Since its inception in 2009, The Bitcoin network has revolutionized how we think about digital currencies and decentralized finance. However, as the number of transactions and users on the Bitcoin network increases, its scalability is becoming a major concern. To address this issue, Layer 2 scaling solutions have emerged, which aim to increase the network’s transactional capacity without compromising its security or decentralization.

The implementation of these solutions has opened up a world of opportunities for Bitcoin, providing faster and cheaper transactions, and enabling the development of decentralized applications on top of the network. In this research article, we will explore the technical details of Bitcoin Layer 2 networks, their benefits, and how they compare to other scaling solutions. Let’s delve deeper into this exciting new world of possibilities together.

Key Takeaways

• Layer 2 solutions are designed to improve the scalability of Bitcoin by allowing faster and cheaper transactions to be processed off-chain reducing congestion on the main blockchain and improving overall network health.
• The Lightning Network represents a solution to Bitcoin’s slow throughput without compromising the security of the Bitcoin Network. Utilizing the Lightning Network, millions of people can send fractions of a bitcoin at instant speed.
• The adoption of Layer 2 solutions like Lightning Network is crucial to their success, enabling more users to transact using Lightning channels and increasing the network’s usage and adoption. The Lightning Network has enabled Bitcoin payments in El Salvador and Bitcoin tips on Twitter, among other use cases.
• Layer 2 solutions like Stacks and Rootstack add new functionalities built on top of the Bitcoin network, introducing Smart contracts and facilitating the creation and use of non-fungible tokens (NFTs), decentralized finance (DeFi) applications, and various other web3 applications.
• While Layer 2 solutions offer numerous benefits, including faster and cheaper transactions, they are not without challenges. For example, the Lightning Network requires users to have the liquidity to fund payment channels, which could limit its adoption by users who do not have enough Bitcoin. Additionally, Layer 2 solutions may pose centralization risks if users rely heavily on a few large, centralized nodes to process transactions.

Bitcoin is one of the most popular cryptocurrencies with a market capitalization of over $540B. However, its performance metrics are not on par with other blockchain solutions and traditional payment systems like Visa and Mastercard. Bitcoin’s current theoretical maximum transactions per second (TPS) is 10 TPS, though in reality it is between 3 and 7 due to the limited block size of Bitcoin. This is relatively low compared to other Layer 1 (L1) blockchain networks. For instance, Ethereum’s current TPS is around 12–15, while newer L1 blockchains like Aptos and Solana can handle 120,000+ TPS theoretically.

Moreover, Bitcoin’s average transaction fees are higher compared to other L1s. According to Blockchair, the average transaction fee on the Bitcoin network is currently around $2.34. In contrast, L1 networks like BNB Chain and Aptos average transaction fee is less than $1.

Another performance metric to consider is the confirmation time for transactions. Bitcoin’s confirmation time can take up to 10 minutes or more, depending on the network’s congestion. In contrast, newer L1 blockchains like Aptos can confirm transactions within seconds.

When compared to traditional payment systems like Visa and Mastercard, Bitcoin’s performance metrics are significantly lower. Visa, for instance, can handle up to 24,000 transactions per second, while Mastercard can handle up to 10,000 transactions per second.

Despite being one of the most well-known and widely used cryptocurrencies, Bitcoin has faced increasing criticism over its scalability and transactional capacity. However, the emergence of Layer 2 scaling solutions has provided a potential solution to these issues, allowing for increased transactional throughput without compromising the network’s security or decentralization.

Bitcoin Layer 2

Layer 2 (L2) is a network or channel that sits on top of a Layer 1 (L1) network like Bitcoin or Ethereum. L2s are designed to enhance the speed and reduce the cost of performing transactions on a blockchain.
L2s improve blockchain scalability by reducing the number of nodes or participants required to validate transactions within the L2 network, thereby reducing the time it takes to achieve consensus.

Bitcoin Layer 2 are scaling solution built on top of the Bitcoin blockchain, which enables users to carry out faster, cheaper, and more efficient transactions. The basic idea behind Layer 2 is to reduce the number of transactions that need to be validated by the Bitcoin network by moving them off-chain and settling them on the main blockchain when necessary. The Layer 2 approach to scaling allows for a large number of transactions to take place without clogging the Bitcoin network and slowing down the system.

