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25 January 2021

The butterfly effect: Why DeFi will force BTC to break its 21M supply ceiling

The butterfly effect: Why DeFi will force BTC to break its 21M supply ceiling

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Driven away by CeFi’s persistent issues with security and regulatory pressure, users are embracing self-custody solutions despite expensive gas fees, network congestion and nascent products.

Perhaps one of the most notable shake-ups to occur in 2020 was Ethereum overtaking Bitcoin as the leading DeFi protocol infrastructure and general settlement network.

Bitcoin will face a decrease in on-chain activity as well as a transaction fee insufficiency due to the rise of DeFi.

Moreover, the trading volume of BTC assets on Ethereum has grown exponentially; it is now expected that over 4% of BTC’s total volume will be deposited on the Ethereum ecosystem by next year should this trend hold.

Currently, it is estimated that transaction fees only cover 30% of mining costs — an insufficient amount, particularly as halvings continue and block rewards decrease.

In light of this challenge, the Bitcoin community has three options moving forward, namely increasing network fees, introducing Bitcoin-based DeFi, or implementing moderate inflation policies.

Similarly, as BTC’s scope of consensus expands, the amount being invested in network security is also decreasing on an annual basis — a trendline that will eventually test the platform.

Using this as our benchmark, it is also clear that BTC’s security costs are positively correlated with BTC’s annual inflation rate, thus it follows that as BTC’s annual inflation rate falls, so too will security costs.

Suppose that in 2040 (that is, when BTC is halved to 0.195 per block), the total value of gold will continue growing at the same rate as GDP (the two are highly correlated, with an average growth rate of 2.18% over the past 20 years), thus reaching $13 trillion in value.

By examining the table, BTC’s security costs to maintain current levels can reach $100 billion under the “optimistic prospects” column in the future.

However, with BTC production dropping and block rewards accounting for only 2.7% of miners’ income, BTC will need to primarily rely on on-chain transactions to cover security costs.

Moreover, Bitcoin still lacks the ability to keep up with massive DeFi transaction volumes from a performance perspective.

In short, the possibility that Bitcoin will dramatically transform to be compatible with smart contracts is low — it is far more likely that BTC will continue to be circulated in DeFi ecosystems as a passive asset.

Through DeFi, BTC will depart from Bitcoin in various forms as a value symbol and circulate in other cheap and easy-to-use Bitcoin layer-two solutions.

In conclusion, I believe that transaction fees will become the main source of income for BTC miners if DeFi continues to rapidly grow.

In turn, this will negatively impact BTC’s network security, with Ethereum overtaking Bitcoin in transaction volume.

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