Market Data 
Bitcoin, the pioneer of blockchain technology, has faced challenges as its adoption has grown. With its original design allowing only seven transactions per second, the network often struggles with scalability, leading to high fees and slower transaction times. To address these issues, Bitcoin layer two (L2) solutions have emerged. These projects aim to enhance the Bitcoin blockchain by developing an execution layer that processes transactions off the main chain, thereby increasing throughput and maintaining security. These L2s also enable new functionality, like smart contracts.
What Are Bitcoin Layer Twos?
Bitcoin layer twos (L2s) are secondary protocols or networks built on top of the Bitcoin blockchain to address its scalability limitations and improve transaction throughput, fees, and speed. Some Bitcoin L2s also introduce smart contract functionality, enabling new use cases such as decentralized finance (defi) on Bitcoin. Bitcoin L2s scale the Bitcoin blockchain by creating an execution layer separate from the main network. This execution layer handles transactions off-chain and then submits the transaction data to the Bitcoin blockchain for final settlement.
What are the main differences between Bitcoin and Ethereum Layer twos?
The main differences between Bitcoin and Ethereum L2 solutions stem from the fundamental architectural distinctions between the two base layer blockchains. Here are some of the key differences:
Security inheritance: Unlike Ethereum’s L2s where validators actively verify L2 transactions, providing direct security inheritance from the Ethereum mainnet, Bitcoin’s L2 networks do not currently benefit from the same direct involvement. Bitcoin L2s rely on their own independent security protocols and mechanisms for verifying transactions within the L2 network itself.
Transaction verification: While Ethereum L2s can leverage the Ethereum mainnet’s ability to verify complex state transitions, fraud proofs, and zero-knowledge proofs, the Bitcoin network lacks such advanced verification capabilities. This limits the types of L2 solutions that can be built on Bitcoin compared to Ethereum.
Smart contract functionality: Ethereum was designed as a general-purpose blockchain with native support for smart contracts, while Bitcoin was not. So while both aim for scalability, Bitcoin layer twos have an additional focus on introducing enhanced programmability and smart contract capabilities to Bitcoin.
Settlement layer: Bitcoin layer twos settle transactions on the Bitcoin blockchain, leveraging its renowned security and decentralization provided by proof-of-work consensus. Ethereum layer twos settle on the Ethereum mainnet, utilizing an arguably less secure proof-of-stake consensus model.
The Need for Bitcoin Layer twos
The main need for Bitcoin layer two (L2) solutions arises from the inherent scalability limitations of the Bitcoin blockchain’s base layer (L1). Directly scaling Bitcoin’s base layer would require trade-offs in decentralization or security. L2s offer a way to scale Bitcoin while still inheriting Bitcoin’s robust security model through settlement on the main chain.
The key reasons necessitating L2 solutions:
Scalability and transaction throughput: The Bitcoin network can only handle around 7 transactions per second due to the 10-minute block time and limited block size. This low throughput leads to network congestion, long confirmation times, and high transaction fees, making Bitcoin impractical for micropayments and everyday transactions at scale.
High transaction fees: During periods of high network activity, Bitcoin transaction fees can spike significantly, with average costs reaching over $120 per transaction on April 20, 2024, during a particularly congested time. High fees make small transactions economically unviable.
Limited smart contract functionality: Bitcoin’s base layer was designed primarily for simple value transfers and lacks advanced smart contract capabilities required for decentralized applications (dapps), decentralized finance (defi), and other use cases.
Unlocking Bitcoin’s capital: A significant portion of Bitcoin’s massive capital remains underutilized as it is primarily used as a store of value. L2s aim to unlock this capital by enabling faster transactions, smart contracts, and innovative applications built on Bitcoin.
Scaling without compromising security: Directly scaling Bitcoin’s base layer would require trade-offs in decentralization or security due to the blockchain trilemma.
How Bitcoin Layer Twos Work
A blockchain network consists of two layers: the execution layer and the consensus layer. The execution layer handles transaction computations, while the consensus layer verifies and approves these transactions. Bitcoin L2s develop a separate execution layer that processes transactions off-chain and submits them to the Bitcoin consensus layer for final settlement. This allows L2 networks to use various technologies (such as rollups) to improve efficiency.
Here are the most common approaches to creating Bitcoin layer twos.
State Channels
State channels, such as those used in the Lightning Network, allow two parties to make an unlimited number of Bitcoin transactions off-chain, without recording each transaction on the main Bitcoin blockchain. This approach significantly enhances transaction speed and reduces costs.
To open a channel, the two parties lock a certain amount of Bitcoin into a multi-signature (multisig) address on the Bitcoin blockchain. A multisig address on Bitcoin is a type of address that requires multiple people to authorize and sign a transaction, rather than just one. They agree on the initial distribution of Bitcoin between them for this channel. Once the channel is open, the parties can make an unlimited number of off-chain transactions, exchanging signed transaction data to update their respective Bitcoin balances in the channel’s current state. These transactions are not broadcast to the Bitcoin network during this process.
