Bitcoin Layer 2 Report: Bitcoin Layer 2s Set to Boom as Bitcoin Continues to Outperform
Show More
Quickly grasp the article's content and gauge market sentiment in just 30 seconds!
Key Takeaways:
Bitcoin’s outperformance and popularity heighten the development of Bitcoin Layer 2.
Bitcoin Layer 2s are booming, with sidechains dominant at the moment and ZK-rollups playing catch-up.
A few first movers might take up more market shares faster than newcomers.
Bitcoin Layer 2s are lagging behind Ethereum Layer 2s, but their community and ecosystem have been more vibrant since the introduction of Bitcoin-related protocols and Layer 2s.
Bitcoin Outperformance Leads to the Popularity of Bitcoin Layer 2
Bitcoin held by users on Bybit. Source: Bybit
Bitcoin trading volume as percentage of total trading volume on Bybit.Source: Bybit
There’s no denying that Bitcoin has been in the driver’s seat of the broader market rally since late September 2023, as evidenced by its ever-growing dominance. The Bitcoin dominance ratio was steady at approximately 40% in 2022, but began to climb in 2023 to a level of 51.1% (as of this writing on May 7, 2024).
The outperformance of Bitcoin, propelled by the approval of Bitcoin Spot ETFs in the U.S., has led to the popularity of Bitcoin trading as evidenced by the trading volume on Bybit, whose data suggests that BTC held by users increased by 18% on a month-on-month basis from March 2024 to April 2024. Moreover, the average trading volume percentage of Bitcoin as of total trading volume on Bybit has increased from 25.6% to approximately 31.8% as of the time of this writing. In our view, the popularity of Bitcoin trading has fueled the popularity of Bitcoin Layer 2s.
What is a Bitcoin Layer 2?
There is no consensus over the definition of a Bitcoin Layer 2. The term generally refers to a network that has a close connection with Bitcoin, aiming to improve Bitcoin's scalability, reduce transaction costs and add virtual machine programmability to the oldest blockchain network. In this article, we define Bitcoin Layer 2 as a separate blockchain network that connects to Bitcoin, either through bridges or other designs. Such platforms directly built on the mainnet of Bitcoin are referred to as Bitcoin protocols, including Runes and Ordinals.
For detailed information on Bitcoin Layer 2 definitions, please refer to this article.
Why talk about Bitcoin Layer 2 now?
Bitcoin Layer 2 is still at an early stage of development. Only a few projects worked on Layer 2 solutions for Bitcoin before they became popular in early 2024. Bitcoin Layer 2 solutions have come to the spotlight since the popularity of Ordinals and Stacks in Q4 2023.
The shift of focus into Bitcoin also comes as Bitcoin continues to outperform Ethereum and other alternative Layer 1s as of September 2023, when the industry started to see hopes of Bitcoin Spot ETF approvals. The approval of these Spot ETFs reduces regulatory risks facing the Bitcoin blockchain, which adds to its competitive advantage against Ethereum, whose own Spot ETF approvals are uncertain as of May 2024.
What’s more, against the backdrop of the successful implementation of Ethereum’s latest road map and the popularity of Ethereum Layer 2s, the Bitcoin community has begun to explore the possibility of more utility for Bitcoin with the help of rollups and sidechains, the Layer 2 solutions that have been battle-tested in the past few years of development with other Layer 1s such as Ethreum and Avalanche.
As Bitcoin continues to gain attention, let’s explore the existing landscape of Bitcoin Layer 2.
Who are the existing players in Bitcoin Layer 2?
According to BTCL2.INFO, there are currently 74 Bitcoin Layer 2 solutions, most of which have come into being in the past two quarters. Despite such a competitive sector, Bitcoin Layer 2s can generally be categorized based on the technology that each player adopts. In short, there are three solutions: state channels, sidechains and rollups. We’ll also cover Bitcoin-related protocols.
Bitcoin Layer 2 landscape. Source: Compiled by Bybit
State Channel
A state channel provides a solution for enhancing scalability and efficiency in cryptocurrency transactions. These networks establish separate channels between transacting parties, enabling off-chain communication and state updates. A new channel is created between the parties involved in a transaction, serving as a communication layer that allows the parties to exchange information and update the state of their wallets off the main blockchain. State changes such as balance variations are recorded within the channel itself.
Once the communication session is complete, the channel is closed, and the final state, including the updated wallet balances, is submitted to the Bitcoin mainnet as a single transaction. Bitcoin miners then verify and incorporate this transaction, updating the network's state accordingly.
