2022 was a difficult year for cryptocurrency. Numerous blowups, along with poor macroeconomic conditions, resulted in a devastating price collapse. Bitcoin ($BTC) fared better than other cryptocurrencies this year, as predicted, but the macro crisis hammered the asset hard.

From a narrative standpoint, Bitcoin has been fairly disliked in the larger crypto market. Ethereum technology advancements, new chain launches, and application-layer improvements have dominated headlines and attention. As a result, this is an interesting moment to reflect on what has happened with Bitcoin.

Bitcoin has had a turbulent year, with use stagnating and miners under growing pressure. However, there were some advantages, like the introduction of Taro. In this memo, we want to go back in time and look at Bitcoin in 2022 to see what it signifies for 2023.

Significant on-Chain trends in 2022

Despite negative BTC price behavior during 2022, Bitcoin network activity has remained constant. In 2022, the number of active Bitcoin wallets remained constant at 4.5M, remaining consistent with the previous four years. Looking over a four-year cycle, the active wallet count is even marginally increasing.

However, it is obvious that active address growth has been flat since about Q1 2021. Given the market situation in 2021, that is not what you would want to see. We haven't observed a big migration of users from the Bitcoin network since active address levels have found a greater base than in the previous cycle. However, we have not witnessed a considerable increase. Instead, we've seen Bitcoin active wallets stay pretty flat into 2022. Even when they reached their peak in 2020, they barely outperformed the previous high from 2017.

Transaction volumes were reasonably consistent in 2022 but have fallen since the apex of the 2021 bull market. Notably, Bitcoin's transaction count has yet to reach its 2017 high. The lack of growth might be attributed in part to the hodl story, which involves individuals purchasing Bitcoin, storing it in cold storage, and never using it. The lack of increase might also be attributed to Lightning absorbing part of the demand. Worryingly, the slowing growth might be due to Bitcoin's inability to sustain its relevance in a world rife with new technologies and storylines. In any case, Bitcoin's lack of transactional growth between 2018 and 2023 is grounds for alarm.

Bitcoin has been flying off exchanges since 2022. The trend we observe for Bitcoin and CEXs is that holders are withdrawing BTC from exchanges and storing it in their own accounts, particularly after the collapse of FTX.

Self-custodied BTC is for holders and may indicate a larger portion of the Bitcoin supply slipping into cold storage over time. When we check at total BTC on exchanges, we observe the same thing. Total BTC on exchanges has decreased by 21% since January 2022, from 2.8M to 2.2M. Hopefully, 2022 will be the year when people realize the value of self-custody.

Given the narrative swing of this cycle, these two facts - consistent network activity in 2022 and net outflows from exchanges - imply that Bitcoin has done rather well. However, despite price increases, network use growth has been limited during the last cycle. It would not be shocking to see BTC demand increase if the macroeconomic backdrop becomes more risk-on.

The year of technology for Bitcoin

In terms of Bitcoin-related technology, two innovations dominated the conversation in 2022: Lightning and Taproot.

The Lightning Network

At its most basic, Lightning allows users to transact BTC on side channels hosted by Lightning nodes. When the channels shut, Bitcoin merely records these transactions on-chain. The transaction capacity of channels is determined by their discrete size. Channel sizes are often limited since Lightning is designed for small currency transactions rather than big BTC transfers. The capacity of the Lightning Network is determined by how many on-chain BTC users have been assigned to Lightning channels. In theory, the more BTC on Lightning, the greater the transaction volume it can manage. Lightning is most likely Bitcoin's most serious effort at scaling Bitcoin to practical e-cash.

Lightning had a strong year in terms of capability. In Q4, BTC on Lightning reached an all-time high of slightly more than 5k BTC ($82.5M). It quickly fell but remained constant at roughly 4.8k BTC ($79.2M).

Following that, we can observe that the overall number of nodes and channels in Lightning has reduced this year. These reductions (particularly in node count) make Lightning a bit more centralized, but they are unlikely to have a substantial impact on its performance. As seen in the figure below, the average Lightning channel size has grown while the basic charge for a Lightning transfer has fully fallen. These figures indicate that Lightning capacity is at an all-time high, with dedicated node suppliers ramping up.

