Bitcoin has gained immense popularity but has not been without its challenges. As more people use the network before the halving, it has become congested. This congestion causes problems such as high fees and long transaction wait times, making it difficult to use Bitcoin for small, everyday transactions.
There is a pressing need for a solution to this scaling problem so that Bitcoin can continue to handle the increased demand on the network, and the answer seems to be layer 2 blockchains. Before we discuss these layer-2 solutions, let's briefly look at various upgrades — Segwit and Taproot— that elevated Bitcoin to where it is today.
What are SegWit and Taproot?
Bitcoin has been evolving through constant innovation and adaptation. Two significant upgrades, Segregated Witness (SegWit) and Taproot, played crucial roles in the ongoing course of Bitcoin. These upgrades addressed some of the network's most pressing challenges and laid the groundwork for a new era of development and expansion within the Bitcoin ecosystem.
SegWit
In 2017, SegWit was introduced to tackle the issue of Bitcoin's ability to scale. This upgrade addressed the problem by increasing the capacity of each block through a technique called "segregation."
SegWit separated the digital signature from the transaction data, leading to a reduction in transaction size. This allowed more transactions to fit into a single block without increasing the block size limit. With SegWit, Bitcoin blocks can now support up to 4MB of transactions in optimal conditions.
SegWit also fixed a vital security issue related to transactions. Before SegWit, it was possible to modify transaction details before they were confirmed on the blockchain, which was a critical problem.
This enhancement increased security and enabled the development of second-layer solutions like the Lightning Network, which improved transaction speed and efficiency.
SegWit has been a significant upgrade for the underlying technology of cryptocurrencies.
Taproot
The SegWit upgrade improved Bitcoin's scalability and security, paving the way for further enhancements. In November 2021, the Taproot upgrade introduced more improvements concentrating on privacy, efficiency, and smart contract capabilities.
By replacing the ECDSA signature scheme, the use of Schnorr signatures enabled the aggregation of multiple signatures into one, thus simplifying and securing complex Bitcoin transactions. As a result, such transactions become indistinguishable from simple transactions recorded on the blockchain.
Taproot improved privacy, optimized space, and reduced fees by making multisig look like regular transactions. It also helped developers make better smart contracts on the Bitcoin network. It makes creating new apps that use Bitcoin's security and decentralization easier.
SegWit and Taproot are both significant upgrades for Bitcoin. They don't just improve the technical side of things. They also expand Bitcoin's abilities beyond its original purpose as a peer-to-peer electronic cash system. These upgrades are the foundation for the new Bitcoin layer-2 ecosystems, which we will discuss in the following sections.
Why does Bitcoin need layer-2 chains?
Bitcoin is recognized as 'digital gold' due to its ability to hold value. Although initially designed as a secure and decentralized payment system, it has not been widely adopted due to its limitations.
Scalability issues
It has a problem with scalability and slow transaction speeds, which causes low throughput and rising transaction costs. Compared to other blockchains, Bitcoin can't handle large amounts of transaction data within a set time frame. Creating a block takes around 10 minutes; the average throughput is seven transactions per second (tps). This is much lower than that of other blockchains like Solana.
While this may not be an issue for large transactions, it becomes impractical for smaller transactions and point-of-sale purchases. On average, the Bitcoin network takes about 10 minutes to finalize a single set of transactions – only 7 transactions per second (TPS).
As more people use Bitcoin, it's causing network congestion and increasing transaction fees. In 2016, the average fee was about 7 cents. But now it's gone up to $31, the highest ever being nearly $63 in April 2021.
Blockchain trilemma
The Bitcoin blockchain cannot be scaled due to the Blockchain Trilemma, which states that optimizing for all three main pillars — decentralization, security, and speed/scalability — is impossible. Bitcoin prioritized decentralization and security, but this meant compromising scalability. Therefore, expanding the Bitcoin blockchain network is not feasible without sacrificing security or decentralization.