The most prominent player is Lightning Network, which has been around since 2016 and endorsed by reputable Web 2.0 players, including Block’s Jack Dorsey. Major CEXs have also adopted the Lightning Network to reduce the transaction costs for users.
State Channel Advantages and Disadvantages.Source: Compiled by Bybit
State channels offer several advantages. They enable faster transactions, since parties don’t need to wait for block confirmations on the main blockchain. Additionally, by batching multiple transactions into a single submission, users can save on transaction fees, especially when conducting multiple transactions within a single session.
As highlighted in the above chart, in addition to the inherent security risk, Lightning Network’s capacity limitation prevents its mass adoption. Its capacity stands at $305 million as of the time of writing, which is a minuscule fraction of Bitcoin’s daily transactions on centralized exchanges.
Furthermore, the state channel is used for token exchange, which (due to the lack of a virtual machine) doesn’t have smart contract capability.
The new player in this field is RGB, a project that tries to add smart contract ability to Bitcoin by working with Lightning Network. Its team calls it a “partial-state smart-contract system” and offers the novel promise of addressing the inherent limitations of state channels. Yet, at the moment, we haven't seen the adoption of RGB's solution by major crypto primitives. That said, we’re excited to see how RGB might transform the state channel solution and provide a novel alternative to the more popular sidechains or rollup solutions.
On a separate note, both Lightning Network and RGB don’t have their own native tokens, and thus, retail users likely won't invest in these two solutions in the near future.
Sidechains
A sidechain is an independent network that operates its own consensus algorithm while maintaining communication with the main network.
To establish connectivity with the main network, sidechains employ bridges that facilitate asset transfers between the two networks. Smart contracts play a crucial role in governing the locking and minting of assets, ensuring proper asset movement between the sidechain and the mainnet. The design of sidechains can vary significantly, with some operating their own security systems separate from the mainnet while others integrate the security features of the main network.
The more established players in this field include Stacks, Liquid Network and Rootstock for Bitcoin’s sidechain solutions, while BEVM, Bouncebit, ANVM and Map Protocol, among others, are rising stars.
Sidechain Project | Features | TVL | Tokens | Market Capitalization (Market Cap) |
Stacks | Largest sidechain solution; proof-of-transfer; EVM compatible | $135 million | STX | STX’s market cap is $3.3 billion |
Liquid Network | Aims to be a settlement layer for exchanges; no virtual machine; L-BTC used in the sidechain | n/a | n/a | n/a |
Rootstock | Merge mining; virtual machine | $190 million | n/a | n/a |
BEVM | Uses BTC as gas on the sidechain | $0.94 million | n/a | n/a |
ANVM (or AlLayer) | AI-driven and EVM compatible sidechain | $654 million | n/a | n/a |
BounceBit | Staking and EVM compatible | $492 million | n/a | n/a |
Map Protocol | Cross-chain interoperability | $110 million | n/a | n/a |
Bitcoin sidechain solutions.Source: Compiled by Bybit via DefiLlama and BTCL2.INFO
There are variations among these sidechains. Generally speaking, new solutions offer more comprehensive solutions, such as more advanced and Ethereum-compatible virtual machines, while the old players, such as Liquid Network, don’t own virtual machines. What’s more, some solutions introduce native tokens such as Stacks, while some adopt Bitcoin as gas tokens, such as Rootstock and BEVM. The adoption of a solution that’s more closely linked with Bitcoin is considered to provide greater security.
It’s interesting to note that the new project AILayer currently sits with the highest TVL among all sidechain solutions, possibly due to anticipation around its airdrop and excitement regarding artificial intelligence (AI).
Rollups
Rollups serve as an execution layer that works in conjunction with the Bitcoin network's consensus layer. Their main purpose is to enhance transaction processing. Rollup Layer 2 networks create an environment in which users can perform various operations. Transactions are organized into batches and sent to the mainnet's consensus layer for final settlement. A rollup batch can include up to 10,000 transactions, which are submitted as a single transaction to the mainnet's consensus layer for settlement. This bundling of transactions allows Layer 2 rollup networks to achieve faster speeds and reduced fees.
There are two types of rollups: optimistic rollups and zero-knowledge rollups. Optimistic rollups batch transactions without initial validation. However, there is a challenge period of approximately seven days to address security concerns. During this period, anyone can raise suspicions and provide proof of fraud to contest the rollup transaction. Once the challenge period expires, the batch is considered valid and is accepted on the Layer 1 chain.
