize miners’ income while maintaining more reasonable and less variable transaction fees.

In conclusion, if DeFi continues to grow rapidly, I believe transaction fees will become the main source of income for BTC miners. This, in turn, has a negative impact on the security of the BTC network, as Ethereum exceeds the transaction volume of Bitcoin. There are three solutions: increase transaction fees, support DeFi, or increase BTC circulation and adopt a moderate inflation plan.

This article does not contain any investment recommendations or recommendations. Every step of trading and investing involves risk and readers should do their own research in making their decision.

The views, thoughts, and opinions expressed herein belong solely to the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Da Hongfei is known for founding the Neo-Blockchain-based “Smart Economy” network with Erick Zhang in 2014. Da received his education from the South China University of Technology with degrees in technology and English. He worked in a consulting company until 2013. After that, he learned to code before starting Neo. Along with Zhang, Da also founded OnChain, a blockchain trading company that provides services to private companies.

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