Smart contract limitations
As a digital currency, Bitcoin serves two purposes — enabling independent, trustless P2P transactions and providing a tech stack to remain a deflationary store of value. This limited core functionality is one of its key features, not a bug, and makes the network robust and tamper-resistant.
Bitcoin has limitations when it comes to smart contracts. Unlike Ethereum, it doesn't support complex smart contract functionality. Bitcoin's base layer was not designed to develop smart contracts and applications. Initially, it was created as a peer-to-peer digital payment system. As a result, the Bitcoin blockchain has hardly seen any development in functions such as decentralized finance (DeFi) and non-fungible tokens (NFTs).
This is where Layer-2s come in.
What is Bitcoin Layer 2?
Layer 2 solutions are secondary networks built on top of the Layer 1 network's architecture. This distinction helps to differentiate between various networks within a blockchain ecosystem.
Bitcoin's Layer 2 solutions are secondary networks that run on top of the main blockchain. They aim to increase the blockchain's ability to handle transactions by bypassing its technical limitations while taking advantage of its strengths.
This can improve the usability of the network in various ways. It's fascinating to see how technology is evolving to meet the growing demands of the blockchain network.
Think of a layer-2 blockchain as an efficient assistant, performing the bulk of the work before returning it to the layer-1 blockchain to be officially logged. This way, Layer 2 processes transactions off-chain, making the entire process smoother and more efficient, before sending them back to be added to the Bitcoin blockchain.
How Do Bitcoin Layer 2s Work?
Regarding processing transactions, Layer 2 solutions share a common goal but differ in their approach to achieving it.
Rollup chains
Blockchain Rollups are a Layer 2 solution that moves multiple transactions from Layer 1 to a separate network, condenses them into a single piece of data, and then returns that data to be added to Layer 1.
According to research, validating Bitcoin transactions can be made faster by up to 100 times using validity rollups. This approach can also be applied to Lightning Network. An execution environment can be implemented to support more flexible smart contract languages and improve smart contract functionality without adding complexity to the main chain.
Sovereign rollups are another type of Bitcoin rollup. They differ from the Optimistic and ZK rollups used in the Ethereum network. Sovereign rollups do not need a settlement layer or smart contracts. They manage their own execution and settlement. They only use the underlying Layer-1 blockchain for consensus and data availability. This is unlike other rollup types that rely on the blockchain to determine a rollup's validity.
Bitcoin rollups are still in their early stages and are being experimented with.
Sidechains
A sidechain is an independent blockchain with consensus mechanisms and connects to Layer 1 via a two-way bridge. This bridge plays a crucial role in enabling the transfer of assets between chains. Because it functions as its blockchain, a sidechain can also support other Layer 2 solutions.
State channels
Layer 2 solutions can assist users in circumventing high transaction fees. Users use this method to establish end-to-end encrypted "channels" to send and receive payments. These channels operate as micro-ledgers, recording all transactions that occur within them.
State Channels keep all transactions within them off-chain, only providing participants' opening and closing balance to the main network when the channel closes. As a result, participants can engage in multiple transactions with individuals or businesses without paying high fees.
Top Bitcoin Layer-2 Solutions in 2024
Several Layer 2 solutions explore the concepts and avenues that we have discussed. Here is an overview of some of the most popular Bitcoin Layer 2s.
1. The Lightning Network
Lightning Network is a Layer-2 payment protocol that reduces network congestion using state channels to handle Bitcoin micropayments off-chain. It allows direct transactions between two parties, bypassing the main blockchain.
To use this network, users send and receive BTC payments through encrypted P2P channels that act as smart contracts. For instance, if you want to send 0.1 BTC to a friend, create a channel with them and fund it with the necessary amount. After completing all the transactions, you can close the channel.
The system remains efficient by only sending the channel's opening and closing balances to the Bitcoin network.
How does the lightning network work?
The Lightning Network technology allows multiple transactions to happen without needing confirmation from the entire Bitcoin network. This feature makes transactions much faster and less expensive. It has effectively addressed the issue of Bitcoin's scalability problems by enabling the network to handle high-volume transaction processing with ease.