Zero-knowledge rollups (ZK-rollups) conduct preliminary validations on each transaction using zero-knowledge validity proofs, eliminating the need for a challenge period. Consequently, transactions from ZK-rollups are instantly hashed onto the mainnet.
Optimistic Rollups | Zero-Knowledge Rollups |
Tuna Chain | Merlin Chain |
Rollux | SatoshiVM |
B2 Network | |
Elastos | |
Spectra Chain | |
Citrea |
Bitcoin Layer 2 rollup solutions. Source: compiled by Bybit
Ethereum’s ecosystem has been implementing both optimistic rollups and zero-knowledge rollups (ZK rollups) for a few years. Bitcoin’s Layer 2s benefit from the development, and there’s been a migration of those advanced Layer 2 technologies to the Bitcoin ecosystem.
It’s clear that ZK-rollups are more popular on BItcoin Layer 2s at the moment, likely due to their lower cost per transaction since there’s less data stored in each batch. Merlin Chain is so far the leader in this league with $1.1 billion TVL, staying ahead of its competitors following the launch of its mainnet and native token, MERL. Merlin Chain has the first-mover advantage, as a dozen DApps within the vibrant community have been up and running.
B2 Network owns the second-largest TVL for Bitcoin’s ZK-rollup solutions, although as of May 2024, it’s only launched a testnet. We might see further inflows into the network as its airdrop plan and mainnet launch send the project buzzling.
Tuna Chain boasts dual architecture and a hybrid infrastructure of optimistic and ZK-rollups, setting itself apart from its competitors. As the first modular Layer 2 for Bitcoin, it has adopted Celestia’s data availability solution and plans to launch its own stablecoin in the second half of 2024. We haven't seen such a dual structure in the Ethereum ecosystem, so it’s interesting to observe how it pushes the limit of the two mainstream rollup solutions.
Bitcoin-related protocols
As mentioned, Bitcoin-related protocols, including Mirror, Runes and Ordinals, don’t have their own blockchain networks. Instead, they’re DApps to the Layer 1 network, i.e., the Bitcoin mainnet.
The Mirror L2 staking protocol offers BTC staking solutions to other Layer 2s with its Mirrored Bitcoin (mBTC). Mirror differs from the centralized BTC staking that wBTC offers by decentralizing its overlapping multisig mechanism.
Ordinals is a unique system of ordering satoshis, the smallest units of Bitcoin, allowing the creation of Bitcoin NFTs. Users can inscribe data, such as text or images, as a digital artifact onto an individual satoshi. This process creates Bitcoin-native digital artifacts (also known as Bitcoin NFTs) that can be stored, transferred and traded on the Bitcoin blockchain.
Runes, created by the same team that developed Ordinals, addresses the issue of congestion resulting from the inefficiency of the BRC-20 token standard within Ordinals using Bitcoin’s native UTXO transaction model.
Comparison of Three Layer 2 Solutions
All three of the solutions above aim to enhance the throughput of Bitcoin, while sidechains and rollups can help add smart contract ability to the Bitcoin ecosystem. As observed from the Ethereum Layer 2 evolution, rollups are a more advanced technology than sidechains, since we don’t see new projects using sidechain architecture. Essentially, sidechains are separate blockchains — and, technically speaking, all alternative Layer 1s can become sidechains as long as they enable the transfer of assets in and out of Bitcoin.
Nonetheless, a few innovative solutions for Bitcoin sidechains aim to address the inherent security risks facing the seemingly outdated Layer 2 solutions, including the merge mining concept from Rootstock.
Risks
Frankly speaking, all risks and limitations facing Ethereum Layer 2s in their early stages of development will arise for Bitcoin Layer 2s.
General Limitations
Security and counterparty risks: All Layer 2 solutions introduce additional tiers of software and complexity, which can increase the risk of security vulnerabilities. On the other hand, the assets are usually transferred from the mainnet or other Layer 1 blockchain to Bitcoin Layer 2 through bridges built and managed by the Layer 2 team. These bridges could be subject to third-party risks resulting from the malicious behavior of network operators.
Interoperability challenges: While sidechains aim to provide interoperability with the main blockchain, achieving seamless and efficient interoperability can be challenging. Transferring assets between the main blockchain and sidechain may require additional steps, such as locking funds on the main chain, waiting for confirmation and then unlocking on the sidechain. These steps can introduce delays, complexity and potential security risks.
