The Bullish Case for Bitcoin Layer-2s

Until early 2023, most of the on-chain activity around Bitcoin was related to transfers and trading of the BTC asset.

With the recent advent of Ordinals, digital artifacts/NFTs, BRC20s, and other arbitrary data are now being stored directly on the Bitcoin blockchain.

This breakthrough has opened up the ability to build on Bitcoin and ignited a new wave of innovation, with developers now experimenting with building DeFi, NFT, and other capabilities in the Bitcoin ecosystem.

Most of this development will take place on Bitcoin Layer-2s to maximize speed and throughput, and minimize transaction costs.

This is why I am so bullish on Bitcoin L2s.

Why do we need L2s for Bitcoin?

Bitcoin is the OG of blockchains but it has drawbacks that limit its functionality. Many Bitcoin maxis and purists believe these limitations are actually features, but I digress.

First, Bitcoin is not scalable. The Bitcoin block size is only 4MB (and was only 1MB prior to the SegWit upgrade in 2017), limiting how many transactions that can be processed. As such, a new block is mined approximately every 10 minutes and the chain can only process 3-7 transactions per second (TPS). 🐢

For comparison, the theoretical maximum block size of Solana is 128MB, allowing the chain to process a theoretical maximum of 65,000 TPS. 🐇 There are tradeoffs made to achieve this speed, but that’s a conversation for another day.

The low throughput of Bitcoin leads to high demand for its blockspace, which in turn results in expensive fees during times of increased network use.

Also, you can’t program on Bitcoin. The Bitcoin base layer was designed for peer-to-peer transactions and does not have any smart contract capabilities like Ethereum, Solana, Avalanche, and most other L1s.

Finally, Bitcoin has limited privacy. All of the transactions on the Bitcoin chain are transparent for everyone to see.

What are Bitcoin L2s?

Bitcoin L2s are protocols built on top of the Bitcoin blockchain, designed to solve the scalability, programmability, and privacy limitations of the base layer.

These solutions enable faster and cheaper transactions, as they do not require every transaction to be recorded on the Bitcoin base layer. Instead, these L2s bundle multiple transactions together and settle them as a single transaction on the main chain, which alleviates congestion, increases speed, and decreases transaction costs.

Furthermore, these L2s retain the security and immutability of the Bitcoin network.

Many L2s provide programmability that the base layer lacks and allows developers to build DeFi, NFT, and other functionality within the Bitcoin ecosystem.

Some L2s provide privacy features that the Bitcoin L1 cannot provide as well.

Types of L2s

There are three primary types of L2 solutions - state channels, rollups, and sidechains.

State Channels

State channels work by establishing an off-chain communication channel between two or more parties. These parties can then transact freely within the channel as many times as they like without the need for global consensus on the main chain. The final balance of the channel is then recorded on the main chain when the channel is closed.

The Lightning Network, one of the most widely adopted Bitcoin L2s, is a state channel solution. Lightning users can establish channels to enable rapid and low-cost transactions between each other. These transactions can also be securely routed through a network of channels, even if the sender and receiver do not have a direct channel open between them.

According to a recent report by River, the Lightning Network has grown by 1212% in 2 years, 🤯 proving the need to move small transactions off the main chain.

Rollups

Rollups help scale Bitcoin by combining multiple off-chain transactions into a single transaction that is then recorded on the base layer. Rollups allow for developers to build DeFi, NFT, and other apps that could not be built on the Bitcoin base layer due to its lack of smart contract capabilities.

Historically there were two primary types of rollups - optimistic rollups and ZK rollups - that differ in the way that they prove to the base chain that these transactions are valid. More recently, a kinda-sorta new type of rollup called “a sovereign rollup” has been introduced.

Optimistic rollups rely on “fraud proofs”, a dispute resolution mechanism where users can challenge transactions and submit evidence that the state update is incorrect. Any incorrect state updates made by the rollup contract will be returned to the previous state.

These rollups are labeled “optimistic” because the transactions are assumed to be correct unless challenged.

On the other hand, ZK rollups use zero-knowledge (aka validity) proofs to proactively confirm that the transactions are valid and the state update made by the rollup contract is correct. A ZK rollup generates a proof of validity for each batch of off-chain transactions then submits it to the base layer to update its state. This eliminates the need for a dispute resolution mechanism that optimistic rollups require.

ZK rollups can also offer privacy functions that are not possible on the base layer.

Sovereign rollups provide similar functionality as optimistic and ZK rollups but differ in that they do not need smart contracts or use a settlement layer (the base layer) for validation; hence the term “sovereign”. Rather, they use the base layer for data availability only.

Some consider Stacks, one of the most popular Bitcoin smart contract L2s, to be a rollup; others consider it to be a sidechain (see below); the Stacks team labels itself simply as a “Bitcoin layer”. 🤷‍♂️

There are other rollups in development such as Rollkit (sovereign), Chainway (sovereign), Bison Labs (ZK), and many more.

Sidechains

Sidechains are separate blockchains that rely on their own set of validators to secure their network, but facilitate the bridging of assets from the main Bitcoin chain to their chain for transactions.

Like rollups, sidechains have smart contract capabilities and thus can be used to build DeFi and other applications. Sidechains can even have other L2s like rollups built on them.

Some don’t consider sidechains as L2s because 1) they are more similar to L1s, with their own consensus mechanisms, and 2) the only thing that truly ties them to the Bitcoin baselayer is the two-way bridge.

Rootstock and Liquid are two of the more popular Bitcoin sidechains.

Rootstock is a smart contract sidechain that uses a merge-mining mechanism, where miners can simultaneously mine both the Bitcoin and Rootstock blockchains. Rootstock aims to be fully compatible with Ethereum's smart contract language, providing developers with a familiar environment to build decentralized applications (dApps) while leveraging Bitcoin's security.

Liquid is a Bitcoin L2 built by Blockstream that focuses on the issuance and settlement of digital assets such as stablecoins, security tokens, and other financial instruments.

Conclusion

As more innovation comes to Bitcoin, L2s will help solve the problems of rising transaction fees, scalability challenges, and lack of programmability faced by the Bitcoin network.

By processing transactions away from the base layer, L2s enable faster, cheaper, and more private transactions while retaining the robust security of the Bitcoin blockchain.

We’ve seen the success of Ethereum L2s, such as Arbitrum, Optimism, Base, and zkSync, and how they’ve garnered billions of dollars of total value locked.

We predict that there will be similar activity on Bitcoin L2s and are super bullish on the Bitcoin ecosystem’s future.