Different types of Layer 2 solutions

The three main types of Layer 2 solutions include:

1. State Channels

State channels have gained significant popularity as a Layer 2 solution for Bitcoin, largely due to the success of the Lightning Network, which is a Layer 2 solution on the Bitcoin network. This approach is optimized for handling micropayments and other high-speed transactions that require efficiency.

State channels operate by creating an off-chain communication channel between two or more parties. Within the channel, these parties can conduct transactions as frequently as they like, with the final balance recorded on the main chain when the channel is closed. This allows for quick, cost-effective transactions, making it ideal for small businesses that receive multiple payments from the same clients.

2. Rollup Chains

Rollups work by bundling multiple off-chain transactions into a single transaction, recorded on the main chain. Rollups rely on a certain type of “proof” for transactions that allows the main chain to verify their correctness, and they can be implemented in two ways: Optimistic (fraud proofs) and Zero Knowledge (validity proofs).

Optimistic rollups assume that all transactions are correct and only need to interact with the main chain when there is a problem. They rely on fraud proofs that demonstrate a transaction has been processed incorrectly or maliciously and are submitted to the main chain as evidence of fraud. If validated, the transaction is reverted, and the fraudulent party is penalized. Examples of optimistic rollups include Optimism and Arbitrum networks on the Ethereum blockchain.

Zero Knowledge rollups (ZK-rollups) use cryptographic proofs (validity proofs) to ensure the correctness of off-chain transactions. These proofs are generated by performing complex computations that verify the validity of transactions without exposing the transaction details, making ZK-rollups one of the more secure and private Layer 2 solutions. Examples of ZK-rollups include zkSync.

3. Sidechains

Sidechains provide an alternative solution by allowing assets to be transferred from the main chain to an independent “side” chain using a 2-way-peg (or bridge), where they can be transacted freely within the network. Sidechains have emerged as a viable option for a wide range of use cases, including building DeFi applications and implementing smart contracts. Additionally, Sidechains can also have other Layer 2 solutions such as Rollups built onto them, making them a flexible option for scaling.

While Sidechains operate independently from the main chain, they still rely on their own set of validators to secure their network. By using the 2-way-peg, Sidechains can tie their transactions back to the main chain. Although the industry tends to disassociate Sidechains from Layer 2 solutions, developers can implement measures such as merged mining with Bitcoin to tie the Sidechain to the main chain. Polygon and Rootstock are some examples of Sidechains that are currently in use.

Benefits of Layer 2 Solutions for Bitcoin

Layer 2 solutions offer several benefits over the main Bitcoin Layer 1 blockchain, including:

• Scalability — Layer 2 solutions primarily aim to enhance scalability by facilitating faster and cheaper transactions while maintaining the integrity of the main blockchain. By enabling off-chain transactions, they also alleviate congestion on the main Bitcoin blockchain, allowing for more transactions to be processed and improving the overall health of the network.
• Lower transaction fees — Bitcoin transactions are processed by decentralized validators called “Miners”. As the network gets more congested, Miners prioritize higher fee transactions. In 2021, fees peaked at $62 per transaction, highlighting the need for scaling solutions. Layer 2 transactions occur off-chain, enabling more transactions with fewer computational resources, and lowering costs.
• Flexibility — Layer 2 solutions are very flexible and can be customized to suit specific needs. This makes them useful for developing new features and applications on top of the Bitcoin network.
• Improved privacy — Bitcoin transactions are recorded on a public blockchain, which means that transaction details can be accessed by anyone with an internet connection, the blockchain itself is secure and anonymous. However, it is possible to link a person’s identity to their wallet address by analyzing transaction patterns. To address this issue, some Layer 2 solutions implement privacy features to offer users a greater degree of anonymity and security.

Several Layer 2 solutions have been developed for Bitcoin, including the Lightning Network, Stacks, and Rootstock. In this paper, we will focus on these Layer 2 solutions as these are the most widely adopted and successful Layer 2 solutions for Bitcoin.