However, we have no opinion on Lightning. We recognize that Bitcoin requires some kind of scaling solution in order to be a functional payment network, but Bitcoin's success as a payment network may be limited.

Rival digital-fiat payment networks are already well-sophisticated, with seamless user experiences, insurance, and security assurances. He claims that Bitcoin cannot compete with these networks by providing quick gratification, being constantly accessible, or being affordable. Competing fiat payment networks provide all of this and more.

Instead, Bitcoin's competitive advantage will most likely be its sovereignty. All digital-fiat payment rails are KYC/AML-compliant, permissioned, censorable, and subject to authoritarian control. However, it has to be seen if the ordinary retail customer values sovereignty enough to choose Bitcoin and Lighting over Visa and an e-transfer. Right now, it seems that they do not.

Taproot

Despite being heralded by supporters as introducing smart contracts to Bitcoin, we have yet to see widespread adoption after more than a year of operation. Despite the narrative, Taproot does not introduce Ethereum-level smart contracts to Bitcoin. Taproot is a significant advance, although it is not as revolutionary as fully expressible smart contracts. The Taproot update, on the other hand, enabled Taro, which expands Lightning's transactional capabilities to incorporate synthetic assets (more on that later).

We have yet to see widespread Taproot adoption. Transaction fees with Bitcoin Taproot are typically between 1-2.5%. Nonetheless, adoption has gradually grown during the year.

The mining industry is in turmoil

If you owned Bitcoin mining stocks in 2022, you are likely aware of how severely the industry has been affected. The deteriorating macroeconomic climate impacted miners with a cruel mix of increasing interest rates, increased energy costs, falling BTC prices, and poor fee income. The majority of large miners recorded severe losses during the whole of 2022, with losses of $430M in the second quarter alone. Given that the macroeconomic environment has not altered since the third quarter, it is anticipated that miners will record additional losses in the fourth quarter.

Miners compelled to sell Bitcoin

Given the price of Bitcoin and the precarious financial situation of miners, it should come as no surprise that miners have begun selling their Bitcoin holdings. The drop in the number of wallets holding significant BTC balances may be attributable in part to mining activity. Historically, the mining business model consisted of selling some Bitcoin to cover expenditures and storing the remainder to profit from the price's long-term growth.

Recently, it seems that miners have been selling everything to keep their businesses viable. Since macro conditions have stayed the same, there is no reason to believe this will change. We must emphasize that miner flows are negligible relative to BTC's total volume, but flows have been a consistent source of selling pressure recently, which must have affected the market.

Energy concerns

Throughout 2022, energy costs have skyrocketed around the globe. As Proof-of-Work (PoW) is energy-intensive, the spike in energy costs was terrible news for miners. Miners seek inexpensive energy sources such as stranded gas or ancient hydro dams, yet, rising energy prices make everything more costly, which negatively impacts mining businesses' profitability.

Bitcoin fee income is not appealing

Throughout 2022, the daily gross miner earnings have fluctuated between 700-1,200 BTC ($11.5M-$19.8M) The majority of Bitcoin miners get the bulk of their income (97%) via inflationary Bitcoin incentives. This is another evidence of network stagnation, which affects the long-term viability of Bitcoin's security mechanism as supply decreases. Bitcoin must ultimately find greater transaction growth in order to sustain fee collection.

Comparing the fee ratio multiple (FRM) of Bitcoin and Ethereum reveals Bitcoin's reliance on transactional volume.

"The FRM estimates the increase in transaction fees required to maintain the same degree of chain security without block rewards."

In essence, the FRM quantifies a network's dependence on block rewards. A smaller multiple means that the network is less reliant on block rewards and generates adequate fees to maintain its security. A large multiple indicates that the network relies heavily on block rewards and that its existing security budget is unsustainable.

Since 2018, Ethereum's FRM has decreased to slightly below 2, meaning a 2x rise in fees is all that is required to counteract the absence of block subsidies. Inconveniently for Bitcoin, its FRM fluctuated between 8 and 115 from 2018 to 2022. Without block rewards, Bitcoin will need many multiples of its present transaction costs to maintain the same degree of security.

