What is Bitcoin Layer 2?

The Bitcoin blockchain was initially designed to facilitate peer-to-peer transactions in a secure and decentralized manner independent of centralized authority. Over the years, as the utility and demand for the Bitcoin blockchain have increased, several constraints have emerged, including higher transaction fees and slower processing times.

To address these issues, Bitcoin Layer 2 (L2) solutions were developed. These solutions aim to scale the Bitcoin network by increasing transaction throughput and reducing latency. They operate on the main Bitcoin blockchain and can handle transactions more efficiently. One notable feature of some Layer 2 solutions is the potential to support more complex applications, such as smart contracts, which are not natively possible on the Bitcoin blockchain.

Challenges With Bitcoin Blockchain

Understanding the significant challenges facing the Bitcoin blockchain is crucial for recognizing the need for Layer 2 technologies. These challenges include limited transaction capacity and extended confirmation times, which Layer 2 solutions seek to mitigate.

Scalability Issues: One inherent issue with the Bitcoin blockchain is scalability, which directly affects transaction throughput and the speed of transaction execution. The Bitcoin blockchain can process only about seven transactions per second (TPS), significantly fewer than some other blockchains. This scalability limitation causes transaction execution delays and increases transaction fees as demand for Bitcoin rises.

Limited Use Case: Bitcoin was primarily designed for peer-to-peer transactions. As such, it is limited in terms of adopting new technological advancements, particularly in the decentralized finance (DeFi) sector. To incorporate functionalities such as decentralized lending and borrowing or the creation of decentralized applications (dApps), there would need to be support for smart contracts. However, the original Bitcoin blockchain does not natively support smart contracts.

Blockchain Trilemma: The blockchain trilemma implies that a blockchain cannot simultaneously achieve scalability, decentralization, and security without compromising at least one of these aspects. In the case of Bitcoin, scalability has been sacrificed to maintain high levels of decentralization and security. As a result, significant scaling of the Bitcoin network cannot be achieved directly on the mainnet without external improvement.

Bringing Layer 2 to The Bitcoin Blockchain

Significant technological advancements have been made to implement Layer 2 on the Bitcoin Blockchain. Two prominent developments in the past decade are the introduction of Taproot and SegWit. Let's briefly discuss how these have been essential to introducing Layer 2 on Bitcoin.

SegWit: Segregated Witness, or SegWit, was implemented on Bitcoin in August 2017 to improve scalability and provide additional security to the blockchain. The update improved scalability by allowing more transactions to fit into a single block and fixed a bug known as 'transaction malleability.' By removing the signature data from the transaction data within a block, more space became available for additional transactions, thus potentially lowering fees. Another significant benefit is that it strictly confines blocks to contain only transaction data by removing the part of the transaction that could be altered (the signature) after it has been issued.

Bitcoin Taproot: Implemented in 2021, Taproot was designed to enhance privacy, improve smart contract functionality, and increase the efficiency of the blockchain. The Taproot update replaced the ECDSA signatures used since Bitcoin's inception with Schnorr signatures. This allows for simpler and more compact transaction signature aggregation, making multi-signature transactions indistinguishable from single-signature transactions. Taproot introduced Tapscripts, enabling developers to deploy more complex smart contracts on the Bitcoin blockchain and potentially opening up new use cases.

Bitcoin Layer 2 Solutions and How They Work

There are various approaches to implementing Layer 2 solutions on the Bitcoin blockchain, each with its unique method of addressing scalability and efficiency challenges.

State Channels

State channels allow participants to conduct numerous transactions off-chain while only necessitating two transactions on the Bitcoin blockchain: one to open the channel and one to close it. This approach helps users avoid the high transaction fees typically associated with conducting numerous transactions on-chain.

In practical terms, users lock up Bitcoin in a multi-sig (multi-signature) wallet, conduct an unlimited number of transactions privately and directly between them without interacting with the main blockchain, and only update the blockchain with the final state when they are ready to close the channel. This method is particularly beneficial for scenarios where parties must transact repeatedly and require instant settlement. An example of this technology is the Lightning Network.

Side Chains

A side chain is a type of Layer 2 solution that creates a separate blockchain connected to the main Bitcoin blockchain. This connection is facilitated through a mechanism known as a two-way peg, which allows assets, typically Bitcoin (BTC), to be transferred between the main Bitcoin blockchain and the side chain.

This setup enables developers to experiment with different consensus protocols and to introduce various features, such as smart contracts. These capabilities can support a range of decentralized applications (dApps). Side chains can operate under different security assumptions and are typically secured by their network of nodes. An example of a platform utilizing side chains is the Rootstock Infrastructure Framework (RIF), which improves Bitcoin's functionality with smart contracts.

Rollups

Rollups are another type of Layer 2 solution that improves blockchain scalability. Transactions are processed off the main blockchain on a separate network, then bundled together, and the data is posted back to the main chain as a single package. There are primarily two different types of rollups: optimistic and zero-knowledge (ZK) rollups. Optimistic rollups assume transactions are valid by default and only verify them if challenged. In contrast, ZK rollups validate all transactions using zero-knowledge proofs before posting them to the main chain, ensuring their correctness and security from the outset.