When they are done transacting, the two parties sign and broadcast the final state of the channel to the Bitcoin blockchain. This final state reflects the latest agreed-upon distribution of Bitcoin between the two parties. The multi-signature conditions are met, allowing the funds to be redistributed according to the final balances.
Sidechains
Bitcoin sidechains, such as the Liquid Network, operate on separate blockchains that are pegged to Bitcoin. These sidechains utilize their own consensus mechanisms, enabling faster transactions and additional features while periodically relaying and finalizing transactions on the Bitcoin mainchain. Here’s how Bitcoin sidechains work:
Two-Way Peg: The fundamental technology that enables the transfer of assets between the Bitcoin mainchain and a sidechain is called the “two-way peg.” To move assets from the Bitcoin mainchain to a sidechain, a user first locks their bitcoins into a special output address on the Bitcoin blockchain by sending a transaction. This action effectively immobilizes the bitcoins on the mainchain. The sidechain then detects this locking event and responds by minting and releasing an equivalent amount of tokens on the sidechain, often referred to as sBTC (sidechain BTC), representing the locked bitcoins from the mainchain. Once on the sidechain, users can freely transfer and utilize these tokens for various purposes, such as transactions and smart contracts, benefiting from the sidechain’s faster and more efficient consensus mechanism. To return assets to the Bitcoin mainchain, the user burns or destroys the sidechain tokens. This burning event is detected by the mainchain, which then releases the originally locked bitcoins back to the user’s address on the mainchain.
Federation/Validators: To manage and validate the two-way peg process securely, sidechains employ a federation or a group of validators. This federation performs several critical functions. The federation or group of validators plays a crucial role in managing and securing the two-way peg process between the mainchain and the sidechain. They monitor the locking and unlocking of assets on both chains, ensuring that transactions are accurately recorded. They also validate that the amount of assets moved matches on both sides, preventing issues such as double-spending. This federation can be operated by trusted parties, multi-signature scripts, or smart contracts, all of which work to maintain the integrity and security of the asset transfer process.
Independent Consensus: A defining feature of sidechains is their independent consensus mechanism, which operates separately from the Bitcoin mainchain. This independence allows sidechains to implement custom block parameters, including different block times, block sizes, and transaction throughput optimized for their specific use cases. They utilize unique consensus algorithms such as Proof-of-Authority (PoA) or Delegated Proof-of-Stake (DpoS), which can be more efficient or suitable for the sidechain’s purposes. Additionally, sidechains introduce advanced features like smart contracts, privacy enhancements, and other scalability solutions that are not natively available on the Bitcoin mainchain.
Rollups
Bitcoin layer two rollups work by moving transaction execution and data off the main Bitcoin blockchain to a separate rollup chain or layer, while still anchoring to Bitcoin for data availability and consensus.
The key mechanisms involved in rollup technology include transaction execution on the rollup chain, data compression, and anchoring to Bitcoin layer one. Users submit transactions to be executed on the rollup chain rather than directly on the Bitcoin blockchain. The rollup chain processes these transactions, updating account balances accordingly. After processing many transactions off-chain, the rollup compresses or “rolls up” the transaction data into a compact cryptographic proof or commitment, which represents the net effect of all those transactions on the state. This compressed proof is then periodically submitted to the Bitcoin blockchain as a single transaction. A smart contract or verification mechanism on Bitcoin’s layer one can efficiently validate and apply the state transition represented by the rollup proof.
However, rollups on Bitcoin face a key challenge since the base Bitcoin layer lacks the ability to natively verify the cryptographic proofs or commitments produced by rollup systems. There are a few approaches being explored to enable rollups on Bitcoin, including sovereign rollups and extending Bitcoin script.
Sovereign rollups use Bitcoin as a data availability layer without relying on it for validity proofs. These rollups operate independently, processing transactions off-chain and publishing only compressed transaction data on Bitcoin. They manage their own consensus mechanisms and transaction execution environments off-chain, using Bitcoin to anchor and store the compressed rollup data. To move assets like BTC in and out of the rollup, a decentralized peg system, such as sBTC, is used, relying on a decentralized group of signers rather than Bitcoin’s base layer.
Extending Bitcoin’s script language and opcodes to enable validity rollups allows Bitcoin’s base layer to verify and enforce the rollup’s state transitions. This would most likely require a soft-fork upgrade to Bitcoin to add new opcodes like OP_CAT or WTC for better programmability.
Types of Bitcoin Layer Two Solutions
As mentioned above, there are broadly three main approaches to implementing Bitcoin layer two solutions For detailed information about how these approaches work, see the above section.
State Channels: State channels enable two parties to create a payment channel off the main Bitcoin blockchain. Transactions occur within this channel, and only the final net result is recorded on the blockchain when the channel is closed. This allows for an unlimited number of transactions without bloating the main chain.
