Bitcoin is decentralized and secure. The downside of both features is that Bitcoin doesn’t scale very well and cannot execute complex smart contracts as Ethereum does. This limits its use and while the mother of cryptocurrencies still stands tall, it needs to change and adapt to the existing demand. 

The most promising technical approach to solve at least one of both issues is the so-called Lightning Network. It is a protocol that runs on top of Bitcoin and offers almost instant finality of transactions by facilitating them off-chain and confirming them at a later point in time. In this sense, the Lightning Network is the transactional layer that still profits from Bitcoin’s security and finality of its blockchain.

TARO is a brand-new invention that was brought to life by Lightning Labs and just introduced in late September 2022 as an alpha version. 

What is TARO?

TARO is the abbreviation for Taproot Asset Representation Overlay and is an open-source solution that is built on the Taproot upgrade that was implemented into Bitcoin in 2021. Its purpose is to bring different digital assets like stablecoins and NFTs to Bitcoin and the Lightning Network. It is therefore a protocol based on Taproot that allows secure token creation and transfer of these tokens on the Lightning Network. These digital assets are very similar to the concept of so-called colored coins.

It can be considered as a layer-3 protocol that allows two options for digital assets to be transferred. The first one is on-chain and the second is a transfer of fungible assets on the Lightning Network if those assets are deposited to a channel.

Lightning transactions are considered to be more private and with only 10 seconds until confirmation, they are almost instant. The Bitcoin blockchain produces a new block roughly every 10 minutes that contains new transactions. With the Lighting Network, this limitation to the blockchain’s scalability is removed and TARO could play a significant role in further Lightning adoption. The first proposal for the new protocol was made in April 2022 by Lightning Labs, and it is not the first attempt to bring tokenized assets to Bitcoin. Another mentionable approach is the Liquid Network that is developed by Blockstream and with the RGB protocol, there is also a third solution in that particular field that exists for Bitcoin.

While TARO is not exclusive when it comes down to provide a layer-3 solution for smart contracts and tokenization, it is the only protocol that builds on Taproot.

How does TARO work, and how are digital assets secured?

The technology offers a variety of options and works securely that allows to issue digital assets that are secured both by Bitcoins blockchain and the Lightning network. Such an asset can be either fungible or non-fungible. TARO offers to:

• The use of any type of asset on the same network.
• Assets that are not controlled by a single entity.
• The supply of each asset can be audited easily at any time.
• Global accessibility at low cost that works 24/7.
• Data privacy controlled by the user and a high security standard for both the network and the assets.

TARO secures assets by using both the Bitcoin network and Lightning. Each asset is registered on the Bitcoin blockchain with hashed metadata that is attached to a transaction. Attaching the plain metadata and storing it on the blockchain would be costly and far from being efficient. By hashing the metadata, a short hash is generated that can be easily verified and cannot be forged.

Such a hash could include millions of transactions or assets, since there is no limitation to the amount of data that can be represented by a hash. In effect, a digital asset from TARO can be transferred in the same fashion as a normal Bitcoin transaction

TARO assets on the Lighting Network

Things work differently on the Lightning Network when transferring assets using TARO. Because of the fact that Lightning requires that an asset can be split or merged together, it is not possible to issue or mint non-fungible tokens on its network.

Fungible assets, on the other hand, are absolutely possible on the Lighting Network, such as stablecoins or utility tokens. The fact that fungible assets will require a scalable network for mass adoption fits perfectly to Lightnings capability of handling millions of transactions. For a TARO asset transfer, only the first and the last payment channel need to be aware of the type of transaction. To all other nodes in the network, the transaction is not distinct from a standard Lightning transaction that is moving Bitcoin.

This situation offers another unique possibility with TARO. Before the technology has been introduced, a marketplace needed to be found to list the new digital asset to create enough interest among investors trading it. With TARO, each node can serve as a broker because only the first and the last node have to be involved with the asset and its transaction. In effect, an asset that is interesting to a limited audience gains as much benefit from TARO as an asset that is important to billions of users. 

What are limitations of TARO?

While TARO offers a lot of exciting new chances it is important to understand that this is not a breakthrough in every possible field. TARO allows asset creation and supports different methods of asset transfer, but it lacks the capabilities to support long and complex scripts. Even though it supports some basic smart contract functions, these are limited when comparing them with those of Ethereum, Solana, Avalanche, and all the other smart contract blockchains that are competing with each other.

Another problem that is created is the history of fungible assets and the size of the transaction graph that needs to be checked each time such an asset is received. When receiving fungible assets, the recipient needs to check all the past transactions using the transaction graph. While the growth for this graph is linear for NFTs, it is exponential for fungible assets. This impacts the scalability even when using the Lightning Network in a similar way when using other blockchain technology because with more usage, the graph keeps on growing.

Finally, there is a catch with the useability of TARO. With Ethereum, each digital asset can be transferred just by entering the address of the recipient. Since TARO is based on the Lightning Network, the recipient needs to create a receipt that includes the address and also specifies the token and the amount. Such a receipt-based transfer is not very comfortable when compared to current methods in place in the DeFi sector.