Bitcoin Renaissance: Exploring Layer 2s

Abstract:

Bitcoin was developed to operate as “a purely peer-to-peer version of electronic cash¹” that maximizes security and decentralization (see Blockchain trilemma below). This strategic design choice supported by the decentralized network of node operators and developer community results in block times being slow relative to other blockchains as of this writing (Ethereum’s average block time is 12 seconds where Bitcoin’s is 10 minutes) and a very limited (i.e., not Turing complete) scripting language. While these strategic choices maximize security and decentralization, they also have led to a lack of development on Bitcoin with respect to other blockchain protocols. This all changed in January 2023, when Bitcoin developer Casey Rodamor combined two previous upgrades to Bitcoin Core’s protocol to launch Ordinals and Inscriptions. The project jumpstarted Bitcoin and Layer 2 development as projects previously deemed impossible on Bitcoin were reconsidered with newfound enthusiasm. This movement has been dubbed the “Bitcoin Renaissance”. This paper is the first in a three-part series providing an overview of what L2s are, how they function, and what sorts of applications they enable on Bitcoin.

Historical Context:

Over the history of blockchain technology, users, developers, and market participants have grappled with the blockchain trilemma. Fundamentally, blockchain technology must make tradeoffs between scalability, security, and decentralization.

A blockchain technology that emphasizes decentralization and security, fundamentally, must make tradeoffs with respect to scalability. In the case of Bitcoin, the network has always emphasized decentralization and security over scalability. For instance, Bitcoin would be more scalable if blocks were able to store twice as many transactions or were produced every five minutes as opposed to ten. However, the data requirements to run a node – a computer that ensures blocks and transactions are valid according to Bitcoin’s consensus mechanism – would need to store more data and require more bandwidth. This would limit the available universe of node operators and decrease decentralization and security. This exact debate occurred in 2017 during the contentious Segregated Witness (SegWit) upgrade. This period is well documented in “The Blocksize Wars” written by Jonathan Bier.

Unlike Ethereum, which has a dynamic and unlimited issuance of ether, Bitcoin has a predetermined and fixed issuance schedule of bitcoin. Like most public blockchains with tokens, the token is a crucial component in incentivizing security of the system from decentralized participants. Bitcoin’s issuance schedule is highlighted by its halving events which occur every 210,000 blocks, roughly every four years, which reduces the amount of bitcoin issued per block by half. In order for Bitcoin to continue to support a robust decentralized pool of miners, the economic incentive must remain enticing.

The graphs below show the security budget in both bitcoin and USD values, with the issuance of bitcoin in purple, and transaction fees in orange. The incentive in bitcoin terms has drastically decreased due to the four halvings reducing the block reward from 50 bitcoin per block to 3.125 as seen in the second graph. However, the incentive in USD terms has greatly increased, driven by the increase in bitcoin’s price. As Bitcoin matures, the supply issuance will continue to decrease and the security budget will rely on transaction fees, which today makes up only 1-5% of the incentive.

Bitcoin’s core design – namely the focus on decentralization and fixed issuance schedule – creates a need for both increased scalability and demand for block space. The Bitcoin Renaissance that began with Ordinals and Inscriptions may spur sufficient Layer 2 protocol and application development to address both issues.

Why Layer 2s

Block space is a scarce and valuable resource. To ensure the continued growth in the usage and utility of Bitcoin, it is crucial to increase the density of data stored. To delve deeper into this topic, let us first examine how block space is measured and understand its operational parameters.

The activation of the SegWit soft fork changed the way block size is measured, shifting from a simple byte count to a more complex “block weight” system. Before SegWit, each Bitcoin block was limited to 1,000,000 bytes, or 1MB. After the soft fork, the maximum number of weight units a block could carry was set at 4,000,000. In this system, a byte of witness data counts as one weight unit, while a byte of non-witness data counts as four weight units. This introduced the concept of virtual bytes (vBytes), where one vByte equals four weight units, maintaining a maximum block size of 1,000,000 vBytes. This change allowed blocks to retain the same 1MB limit for non-witness data as before SegWit, while increasing the total block size within the witness field. Importantly, as a soft fork focused on backward compatibility, this change allowed nodes that did not upgrade to still process valid blocks by ignoring the witness field, while providing increased scalability and flexibility for those who adopted the changes.

Although the adoption of SegWit was gradual, it is now common practice, with over 95% of all active wallets utilizing it². Following SegWit, the average block size measured in bytes roughly doubled to 2MB. However, recent changes in Bitcoin driven by Taproot, a Layer 1 improvement, has driven further utility of bitcoin through projects such as Ordinals and Inscriptions. This has come at the expense of scalability as these larger transactions drive fees up.

In addition to limited block space, Bitcoin also has much longer block times – the average time for the next block to be added to the chain – than other blockchains. For example, Ethereum has an average block time of 12 seconds. Bitcoin’s slower block time and limited block space results in a throughput of 8.5 transactions per second.³ Compare that to roughly 15 transactions per second on Ethereum Layer 1, around 130 TPS on Ethereum rollups⁴ , 2,500 on Solana⁵ , and up to 65,0006⁶ on the Visa network, the need for scaling solutions on Bitcoin becomes increasingly evident. Layer 2 solutions seek to provide both, further scalability on bitcoin, as well as increased utility.