Sidechains: Sidechains are separate blockchains that run in parallel to Bitcoin, connected via a two-way bridge. This bridge enables the transfer of assets between the sidechain and the main Bitcoin chain. Sidechains can have their own rules, consensus mechanisms, native tokens, and support additional features like smart contracts.
Rollups: Rollup chains bundle numerous off-chain transactions into a single transaction, generating a cryptographic proof of validity. This bundled transaction is then submitted to the Bitcoin blockchain for settlement.
Additionally, other mechanisms for L2 scaling exist that do not fall into the categories of sidechains, state channels, or rollups. These include client-side validators, Chaumian ecash mechanisms, wrapped tokens, and anchored chain schemes.
Advantages of Bitcoin Layer twos
Bitcoin’s layer one, while renowned for its security and decentralization, suffers from several performance limitations. Transactions on the Bitcoin mainchain take around 10 minutes to confirm, lack smart contract functionality, and often incur high transaction fees due to network congestion. To address these challenges, Bitcoin layer two solutions have been developed, providing a range of enhancements that significantly improve the usability and functionality of the Bitcoin network.
Scalability: One of the most significant advantages of Bitcoin layer two solutions is their ability to dramatically increase the network’s transaction capacity. By processing transactions off the main blockchain, layer two projects can handle a much higher volume of transactions per second compared to Bitcoin’s base layer. This offloading reduces congestion on the main chain, resulting in smoother and more efficient network operations. The increased scalability is crucial for the widespread adoption of Bitcoin for everyday transactions and high-frequency trading.
Lower Transaction Fees: Since layer two transactions do not require all transaction data to be recorded on the Bitcoin blockchain, they significantly reduce the amount of data that needs to be stored. This leads to lower transaction fees, making microtransactions and other small-value transfers economically viable. Users benefit from the reduced costs, which is particularly important for applications such as remittances and micropayments, where high fees can be prohibitive.
Faster Confirmations: Layer two solutions offer near-instant transaction confirmations, a stark contrast to the 10-minute average block time on the Bitcoin mainchain. This rapid confirmation time is essential for use cases requiring quick settlement, such as point-of-sale transactions and online commerce. The ability to achieve faster confirmations enhances the user experience and broadens the range of practical applications for Bitcoin.
Enhanced Privacy: Some layer two implementations provide enhanced privacy features. Techniques such as onion routing and payment channel anonymity make it more difficult to trace transactions, offering users a higher level of privacy.
Smart Contract Capabilities: Certain Bitcoin layer two projects enable smart contract functionality on top of Bitcoin. This addition unlocks new use cases, including dapps and defi protocols.
Inherited Security: Layer two solutions derive some amount of their security from the underlying Bitcoin blockchain. By anchoring transactions to Bitcoin’s robust and decentralized proof-of-work consensus, layer two networks can benefit from the massive computing power that secures the Bitcoin network.
Challenges of Bitcoin Layer twos
Despite their advantages, Bitcoin L2 networks face challenges, particularly in secure bridging between Bitcoin and L2 networks and the speed and ability to settle proofs on the Bitcoin network. Bridges can be prone to security risks, and improvements in settlement speed and cost are needed for future scalability.
Some of the biggest challenges facing BitcoinL2 solutions include:
Secure Bridging Between Bitcoin and L2 Networks: Bitcoin L2 networks like sidechains use bridges to connect with the Bitcoin mainchain. These bridges work by locking assets on Bitcoin and minting equivalent tokens on the L2 chain. However, this bridging design has security risks and user experience issues. Many cryptocurrency hacks and losses have occurred due to vulnerabilities in cross-chain bridges.
Speed and Cost of Settling on Bitcoin Network: While L2 solutions process transactions off-chain, they ultimately need to settle the final state on the Bitcoin mainchain. The speed and cost of this settlement process on Bitcoin’s base layer are significant factors affecting the efficiency of L2 networks.
Maintaining Security Without Direct Bitcoin Validation: Unlike Ethereum L2s where validators verify L2 transactions, Bitcoin L2s do not entirely inherit security from Bitcoin’s nodes, which validate transactions. Bitcoin L2s must rely on their own independent security protocols, making it challenging to achieve the same level of security as Bitcoin’s base layer.
Increased Centralization Risks: Some L2 solutions require establishing payment channels and relay nodes, or running their own consensus mechanism. This could lead to the concentration of control in the hands of a few entities, potentially undermining Bitcoin’s decentralized principles.
Technical Complexities and Integration Challenges: Integrating L2 solutions with Bitcoin’s existing infrastructure involves significant technical complexities, such as ensuring compatibility, maintaining security standards, and achieving consensus within the community on proposed updates.
What do you think about Bitcoin layer two projects? Share your thoughts and opinions about this subject in the comments section below.