Abandoning the issue of long-term viability, a decline in the BTC price substantially affects short-term miner earnings, causing them to sell rather than hold. These inflationary benefits are a major source of supply and selling pressure. At current BTC pricing and extrapolating from 2022's BTC issuance, the yearly BTC supply increase is between $4.2B and $7.2B. In light of tighter monetary circumstances, this portrays an even worse picture for miners in particular, but also for Bitcoin as a whole.

An unexpected increase in hash power

Bitcoin has never been safer despite falling prices, increasing interest rates, and miners selling their coins. The Bitcoin network's hash rate and difficulty achieved an all-time peak in 2022. The fact that hashish has reached an all-time high is the exact opposite of what one would anticipate.

Source: Blockchain.com

However, what caused this? Theoretically, Ethereum PoW miners may have transferred rack space to BTC mining, or current miners may have purchased substantially discounted ASICs from failing miners. Perhaps hash rate and difficulty are just trailing behind. If so, they will decline dramatically in the future. As miners continue to struggle, it is plausible to anticipate a fall in hash and difficulty.

Bankruptcy

All of these factors have resulted in large declines in mining stock prices. Some bigger companies, such as Core Scientific, may even declare bankruptcy if persistently unfavorable market conditions persist. Several mining stocks have dropped by more than 90%. Large mining organizations may be compelled to dissolve if the macroeconomic situation does not improve.

Things that you should keep an eye on

In 2023, we will be keeping an eye on Bitcoin in relation to the following three regions and trends: Each of them, barring the influence of larger market forces, has the potential to usher in a new era for Bitcoin and serve as a constructive catalyst for price movement.

ZK-Bitcoin

The long-term utility of bitcoins seems to be restricted in a future where smart contract chains are prevalent. The use of smart contracts enables a wide variety of new capabilities and applications for cryptocurrencies. We have all seen the usefulness that has been added to cryptocurrency via the use of NFTs, DeFi, and P2E gaming. All of these were made feasible because programmers were able to employ blockchains that supported smart contracts. It would seem that Bitcoin will need some type of expressible smart contract in order to keep its place in the world economy.

Bitcoin continues to operate normally, and we are aware that its core utility does not need to be based on smart contracts in any way, shape or form. Everyone admires Bitcoin, whether openly or covertly since it was the driving force behind the creation of this whole sector; nonetheless, the total addressable market for smart contracts is orders of magnitude bigger than digital gold. Here is where zero-knowledge rollups for Bitcoin have the potential to completely revolutionize the currency.

Source: bitcoinrollups.org

Bitcoin zk-rollups would offer extra functionality, scale, and privacy to Bitcoin while still following the cryptocurrency's maximally decentralized ethos. This idea was recently given new life by a paper written by John Light. The majority of the technological obstacles are unknown, but judging from Light's work, it seems to be possible.

In essence, Bitcoin would launch an update that would allow nodes to validate zk-proofs derived from specific zk-rollup layers that are layered on top of Bitcoin. It is important for Bitcoin's functioning that subsequent zk-layers scale up and increase Bitcoin's capabilities. These layers might contain Turing-complete smart contracts, games, or customized payments — practically whatever an EVM chain can accomplish.

Light even posits that Bitcoin might employ validity proofs to constantly grow as blockspace in each succeeding layer fills up. If block space is full on one layer, put another zk-layer above it to take part of the burden. As a result, it is possible to develop a whole cryptographic currency ecosystem on top of Bitcoin. This is something that might happen, but it's not likely to happen at any time in the near future. And considering the typical vehement opposition of Bitcoin believers, it's very feasible that this may either never really come to pass or take place considerably later than anticipated.