Layer 2 Overview:

We define a Layer 2 blockchain as any off-chain network, system, or technology built on top of a base layer blockchain that enhances or extends the scalability and utility of the underlying blockchain. Historically, Bitcoin has relied heavily on the Lightning Network, a state chain and Layer 2 solution, for this use case. However, other blockchains such as Ethereum have fostered a more robust and diverse Layer 2 development community. That all changed in January 2023 when Ordinals, a new protocol utilizing the SegWit and Taproot upgrades, shifted the Overton window for bitcoin from strictly a store of value to a more robust and development friendly ecosystem. Since January 2023, a development renaissance is underway with innovations developed on Ethereum—and previously thought impossible to be deployed on Bitcoin—beginning to bridge over to Bitcoin.

While a Layer 2 generally aims to increase the functionality of the underlying blockchain – in this case Bitcoin – this is a broad goal. Each development community and project take a slightly different approach with different aims. In line with the research done by Bitcoin Layers, we have defined three buckets: rollups, sidechains, and state channels.

Rollups:

A rollup is a Layer 2 scaling solution that compiles many transactions off-chain and batches them into a single piece of data to broadcast to the Layer 1 blockchain. In turn, transactions on the L2 are not subject to fees on an individual basis, creating great opportunities to improve efficiency and lowering transaction costs for users. Rollups were first described by Vitalik Buterin, the founder of the Ethereum Foundation, as a scaling solution to Ethereum. Within rollups, there are two primary approaches to implementation: optimistic and zero- knowledge.

Optimistic rollups bundle multiple off-chain transactions together and publish them to the Layer 1 blockchain. To save on data and computational costs, optimistic rollups begin with the assumption that all transactions are valid when they are published to the Layer 1 blockchain. If all the included transactions are – in fact – valid, then the published transactions remain on the Layer 1 and nothing more needs to be done. However, in the case where invalid transactions are included, optimistic rollups utilize a fraud-proof mechanism to invalidate any incorrect data. The fraud-proof mechanism allows any user to dispute a transaction and, if successful, the rollup must re-execute the transactions and update its own state accordingly. While optimistic roll-ups increase Layer 1 scalability, they do make a security tradeoff with respect to time as transaction finality does not occur until the end of the challenge period (typically seven days).

While optimistic rollups rely on rational economic actors to invalidate fraud transactions through the fraud-proof mechanism, zero-knowledge rollups attempt to reach consensus on a batch of transactions differently, relying on complex cryptography known as validity proofs. The validity proof provides cryptographic assurance that the batch of data proposed by the node is the result of the batch of transactions included in the rollup. Therefore, there is no delay in finality when using a zero-knowledge proof as there is no fraud-proof dispute mechanism.

Sidechains:

A sidechain is a separate blockchain that is connected to the Layer 1 blockchain with a two- way bridge. This bridge acts as a peg-in and peg-out mechanism allowing users to move from the Layer 1 blockchain to the sidechain and vice versa. Sidechains may rely on the original blockchain’s security through techniques such as merged-mining or they may have their own security model.

State Channel:

A state channel is a blockchain scaling solution that facilitates transactions outside the main blockchain. The “state” refers to the data stored on the blockchain where “channel” refers to the communication that takes place off-chain. For instance, say Alice and Bob open a state channel on Bitcoin and fund it with one bitcoin. They simply create a 2-of-2 multi-signature transaction on Bitcoin – a transaction that is only valid if both users sign the transaction with their private keys. This creates a new “state” on the blockchain. The channel is then incrementally updated each time they transact. Say Alice sends Bob 0.1 bitcoin. Later, Bob sends Alice 0.3 bitcoin. The channel tracks the net balance between the two of them ensuring cheap and fast payments.

The Bitcoin blockchain will show the “state”, where they collectively own one bitcoin, whereas the channel will allow them to spend up to one bitcoin back and forth until they decide to settle the transaction and update the “state” displayed on the bitcoin blockchain.

Conclusion

Bitcoin developers have typically viewed their role as one of maintaining a project adverse to change. Every proposal to improve Bitcoin comes under great scrutiny and often the conversation is focused around ‘what potential harm could come with this’ opposed to ‘what benefits could this unlock.’

Following the taproot soft fork in November 2021, the conversation began to shift and quietly the groundwork was laid for more innovation from the developer community. The turning point was highlighted with the breakout project Ordinals in January 2023. This unlocked use cases typically earmarked for other blockchains.

Despite the conservative cohort known as bitcoin maximalists, whose belief is that bitcoin should only be used as a money, the Overton window has shifted. Excitement is building on the world’s oldest blockchain. Developers who shied away from the limitations of Bitcoin’s scripting language (code) are now building exciting new applications never before seen on Bitcoin. These developers working on a new era for bitcoin are hoping to unlock utility for an immense decentralized user base that represents over half the total value of all crypto. How this era develops, and what is created is still very much unknown. While this report provides a high-level overview of the Layer 2 development occurring on Bitcoin, we plan to publish two subsequent reports to take a deeper dive: one on the technology being developed and another on the applications that utilize this new technology on Bitcoin.