Lightning Network

Proposed in a white paper in 2016, The Lightning Network (also referred to as Lightning or LN) is a scalability solution built on top of Bitcoin that allows users to quickly send and receive BTC with very low transaction fees. Lightning is considered to be an off-chain Layer 2 solution, meaning that transfers are done via a new network of payment channels anchored in Bitcoin’s blockchain.

The Lightning Network’s architecture consists of two main components: nodes and payment channels. Nodes are computers that run the Lightning Network software and maintain a copy of the Lightning Network’s payment channel network. Payment channels are the two-way payment channels between two parties that allow for fast and cheap Bitcoin transactions.

Lightning Network aims to solve Bitcoin network limitations by providing instant and inexpensive transactions while achieving a throughput of approximately 1 million transactions per second theoretically. The Lightning Network charges incredibly small fees, with a base fee per transaction of 1 Satoshi (or 0.00000001 BTC), roughly the equivalent of US$0.00028. While Lightning can be used for any type of transfer, most find it useful for micropayments or smaller transfers that are typically uneconomical due to base layer fees.

Lightning Network stats

The Lightning Network has seen steady growth since its launch in 2018. One key measure of growth is the number of nodes on the network. As of March 2023, there are over 84,498 Lightning Network active channels, with around 11,992 online nodes.

The Lightning Network’s capacity has also been increasing steadily. The total capacity of the Lightning Network has reached over 5,490 BTC, worth over $147 million. This is a significant increase from the early days of the network when the total capacity was just a few hundred Bitcoin. This capacity growth indicates that the Lightning Network is becoming a more attractive option for users who want to transact Bitcoin quickly and efficiently.

The Lightning Network’s ability to process transactions quickly and efficiently is essential for micropayments and small transactions, which are often not feasible on the Bitcoin blockchain due to high transaction fees and slow confirmation times.

The Lightning Network’s ability to offer faster, cheaper, and more scalable transactions has made it an increasingly popular solution for businesses and individuals alike. One notable example is Strike, a payment service that uses the Lightning Network to enable Bitcoin payments in El Salvador. Another example is Twitter, which adopted the Lightning Network to allow users to send and receive Bitcoin tips on its platform in 2021.

The Lightning Network’s ability to mitigate the challenges faced by the Bitcoin mainnet has opened up new possibilities for the adoption and use of Bitcoin as a global digital currency.

The widespread adoption of the Lightning Network is key to its success as a Layer 2 solution. With more users transacting using Lightning channels, the network’s usage, and adoption continue to grow. In recent years, the Lightning Network has seen significant adoption within the Bitcoin community. Many wallets and exchanges now support Lightning transactions, making it easier for users to send and receive Bitcoin quickly and at lower fees.

Additionally, the integration of Lightning Network-based payment services, such as Strike, has enabled businesses and individuals to utilize Bitcoin for everyday transactions. This growing adoption is a testament to the Lightning Network’s potential to provide a scalable and efficient solution to the challenges facing the Bitcoin network.

Lightning Network Ecosystem

The Lightning Network has rapidly emerged as Bitcoin’s primary scaling solution, experiencing remarkable growth in adoption and use cases. While still in its early stages, the Lightning Network is attracting an increasing number of companies and developers to build out a diverse range of solutions and use cases on top of the protocol.

These applications span various domains such as wallets, liquidity, payment solutions, social media, gaming, banking, rewards, and more.

As the Lightning Network continues to mature, it has the potential to revolutionize the way we use Bitcoin and enable a wide range of innovative applications.

Stacks

In 2017, two Princeton alumni Muneeb Ali and Ryan Shea co-founded a blockchain project called Blockstack. In 2020, the project was rebranded as Stacks and has since gained significant attention in the blockchain space. Stack’s development began after the company raised $50 million through a token offering.

Stacks is a unique layer-2 blockchain protocol that’s built on top of the Bitcoin network, providing a new way to add functionality to the Bitcoin network without changing any of Bitcoin’s existing features. The protocol enables self-executing smart contracts, opening up the possibility for decentralized applications and other innovative use cases. This is made possible by Stacks’ innovative consensus mechanism, known as Proof-of-Transfer (PoX), which uses Bitcoin’s security to secure the Stacks network.

