How Bitcoin L2s Can Unlock a Huge Crypto Market Without Sacrificing BTC’s Core Principles

As the global Bitcoin and crypto adoption continues, Layer 2 solutions can unlock a significant share of the crypto market. Here’s all you need to know about Bitcoin L2s.

What are Bitcoin L2s

Bitcoin Layer 2 solutions are secondary protocols built on top of the Bitcoin blockchain.

L2s have been developed to combat various challenges of the original BTC design, some of them related to scalability, high fees, and slow transaction times.

Advantages of Bitcoin L2s

Bitcoin L2s enhance the Bitcoin network by:

• Processing transactions off the main blockchain by creating a separate execution layer
• Increasing transaction throughput
• Maintaining security
• Enabling new features such as smart contracts
• Boosting scalability
• Expanding Bitcoin’s use cases

The L2 definition ranges from trusted solutions (sidechains) to trust-minimized solutions (ZK rollups) and more specialized protocols (payment channels).

Bitcoin L2s vs. Ethereum L2s

In trying to understand Bitcoin L2s, some people reason by analogy to Ethereum L2s (scaling solutions on top of Ethereum), which leads to some incorrect conclusions including the following:

1. Underestimating the market size – Bitcoin’s lack of programmability on L1 means that programmable L2s could bring a larger market opportunity vs. Ethereum L2s.
2. Missing the element that determines the “winner” – Security will matter more/earlier for BTC L2s compared to ETH L2s.
3. Underestimating what is possible to build – Recent breakthroughs have unlocked the ability to build Bitcoin ZK-rollups with optimistic ZK bridges (carrying a 1 of n trust assumption); potential future upgrades could make them fully trustless (enabling direct ZK verification and removing the 1 of n).

ZK-rollups support increased blockchain scalability by moving computation and state off-chain while storing transaction data in bundled-up batches on-chain.

Below, we’ll address the three misunderstandings.

1. Underestimating the Total Addressable Market (TAM)

TAM is also referred to as the total available market and it’s the overall revenue opportunity that is available for a product/service if 100% market share is achieved.

Bitcoin L2s present a larger market opportunity compared to Ethereum L2s due to the following reasons:

• Bitcoin’s larger market cap
• ETH L2s are for scaling – ETH L1 has fully programmable execution, being home to a more valuable state than its L2s; L1 is also starting to scale execution, and L2s enable the same use cases just faster and cheaper.
• BTC L2s are for scaling and programmability – Bitcoin L1 lacks programmability, needed to unlock robust privacy, better self-custodial UX, and basic BTC DeFi.

Most market participants use ETH L2s as their mental model for BTC L2s, but the current comparison is to ETH L1. Also, the winning BTC L2 will be Bitcoin’s execution layer.

A programmability functionality is valuable and L2s offer the opportunity to build it. This is important because execution layers demonstrate extreme power law distributions:

• Ethereum – ETH L1 facilitates most of the valuable ETH execution, dominating metrics such as REV, DeFi TVL, and stablecoin issuance.
• Bitcoin – As L1 lacks programmability, the dominant BTC execution layer must be an L2, and the only question is which L2 it will be.

Bitcoin’s leading execution layer:

• Must meaningfully boost BTC’s functionality (unlock better privacy, self-custody UX, and basic DeFi)
• Must not meaningfully sacrifice BTC’s strengths (secure self-custody, seizure resistance, and permissionless use)

2. Missing the Element that Determines the Winner – Security

All of the above highlights that security is essential and it’s a mistake to consider that high security will not matter for BTC L2s, because it hasn’t for ETH L2s.

Drawing conclusions from the usage patterns of current ETH L2s users is misleading and security will matter more and earlier for BTC L2s compared to ETH L2s. This is not due to the divergent risk profiles of BTC and ETH users, as both groups have comparable sensitivity to security risks.

Overall, low security means high risk which translates into a high cost of capital, which means less capital. We can conclude that higher security means more capital.

Some users even see holding ETH ETFs as a more secure solution compared to simply holding ETH. This means that security is holding back serious capital from L2s.

Bitcoin’s programmable execution layer presents a huge market with a few competitors because building on BTC is hard work. This leads to the next issue – underestimating what’s possible to build on BTC.

3. Underestimating What’s Possible to Build

Bitcoin’s leading L2 solution will have to be as close as possible to Bitcoin itself.

As explained above, security is essential, so building L2s with require the team at the forefront of Bitcoin scaling research and development.

Bitcoin culture is vital as well, and the team will have to include serious Bitcoiners who have been working for years to fulfill Bitcoin’s vision.