Top Bitcoin Layer 2 Networks

Lightning Network

One of the most prominent Layer 2 solutions, the Lightning Network, was launched by Joseph Poon and Thaddeus Dryja. It was first proposed in a 2015 whitepaper and has been actively developed. The primary purpose of the Lightning Network is to enhance the scalability of the Bitcoin blockchain and, importantly, to reduce transaction costs during periods of high congestion.

The Lightning Network is built on the concept of state channels. This allows participants to create a channel via a smart contract, where transactions are conducted off the main chain. After the transactions are completed, the channel is closed, and only the opening and closing balances are recorded on the Bitcoin blockchain. This method provides greater efficiency and reduces redundancy.

Within the Lightning Network, hundreds to millions of transactions can occur within a single channel, making transactions significantly cheaper since fees are incurred as if they were a single transaction.

Rootstock (RSK)

Rootstock is a Layer 2 solution that operates using a sidechain mechanism, incorporating a two-way peg into its system. It effectively brings Ethereum-style smart contract capabilities to the Bitcoin network, allowing developers to deploy decentralized applications (dApps) and use smart contracts while leveraging the security of the Bitcoin blockchain.

Practically, Rootstock’s two-way peg allows for the seamless transfer of Bitcoin between the Bitcoin blockchain and the RSK sidechain. Another key feature of Rootstock is merge-mining, which allows the RSK sidechain to benefit from the security of the Bitcoin blockchain. Rootstock supports a Turing-complete scripting language, enabling the implementation of smart contracts and other functionalities. DeFi platforms like ReHold utilize Rootstock (RSK) to innovate within the Bitcoin ecosystem.

ReHold has developed the first Bitcoin-based perpetual futures platform, known as PerpDex, which allows users to open leveraged positions on Bitcoin easily. ReHold also offers "Dual Investment," a product designed for yield farming using Bitcoin. These developments leverage the smart contract capabilities of Rootstock to expand Bitcoin's utility in decentralized finance.

Liquid Network

The Liquid Network, launched in 2018 by Blockstream, is a sidechain that utilizes a two-way peg mechanism. This allows for seamless transfers between Bitcoin and the Liquid sidechain. Liquid aims to enhance transaction speeds and privacy for traders and exchanges while enabling the secure issuance of various types of digital assets.

Unlike Bitcoin, which relies on proof of work to achieve consensus, the Liquid Network uses a federated consensus model. This model involves a group of trusted functionaries (major cryptocurrency exchanges, financial institutions, and other blockchain companies) who validate and confirm transactions. For privacy, the Liquid Network enables certain transaction details, such as the amount transferred, to be hidden from public view and accessible only to the participants involved.

Stacks Network

Launched in 2018 by Blockstack (now known as Hiro Systems), Stacks Network operates as a layer to Bitcoin, using a unique consensus mechanism called proof of transfer (PoX). Stacks aims to enhance Bitcoin’s functionality by introducing smart contracts and decentralized applications (dApps) to the Bitcoin network.

Stacks facilitates direct swaps between its native token (STX) and BTC, supporting a native trading environment and liquidity pools. This integration could potentially increase the utility and value of both Stacks and Bitcoin.

Challenges With Bitcoin Layer 2

While Layer 2 on Bitcoin provides the necessary innovation to address issues such as demand surges, high transaction fees, and, importantly, the introduction of decentralized applications (dApps), it also presents inherent challenges. Let's examine some of these issues:

Security Vulnerability: Layer 2 solutions are exposed to security vulnerabilities that arise from the bridging process, which involves asset transfers between the Bitcoin blockchain and the Layer 2 blockchain. This process typically utilizes a smart contract where Bitcoin is locked and an equivalent amount of the sidechain’s native token is minted. The locking and minting of tokens via a smart contract are susceptible to vulnerabilities that hackers can exploit, potentially leading to the siphoning of funds. This vulnerability puts the entire system at risk.

Protocol and Codebase Vulnerabilities: Layer 2 solutions introduce new protocols and codebases, which may contain vulnerabilities or bugs not present in Bitcoin's more thoroughly tested base layer. This includes potential issues with the software that manages channels or sidechains, which could compromise the security or integrity of transactions.

Unfavorable User Experience: While solutions like rollups and state channels are effective for facilitating fast and seamless transactions on the blockchain, they have drawbacks. Transactions in state channels may be delayed until the final settlement is confirmed on the main blockchain. Additionally, the complexity involved in opening and managing payment channels or understanding how to transfer BTC to sidechains can hinder adoption due to its demanding nature.

Bitcoin Layer 2: Paving the Way for More Innovation

Bitcoin Layer 2 solutions are crucial for expanding the blockchain's capabilities, especially in decentralized finance (DeFi), where Bitcoin has traditionally been less active. As these technologies develop, they are expected to introduce a broader range of applications. However, for their full potential to be realized, it is critical to enhance security measures and streamline user experiences to encourage wider adoption and ensure the reliability of these innovations.