It uses a smart contract called hashed timelock contracts (HTLCs) to carry out multi-party transactions and payment routing securely. The HTLC allows the recipient to receive funds only after certain conditions are met within a specific period or block time.
2. Rootstock (RSK)
The Rootstock blockchain confirms transactions using the Proof of Work (PoW) consensus mechanism. Miners can mine Bitcoin and Rootstock simultaneously using the same hashing algorithm and sharing the same computational power. Rootstock confirms blocks in around 30 seconds and can handle 10 to 20 transactions per second. Transactions are confirmed and packaged before being sent to Bitcoin's base layer for settlement.
Rootstock is a platform that extends Bitcoin's capabilities by allowing developers to use smart contracts. These contracts are computer programs that can run automatically and without intermediaries. Rootstock also will enable developers to use Ethereum's programming language, Solidity, and execute Ethereum smart contracts on their platform.
One of the critical features of Rootstock is the RSK Infrastructure Framework (RIF), which provides a set of decentralized services that developers can use to build and deploy decentralized applications or "dApps" on the Rootstock network. This framework helps make developing a dApp easier and more efficient.
3. Stacks protocol
Stacks has emerged as a leading Bitcoin Layer 2 (L2) solution since its launch on the mainnet in 2018 as Blockstack. This protocol facilitates deploying self-executing smart contracts on Bitcoin without implementing a fork. The protocol leverages microblocks for quickness and a unique Proof-of-Transfer (PoX) mechanism to connect them to blocks on Layer 1. It offers a user-friendly, readily available, easy-to-use approach to executing smart contracts and decentralized applications within the Bitcoin ecosystem.
4. Mintlayer
Mintlayer is a blockchain solution built on Bitcoin that aims to enhance token interoperability, promote decentralized trading, reduce transaction costs, and increase throughput while maintaining compatibility with Bitcoin. Its approach offers legal tokenization, cost efficiency, and enhanced privacy features for a more inclusive, efficient, and secure DeFi ecosystem.
5. Liquid network
The Liquid Network is a sidechain for Bitcoin's Layer 2 that operates on the open-source Elements blockchain platform. It is governed by a distributed federation of Bitcoin companies, exchanges, and other stakeholders, and it has a native asset, Liquid (L-BTC). Like Rootstock, it uses a two-way peg to convert BTC to L-BTC and vice versa.
6. Interlay
Interlay is a platform that integrates Bitcoin with decentralized finance (DeFi) across multiple blockchains. It offers a modular approach, allowing users to control their private keys while engaging in DeFi activities. Interlay's iBTC mechanism enables users to lock their BTC securely, mint iBTC at a 1:1 ratio, and engage in DeFi activities across various blockchains. Interlay is audited by leading firms in blockchain security and governed by the community through the voting power of governance (INTR) tokens.
7. Babylon
Babylon introduces a Bitcoin Staking Protocol, allowing Bitcoin holders to earn yields from their idle Bitcoins without trusting a third party. The protocol offers trustless staking, complete security against PoS attacks, fast and scalable restaking, and ecosystem partnerships.
8. Drivechain
Drivechain proposes a way for Bitcoin to work with sidechains using BIPs 300 and 301. This allows for new features and applications without risking the main blockchain's safety. It enables the transfer of BTC between Bitcoin and sidechains.
Drivechain promotes permissionless innovation, facilitates scalability and flexibility, and is presented as a zero-risk solution that can be easily reverted if necessary. BIPs 300 and 301 define the technical mechanisms behind its operation.
9. Threshold Network
Threshold Network uses threshold cryptography to secure digital assets, enhance user sovereignty, and ensure privacy and security. It offers tBTC for seamless integration of Bitcoin into DeFi, TACo Plugin for end-to-end decentralized encryption, and a DAO governance model for a community-driven approach to network governance.
Challenges facing Bitcoin's layer-2 networks
Bitcoin's Layer 2 networks are not yet as battle-tested as Bitcoin itself in robustness, even though they have high security and reliability. They introduce a new set of risks and challenges as independent networks.