State Channel
Counterparty risk: State channels involve direct interactions between participants, which means there’s a higher level of counterparty risk as compared to on-chain transactions. If a participant behaves maliciously or fails to fulfill their obligations, such as refusing to sign and submit the final state to the blockchain, it can result in disputes or a loss of funds.
Channel congestion: In order to conduct transactions, state channels rely on participants' availability and responsiveness. Delays can occur if there are multiple pending transactions within a state channel, and participants may need to wait for a dispute resolution process to resolve any issues. This can impact the efficiency and usability of state channels, especially during periods of high demand.
Limited functionality: State channels are primarily designed for simple and frequent transactions between a limited set of participants. Complex smart contract interactions or transactions involving a large number of participants may not be suitable for state channels. This limitation restricts the use cases and functionality of state channels as compared to on-chain transactions.
Exit scams: State channels can be susceptible to exit scams. If a malicious participant or operator abruptly closes the channel and disappears with the locked funds, it can result in significant financial losses for other participants.
Sidechains
Trust and reliance: Sidechains often require participants to trust the validators or operators of the sidechain, and to rely on these entities to properly validate and secure transactions. Malicious behavior or a breach of trust on the part of a validator or operator can lead to financial losses and other adverse consequences for participants.
Rollups are still being explored as a technology, and have no specific limitations unique to themselves. Their major risks, so far, lie in the failure to catch up with the latest technology.
Overall, rollups are poised to become the dominant technology in Bitcoin Layer 2s in the medium to long term, as evidenced by the success of Merlin Chain.
Can Bitcoin Layer 2 Challenge Ethereum Layer 2?
Bitcoin Layer 2 | Ethereum Layer 2 | |
Popular Solutions | State channels, sidechains, rollups | Rollups |
Dominant types | Sidechains and ZK-rollups are leading | Optimistic rollups are leading |
TVL of Layer 2 | ~$2.5 billion | ~$40 billion |
Bitcoin Layer 2 vs. Ethereum Layer 2. Source: Compiled by Bybit
Bitcoin Layer 2 development is still at an early stage, with its TVL far behind that of Ethereum. Thanks to the development of the Ethereum ecosystem, rollup technology has become more mature. Therefore, in the long run, rollup technology can be accelerated on Bitcoin’s network due to open-source features within the crypto field.
What sets the two ecosystems apart is the mechanism of each mainnet per se. Bitcoin doesn't have smart contract capability, and its slow throughput could limit its Layer 2 solutions. For example, Stacks has been struggling to increase its output, as its throughput has been tied to Bitcoin’s. Its new Nakamoto upgrade aims to address this issue by separating block production from cryptographic sortitions. Furthermore, Bitcoin Layer 2s have to offer smart contract ability in order to add more utility to the mainnet, since Bitcoin’s network lacks virtual machine programmability. Thus, those Layer 2s without smart contract functionality might lose out to those that even have EVM compatibility.
All in all, Bitcoin’s Layer 2 solutions still have room to grow, and need to battle-test their applications because of their short operation history. In particular, an infrastructure such as the crypto wallet isn’t well established at the moment, which might limit the migration of new users to the ecosystem.
Final Thoughts
Bitcoin Layer 2s have expanded the utility of BTC beyond its current label as merely “digital gold.” They leverage the superior security offered by Bitcoin mining, placing Bitcoin Layer 2 in a good position to challenge incumbents, such as Ethereum and Solana.
Nonetheless, the road to Bitcoin Layer 2 adoption is being viewed as bumpier than it was for Ethereum. Due to the older architecture of the Bitcoin blockchain’s design, the mainnet itself is limited in terms of programmability, which could possibly lead to additional issues for communities to address. However, thanks to the technological advancements in Layer 2, particularly in regard to ZK-rollups, Bitcoin’s community has good references and could directly adopt the more advanced ZK-rollups in its Layer 2 offerings.
Some analysts view the Bitcoin community as “resistant to change and new innovation,” which might slow down the development of Layer 2. However, with the launch of Ordinals and Runes and the popularity of their on-chain transactions, we’re of the view that new innovation drives the community culture. In particular, new investors, project owners and new users could be the transfusion of new blood that impacts the existing community.
As Bitcoin is one of the few remaining proof of work (PoW) blockchains and continues to outperform other alternative blockchains, Bitcoin Layer 2 development has enormous potential to explore.
Grab Up to 5,000 USDT in Rewards
Get additional 50 USDT welcome gift instantly when you sign up today.