Bitcoin: L2s on the Horizon
Bitcoin currently finds itself at a crossroads in its evolution. Layer 2 (L2) solutions built on top of the Bitcoin blockchain are growing in number and scale. These Layer 2 systems offer both promising advantages and potential drawbacks, contributing to the complex decision-making process facing all Bitcoin stakeholders.
About L2s
Layer 2 protocols are solutions built on top of a base network to help scale transactions and data. L2s serve as an extension augmenting their respective base layer or L1 networks. Layer 2 networks work by processing transactions in large bundles on their own before submitting proof of the transactions to the base layer. This process is commonly referred to as “off-chain” scaling, and it takes a massive load off the base network. This enables L1s to focus on security, decentralization, and data availability, while L2s handle scalability.
There are many contenders offering Bitcoin L2 solutions including; Drivechains, Kasar labs, Chainway, and Taproot Wizards. Existing solutions include Liquid and the Lightning Network.
Pros of Layer 2 Solutions:
Scalability: Layer 2 solutions can improve the scalability of the Bitcoin network. By enabling off-chain transactions and infrastructure, L2 systems can alleviate the congestion on the Bitcoin chain (L1), and allow new kinds of smart contracts and digital assets to be built on top of the Bitcoin base layer.
Lower Transaction Fees: Layer 2 solutions can provide relief from L1 transaction fees. This affordability can make Bitcoin more accessible and attractive for everyday transactions thereby retaining economic activity within the greater Bitcoin ecosystem as opposed to participants offloading transactions to cheaper faster chains like Litecoin, Stellar, or Dogecoin during periods of network congestion.
Enhanced Privacy: Some Layer 2 solutions provide improved privacy features by obfuscating transaction details.
Maintain Security: Security and decentralization are the core focus of the Bitcoin network. Since layer 2 chains are built on top, users can benefit from the security of the primary blockchain.
Cons of Layer 2 Solutions:
Centralization: A potential drawback of some Layer 2 systems is the risk of centralization. Depending on the design and governance of these solutions, they may become controlled by a small number of entities, which could undermine the decentralized nature of Bitcoin.
Security Concerns: This is by far the greatest concern. Layer 2 solutions introduce new layers of complexity and security considerations. If not implemented and audited correctly, they may introduce vulnerabilities that could be exploited by malicious actors. To implement many of the proposed L2 networks, the Bitcoin network will require a software upgrade in the form of a softfork.
Bitcoin Security: Past Issues
Every Bitcoin softfork and upgrade introduces risk and potentially broadens the attack surface of the Bitcoin protocol. We have witnessed Bitcoin issues arise over time, and it is important to acknowledge where we have been to clearly discuss paths forward. Here is a list of past security events of note:
8/15/2010: Block 74,638 an “overflow” bug allowed a malicious actor to create 92 billion bitcoin. The issue was addressed four hours later via a patch provided by Satoshi Nakamoto.
3/12/13: Block 225430 There was a severe issue with the compatibility between Bitcoin client 0.7 and the updated version 0.8, which caused the main chain to fork into two. Developers coordinated to get a large mining pool to revert the chain to prior software. This was controversial as it was seen to be a centralized action.
7/4/15: An error in the Bitcoin Improvement Proposal BIP66 (soft fork) upgrade lead to the Bitcoin chain splitting into two, until the “good” PoW took over.
11/14/21: Although not a security issue as of the time of writing, the Taproot upgrade permitted unanticipated on-chain activity including Ordinals. Ordinals allow for NFTs like Bitcoin Punks to be directly created on Bitcoin¹. Taproot is a friendly reminder that every update can bring with it unforeseen consequences.
With past as prologue, Bitcoin’s history provides a clear proverb; above all else, upgrade with care.
Ossification vs Dynamism
The Bitcoin community is split between two competing philosophies regarding the evolution of the network. On one side (Team Ossify) are those who advocate for leaving the base layer protocol unchanged, emphasizing the importance of maintaining Bitcoin's core principles of decentralization and security. They argue that tampering with the base layer risks introducing potential vulnerabilities and could jeopardize the trust that has been built around Bitcoin's unchanging core tenants. This group sees Bitcoin primarily as a store of value or digital gold, with the primary focus on preserving its scarcity and censorship resistance.
Conversely, another faction (Team Dynamism) within the Bitcoin community believes in allowing additional upgrades and prospective Layer 2 (L2) solutions to grow the Bitcoin ecosystem. This camp sees Bitcoin's potential to be more than a store of value but also a platform for many alternative use cases. They argue that scalability improvements and L2 solutions can enhance Bitcoin's utility for users and provide an additional source of revenue to miners².
Ultimately, the outcome will depend on the consensus and collaboration within the Bitcoin community, as well as the ability to address the concerns and goals of both sides.
Our View: Risk vs Reward
The proliferation of Bitcoin L2s is inevitable. While the sanctity of the base chain operation and security is paramount, L2 solutions are being built and shipped at an accelerating rate. There is a considerable market for broader activity backed by the preeminent security L1 Bitcoin. For instance, Ethereum based Defi is currently valued in the eleven figure range. With appropriate tooling, much of this activity could find its way to Bitcoin.
L2 revenue streams to Bitcoin miners will be increasingly alluring leading up to the halving. Miners are economic actors, and they will assess the trade-offs of all upgrades accordingly. It is hard to turn down revenue when you’re eyeing a 50% decrease in units sold in the next six months.
The Bitcoin ecosystem has an opportunity to grow and provide a platform for dozens of use cases backed by the strongest network security available. The requisite upgrades are not without risk, and perhaps the next upgrade should aim to be the last. Nevertheless, stasis can be a far greater risk, and as noted above, Bitcoin has never truly been a static network.
The rewards for becoming the blockchain of record for an international store of value, unit of account, ledger of record, and digital cash are in the tens of trillions. John Paul Jones, a vanguard of liberty said it best: “Those who will not risk, cannot win.”
¹Counterparty allowed early Bitcoin NFTs
²Ordinal miner revenue has reached >$100mm YTD