For instance, in 2022, Lightning users experienced a unique 'unattributed payment routing' failure due to a bug. As a result, they ended up interacting with faulty nodes without realizing the problem for a long time.
Additionally, Federated sidechains like the Liquid Network are still in their nascent development and market adoption stages. Unlike Bitcoin, which has thousands of miners worldwide, they have much fewer nodes (15, in Liquid's case) to sign and confirm transactions. This means that Bitcoin's Layer 2 networks can often be more centralized than the main network.
Benefits of Bitcoin Layer 2 networks
Layer 2 solutions can improve Bitcoin's functionality in several ways. They can increase transaction throughput beyond what is currently possible with Bitcoin's main layer, which makes them more scalable. Layer 2 networks can significantly reduce transaction costs by handling transactions outside the main chain. Platforms like Stacks and Rootstock offer smart contracts and DApps, allowing more versatile Bitcoin use. Some Layer 2 solutions also provide enhanced privacy features for transactions unavailable on Bitcoin's mainnet.
Drawbacks of Bitcoin Layer 2 networks
The Layer 2 ecosystem can be complicated for end-users, which may slow down adoption. Layer 2 solutions could also face unique vulnerabilities while relying on Bitcoin's security. Liquidity can also become fragmented across different Layer 2 solutions, complicating trading and other financial activities. Lastly, developers might need time to understand new protocols, languages, and environments, which could slow down innovation within the ecosystem.
Conclusion
Bitcoin has several scaling solutions, such as Lightning Network, Rootstock, Stacks, and Liquid Network. These protocols and emerging Layer-2 solutions like rollups benefit the Bitcoin network. They can help increase the adoption of the broader Bitcoin ecosystem.
FAQs
1. What is a Bitcoin Layer 2 solution?
A Bitcoin Layer 2 solution is a secondary framework or protocol built on the Bitcoin blockchain. It addresses the scalability and transaction speed limitations of the Bitcoin network by handling transactions off-chain while taking advantage of the security of the main blockchain.
2. How do Bitcoin Layer 2 networks work?
Layer 2 solutions work by conducting transactions off the main Bitcoin blockchain, thus reducing congestion and increasing scalability. They use smart contracts or other cryptographic techniques to establish trust among participants and enable faster and cheaper transactions. These transactions are then settled on the main Bitcoin blockchain periodically, ensuring the security and decentralization of the network.
3. What are some examples of Bitcoin Layer 2 solutions?
Examples of Bitcoin Layer 2 solutions include the Lightning Network, which enables instant micropayments by creating payment channels between users, and the Liquid Network, which facilitates faster and more confidential transactions for exchanges and institutions.
4. What are the benefits of using Layer 2 solutions for Bitcoin transactions?
Layer 2 solutions offer several benefits, including scalability, reduced transaction fees, faster transaction confirmations, and improved privacy. They also enable innovative use cases such as micropayments and decentralized finance (DeFi) applications on the Bitcoin network.
5. Are Layer 2 solutions secure?
Yes, Layer 2 solutions are designed to be secure, leveraging cryptographic techniques and smart contracts to ensure the integrity of transactions. While some risks may be associated with specific implementations, such as potential vulnerabilities in smart contracts, overall, Layer 2 solutions aim to enhance the security of the Bitcoin network.
6. Can I still access my funds if the Layer 2 solution experiences downtime or is compromised?
In most cases, Layer 2 solutions are designed with fail-safes to ensure that users can access their funds even if the solution experiences downtime or is compromised. For example, the Lightning Network allows users to close their payment channels and settle their transactions on the main Bitcoin blockchain if necessary.
7. Are Layer 2 solutions the future of Bitcoin transactions?
While Layer 2 solutions show great promise in addressing Bitcoin's scalability challenges, they are just one aspect of the broader scalability solutions explored within the Bitcoin ecosystem. The future of Bitcoin transactions may involve a combination of Layer 2 solutions, on-chain optimizations, and advancements in protocol development to ensure the network's long-term viability and scalability.