Common approaches to Bitcoin L2s solutions include the following:

• State Channels – Used by the Lightning Network, allowing two parties to conduct numerous transactions off-chain, and only the final state is recorded on the blockchain, enhancing speed and reducing costs.
• Sidechains – These operate as separate blockchains pegged to Bitcoin; an example is Liquid Network which enables faster transactions and additional features, periodically settling on the Bitcoin main chain.
• Roll-ups – These bundle multiple off-chain transactions into a single transaction, creating a cryptographic proof of validity submitted to the Bitcoin blockchain for settlement.

Challenges of Bitcoin L2s

Some of the biggest challenges that Bitcoin L2s face are the following:

Secure bridging between BTC and L2s

Bitcoin L2s such as sidechains use bridges to connect with the Bitcoin main blockchain. These bridges work by locking assets on Bitcoin and minting equivalent tokens on the L2 chain.

This bridging design has security risks and UX issues potentially leading to hacks and losses.

Speed and Cost of Settling on Bitcoin

L2 solutions process transactions off-chain, and they need to settle the final state on the Bitcoin main chain.

The speed and costs of the settlement process on Bitcoin’s base layer are important factors that impact L2s’ efficiency.

Maintaining Security Without Direct Bitcoin Validation

Bitcoin L2s must rely on their own independent security protocols, which makes it challenging to achieve a high level of security as Bitcoin’s base layer.

Bitcoin L2s do not entirely inherit security from Bitcoin’s nodes which validate transactions.

Centralization Risks

Some L2s require establishing payment channels and relay nodes or running their own consensus mechanism.

This can lead to the concentration of control in the hands of just a few entities, which opposes the decentralized principles of Bitcoin.

Technical Complexities/Integration Challenges

Integrating L2s with Bitcoin’s existing infrastructure involves tech complexities including:

• Ensuring compatibility
• Maintaining high-security standards
• Achieving consensus with the community on proposed updates

Key Bitcoin L2 Projects

1. Lightning Network

This is the most popular Bitcoin L2 solution. It uses state channels to facilitate off-chain transactions between two parties, allowing for almost instant and cheap transactions, and enhancing Bitcoin’s usability for everyday payments.

Key features include:

• Low fees
• Off-chain transactions
• Instant payment settlements
• Boosted privacy

On January 30, Tether, the largest crypto company, announced that USDT launched on Bitcoin’s Lightning Network, paving the way for a new era in technology and opening the doors to a huge sector, supporting adoption.

2. Liquid Network

Developed by Blockstream, the Liquid Network, is a Bitcoin sidechain designed for fast and confidential transactions. This enables the issuance and transfer of assets, including Bitcoin and stablecoins, with low fees and quicker settlements compared to the main Bitcoin chain.

Key features include the following:

• 2-way peg for transferring Bitcoin
• Confidential transactions
• Asset issuance and management
• Fast settlement times

3. Stacks

Stacks is a unique L2 solution that integrates with the Bitcoin blockchain to enable smart contracts, dApps, and digital assets. It uses a consensus mechanism called Proof of Transfer (PoX) that anchors to Bitcoin for security. Stacks Network also integrates a native token, Stacks (STX).

Key features include the following:

• Smart contracts
• Proof of Transfer (PoX) consensus
• dApps
• Integration with Bitcoin’s security model

4. Strata

Alpen Labs is building Strata – a zkEVM rollup on Bitcoin with a hybrid optimistic-ZK bridge. The team has been working to scale and extend Bitcoin using zk-SNARKs since 2022.

Key features include the following:

• Zero-knowledge roll-up tech, reducing the computational load on the main chain
• BitVM bridge, ensuring interaction with Bitcoin without compromising security or requiring 3rd party trust
• Enhanced scalability, increasing Bitcoin’s transaction throughput by employing ZK roll-up tech
• Security and decentralization

Bitcoin is already at the center of the crypto industry, having all the necessary features to win: it is the first digital asset with an anonymous founder and a fixed supply.

Building Bitcoin L2s Without Sacrificing BTC Core Principles

Building Bitcoin L2s has to bring scalability and programmability to Bitcoin without sacrificing its core principles – self-custody, seizure resistance, and permissionless use.

There are two main types of Bitcoiners in the crypto industry:

• The ones whose main objective is for Bitcoin to have a positive impact on society
• The ones whose main objective is for the BTC price to go up, no matter what

The first group of Bitcoiners requires private, scalable, and easier use of Bitcoin to make a positive impact, and the second group wants to make Bitcoin better money, which leads to increased adoption and price.

However, both groups of Bitcoiners see a consistent security budget as an essential functionality.

L2s are one of the best paths to provide a consistent security budget for Bitcoin miners long-term as the block reward goes away.

Important Bitcoin use cases are possible via a proper Bitcoin L2, including BTC-backed loans, BTC-backed stablecoins, private and instant BTC payments, flexible, scalable BTC vaults, and more.

Surrounded by a lot of optimism and building efforts, Bitcoin is on the right path to a bright future.