Taproot Explained: Bringing DeFi to Bitcoin

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Taproot, the first update to the Bitcoin protocol in four years, will provide better privacy and security to the leading blockchain. Crucially, it will also improve smart contract efficiency.

What is Taproot?

Bitcoin’s highly anticipated Taproot update was accepted by more than 90% of the blockchain’s mining hashrate over the weekend, signaling that the majority of the community is ready to implement the change to the protocol. Taproot is Bitcoin’s first update in four years, following the divisive Segwit update that spawned Bitcoin Cash. Although Binance showed some resistance to Taproot, it now seems to have gained approval across the Bitcoin community. Taproot was locked in at block 687285 to celebrations across social media. SlushPool, one of Bitcoin’s leading mining pools, mined the block Saturday.

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 a 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.

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.

Effectively, Taproot will make complex 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.

Disclaimer: The author held ETH and several other cryptocurrencies at the time of writing.

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