Stablecoins for Bitcoin

Taproot introduced additional assets to Bitcoin, despite the fact that smart contracts written in EVM are more expressible. Users will be able to create and transfer synthetic assets, tokens, and NFTs on Bitcoin with the help of Taro, which stands for Taproot Asset Representation Overlay. Taro is built on top of Taproot. Lightning, which uses Taro, could one day enable USDC, which would allow regular US dollar transactions to be protected by Bitcoin at the network's foundation layer. Because the story of "sound money hodl and stack" presumably causes individuals to be less inclined to waste sats, Taro may encourage more people to utilize Lightning. Stablecoins may end up being the dominant force in Lightning instead.

Taro is able to construct a network for the transfer of non-Bitcoin assets that is both quick and somewhat secret by using the Bitcoin UTXO mechanism, Lightning, and Taproot. In order for it to function, merkles and information derived from hashed Taro assets are attached to Bitcoin transactions. The information is associated with the transfer of off-chain Taro assets as well as their ownership.

Source: Taro

On Lightning, users are able to transfer fungible assets, but on the main chain, users may only transfer non-fungible tokens. Users of Lightning, on the other hand, have the ability to move Taro assets fast and discreetly. Because Taproot, Merkle trees, and hash data are used by Taro, the only individuals who would be able to see a transaction involving a Taro asset on Lightning would be the end nodes involved in the transaction. Any nodes that come in between would just observe what seems to be a standard Lightning transaction.

The account-based architecture used by Ethereum and other smart contract chains stands in striking contrast to the Taproot-Taro system's emphasis on transaction confidentiality. The Taro balances are not made public. In the meanwhile, EVM balances remain completely open to the public. Bitcoin may once again support private cash transactions thanks to Taro, which would offer Lightning an advantage over other fintech payment rails already in existence.

If Taro is successful and gains widespread usage, it has the potential to expand Bitcoin's utility beyond that of "sound money." On the other hand, as was said previously, neither Taproot nor Taro would introduce EVM-like smart contracts to the Bitcoin network. For Turing-complete smart contracts, Bitcoin needs a second system such as RSK (merge-mined EVM chain), Stacks, or zk-rollups.

Putting emphasis on Africa

Bitcoin's power to free people from the shackles of authoritarian governments places it in illustrious company with the printing press and the internet. Africa's lengthy history of colonialism, current monetary colonialism, and IMF debt might make it a fertile ground for the adoption of cryptocurrencies such as Bitcoin. People in Africa are fighting to make ends meet despite unfavorable economic conditions, despite the continent's rising population and increased internet penetration. It is the perfect time to implement an original monetary standard in this part of the world.

It shouldn't come as a surprise that many attempts to mainstream Bitcoin have been focused on Africa; even the International Monetary Fund has taken notice of this trend. Despite the fact that twenty percent of countries in sub-Saharan Africa have banned cryptocurrencies, the African continent boasts one of the most rapidly expanding cryptocurrency industries in the world. At the recent African Bitcoin Conference in Ghana, attendees were able to see individuals paying for groceries with Bitcoin and hydro-powered mining operations. Africa has the largest percentage of peer-to-peer Bitcoin transactions of any region in the world. The events that take place in Africa will be carefully monitored by us. It's possible that Bitcoin and Africa are destined to be together.

Looking forward

The year 2022 was a difficult one for cryptocurrencies, although Bitcoin kept running. Despite the anxiety that some miners were experiencing, blocks continued to be mined, and there was no breach in network security. When you take into account Taproot, Taro, Lightning, the African market, and — very far in the future — the possibility of zk-rollups on Bitcoin, the future seems to be rather promising.

On the other hand, it would be wise to exercise caution in the near future. It would seem that the mining sector is going through a difficult time, and there is no assurance that the whole situation will get better in 2023. To this day, we do not know if Bitcoin mining companies will be able to make it through another year of high fees and low Bitcoin values. It is difficult to anticipate how the collapse of the mining industry would affect Bitcoin's security, but it might be catastrophic.

Given that miners make the bulk of their money off of Bitcoin inflation, they will need to sell the newly created supply in order to maintain their financial stability. Even at the rates that are now being offered, the bid that is required for that additional supply is quite high. And in a world where liquidity is becoming more scarce, it's possible that it won't even exist at all.

Disclaimer:
This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.

2022 was a disappointing year for Bitcoin. What to expect in 2023?