Proof-of-Transfer Explained

Crypto networks use a consensus mechanism to secure the blockchain. Two of the most commonly used consensus mechanisms are Proof-of-Work (PoW) and Proof-of-Stake (PoS).

Proof-of-Transfer is a unique consensus mechanism that leverages the security of an existing blockchain, such as Bitcoin, to secure a second blockchain, like Stacks. PoX accomplishes this by allowing miners to transfer the native cryptocurrency of the parent blockchain to the child blockchain in exchange for mining rewards. The transferred cryptocurrency acts as “proof” of work, demonstrating that the miner has expended resources to obtain it. This approach allows PoX to leverage the security and hash power of an established blockchain, while still maintaining its independent network.

Proof-of-Transfer offers an innovative and sustainable solution to Bitcoin’s scalability and programmability challenges. Unlike other solutions that consume additional energy, Stacks miners leverage Bitcoin’s existing Proof-of-Work (PoW) consensus algorithm by transacting Bitcoin. By doing so, they create new Stacks blocks and enhance the scalability of the network without adding any additional burden on the environment.

Although Stacks builds on top of Bitcoin, it is not a second-layer technology designed to increase Bitcoin’s transaction throughput. Instead, it aims to bring new functionalities to Bitcoin’s base-layer blockchain.

Stacks achieves this by implementing a mechanism called microblocks, which enables increased transaction throughput and speed. Stacks blocks that are confirmed simultaneously to Bitcoin blocks are called anchor blocks, which occur every 10 minutes on average according to Bitcoin’s mining algorithm. In between these anchor blocks, Stacks allows for the creation of microblocks that facilitate rapid settlement of Stacks transactions with a high degree of confidence. Transactions incorporated into microblocks get confirmed once the associated anchor block has been approved, enabling the Stacks blockchain to achieve scalability.

By utilizing microblocks, Stacks overcomes the network limitations of the Bitcoin blockchain and provides a fast, scalable, and efficient solution for executing Bitcoin smart contracts that utilize the Clarity programming language (a smart contract programing language designed specifically for Stacks), processing transactions, rewarding miners, and enabling its holders to earn BTC via a process known as stacking. This approach enables the Stacks blockchain to achieve scalability, making it a viable option for developers looking for an efficient and scalable blockchain solution.

Stacks ecosystem

At the heart of the Stacks ecosystem is its native digital token, STX. The token is used to execute Bitcoin smart contracts that are built using the Clarity programming language. Additionally, STX powers transactions on the Stacks network, rewards miners, and enables token holders to earn Bitcoin through stacking. As of the time of writing, STX has a total market capitalization of over $1.2 billion and is priced at around $0.89.

In recent weeks, the token’s value has increased as more market participants have become interested in creating Bitcoin NFTs using the Stacks layer-2 protocol. The Stacks ecosystem has inherent functionality that enables the creation of NFTs, and according to Muneeb Ali, one of the co-founders of Stacks, there have already been 650,000 Bitcoin NFTs minted on the Stacks layer-2.

The total value locked (TVL) in the Stacks ecosystem has also experienced a significant surge, rising from $14 million in February to $60 million in mid-March, as per data from DeFiLlama. However, it has since decreased to $47 million.

The Stacks ecosystem and community include a growing number of dApps such as Alex, Arkadiko, Gamma, etc., and a thriving community of developers and contributors. The community is actively working to build out the Stacks ecosystem and promote the adoption of Stacks-based dApps and services.

Here are some notable projects being built on Stacks.

The Stacks layer-2 protocol offers several advantages to developers, as it can facilitate the creation and use of non-fungible tokens (NFTs), decentralized finance (DeFi) applications, and various other web3 applications. Additionally, Stacks is slated for an upcoming upgrade later this year, which will improve its speed and scalability even further ushering in a new era of Bitcoin innovation.

Rootstock

Rootstock, also known as RSK is a general-purpose smart contract platform secured by the Bitcoin network. Rootstock was created by RSK Labs to overcome Ethereum’s limitations by leveraging Bitcoin’s unmatched stability, security, and economic power. RSK allows for the porting of smart contracts from Ethereum, enabling Ethereum applications to become compatible with the Bitcoin blockchain. Additionally, RSK offers faster transaction speeds that are approximately 10 times faster than Ethereum, with gas fees that are 50 times cheaper.

Key Features of RSK

In this section, we will explore how the RSK blockchain works, focusing on its unique features and advantages. Specifically, we will delve into the concept of merged mining, the Powpeg protocol, and the RSK Virtual Machine (RVM) that enables interoperability with Ethereum.

Merged Mining:

To increase efficiency and security, the RSK blockchain utilizes merged mining, which allows miners to generate RSK blocks while mining Bitcoin simultaneously. This is possible because both blockchains use the same Proof-of-Work (PoW) consensus algorithm. Miners contribute hash rate to mine blocks on RSK, and these blocks are validated, bundled, and sent to the Bitcoin network. The process of merged mining increases profitability for miners without requiring additional resources.

POWpeg:

RSK uses smartBTC (RBTC) as its asset and gas token, which is issued at a 1:1 ratio against BTC locked on the Bitcoin network. The Powpeg protocol facilitates the transfer of BTC to and from the RSK blockchain. Transferring BTC to RSK requires locking the corresponding BTC amount into a vault on the Bitcoin network while transferring BTC back to Bitcoin requires sending an amount of RBTC to a smart contract on RSK.

RSK Virtual Machine (RVM):

One advantage of RSK is its interoperability with Ethereum smart contracts. RSK Virtual Machine (RVM) is based on the Ethereum Virtual Machine, enabling the execution of Ethereum smart contracts on RSK. Developers can use the same code, tooling, and libraries when building RSK applications. This gives the Ethereum community a cheaper, faster alternative for interacting with their favorite dApps. Solidity, the same smart contract programming language used on Ethereum, can also be used for coding RSK applications.

Benefits of the RSK Network

Smart contracts

RSK offers fully autonomous smart contract functionality that eliminates the need for intermediaries to facilitate transactions. This feature is not natively available on Bitcoin’s base layer due to its limited programmability, but RSK’s implementation allows developers to build decentralized applications on top of the robust Bitcoin network.

Scalability

RSK is a blockchain designed to improve the scalability of the Bitcoin network. Transactions on RSK are confirmed, bundled, and then sent to the Bitcoin base layer for final settlement. This bundling mechanism increases Bitcoin’s throughput, thereby enhancing the network’s ability to accommodate a greater number of users, applications, and transactions.

Near-instant settlement

Compared to Bitcoin’s block time of 10 minutes, RSK generates new blocks in just 33 seconds, making it significantly faster. Additionally, RSK boasts a transaction processing speed of 10–20 transactions per second (tps), which is substantially higher than Bitcoin’s capacity of about 3–7 TPS.

RSK Ecosystem

The RSK network aims to create a more accessible and inclusive financial system on the world’s most prominent blockchain, Bitcoin. With the RSK Virtual Machine (RVM), developers can build new decentralized applications (dApps) or expand on their existing Ethereum applications seamlessly. Some dApps already on RSK include:

RSK has been designed to enhance the scalability of Bitcoin and enable DeFi applications. With the help of Powpeg and merged mining, users can securely access smart contracts on RSK using their BTC. This allows Bitcoin holders to explore a new decentralized finance ecosystem built on top of Bitcoin using RBTC. Additionally, RSK supports EVM, making it simple for users and developers to interact with Ethereum smart contracts. Furthermore, RSK enhances Bitcoin’s performance by enabling faster and more efficient transactions than its base layer.

Bitcoin Smart Contracts and NFTs

Recent developments in Bitcoin layer 2 networks have brought about exciting new possibilities for smart contracts and NFTs on the Bitcoin blockchain. Smart contracts have become a defining feature of the blockchain ecosystem, particularly within the Ethereum community. However, in comparison to Ethereum’s extensive smart contract ecosystem, Bitcoin’s usage of smart contracts has been somewhat limited.

Nonetheless, with the advent of layer 2 solutions, there is growing interest in the potential for smart contracts on the Bitcoin network. Recently, the launch of Ordinals, which unlocked NFT-like functionality for Bitcoin users, has sparked renewed interest in Bitcoin’s potential for smart contract applications. This has been further amplified by the rise of the Stacks smart contract protocol.

Compared to Ethereum, the infrastructure for Bitcoin NFT trading is still in its early stages and lacks development, especially in terms of decentralized trading. Several investors have expressed the need for marketplaces and NFT minting platforms to be created for Ordinals.

The Bitcoin developer community has previously discouraged using the network for anything other than payments because it clogs the space and increases transaction fees. The adoption of Ordinals will again be subject to the social acceptance of the method to inscribe additional data on the Bitcoin blockchain, which is bound to present challenges such as network congestion and increased fees.

However, the number of Ordinals inscribed on Bitcoin surged significantly at the start of February this year as the instrument exploded. The trend slowed down due to a lack of trading infrastructure, with less than 15,000 NFTs inscribed on most days.

Ordinals are still a new phenomenon and have gained a lot of traction recently. While some are optimistic about the potential of Ordinals and other layer2 protocols to enhance the functionality of Bitcoin, others remain skeptical about the impact of these developments on the network’s long-term viability, it remains to be seen how the Bitcoin community will react to the potential challenges posed by increased NFT activity.

Challenges of Bitcoin Layer 2 solutions

Layer 2 solutions offer several advantages to the Bitcoin network, including improved scalability, faster and cheaper transactions, and increased privacy. However, several challenges remain that need to be addressed, including:

Centralization risks — Layer 2 solutions like the Lightning Network create a network of payment channels centralized around nodes with more Bitcoin, with this architecture there is a risk that users will rely heavily on a few large, centralized nodes to process their transactions. This concentration of power could pose a security risk, as a small number of validators would control all the transactions on the Layer 2 network. To mitigate this risk, efforts are being made to promote the use of decentralized nodes and incentivize network participation.

Limited smart contract functionality — Bitcoin was not originally designed as a smart contract platform, and some Layer 2 solutions that are specifically designed for smart contract-enabled platforms may not be readily available for Bitcoin. However, efforts are being made to develop Layer 2 solutions that can enable more sophisticated functionality.

Complexity — While Layer 2 solutions have the potential to improve Bitcoin usability, they are currently more complex to interact with than the main Bitcoin network. To use Layer 2 solutions, assets from Bitcoin must be bridged to the Layer 2 network, which can be a challenging process for even experienced crypto users. Efforts are being made to simplify this process and make Layer 2 solutions more accessible to a wider range of users.

Liquidity — Solutions like the Lightning Network which relies on liquidity to open payment channels could limit its adoption by users who do not have enough Bitcoin to fund channels. However, there are ongoing efforts to address these liquidity issues.

Conclusion

Bitcoin Layer 2 solutions offer a promising approach to addressing Bitcoin’s scalability challenges. By moving transactions off-chain and settling them only when necessary on the main Bitcoin blockchain, Layer 2 solutions enable faster, cheaper, and more efficient transactions. The Lightning Network, in particular, has shown great potential in enabling fast and cheap Bitcoin transactions, while also offering more privacy and allowing for micropayments.

However, there are still some challenges that Bitcoin Layer 2 solutions face, including the complexity of setting up payment channels, reliance on the main Bitcoin blockchain for security, and the risk of bugs and vulnerabilities. It is important to note that Layer 2 solutions are still in their early stages of development, and more research and testing are needed to ensure their security and reliability.

Overall, Bitcoin Layer 2 solutions offer a promising solution to Bitcoin’s scalability challenges, and they have the potential to greatly enhance the usability and accessibility of Bitcoin for users around the world. With ongoing development and improvements, Bitcoin Layer 2 solutions are likely to play a significant role in the future of Bitcoin and cryptocurrency as a whole.

Further Reading

lightning network paper

Community

Docs.stacks.co

RSK whitepaper

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Disclosure

The material above has been prepared by BTS Ventures and is intended for information purposes only. This material is not intended to be relied upon as investment or forecast advice. This article does not recommend or suggest buying or selling any cryptocurrencies, or implementing any type of investment strategy. BTS Ventures research derived this information and opinions from proprietary and nonproprietary sources it considers to be reliable. They aren’t necessarily all-inclusive and can’t be guaranteed to be completely accurate. Always remember to Do Your Own Research (DYOR) and tread carefully.

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