Almost 15 years after Bitcoin sparked the digital currency revolution, it is now perceived as solid money. After dozens of hard forks and developer attempts to optimize Bitcoin’s core code, the pioneering cryptocurrency opted for decentralization and a solid incentive structure for miners.
Both have been crucial for Bitcoin to survive market crashes, media attacks and government attempts to ban it. However, even with the SegWit upgrade effectively increasing its block size to 4MB in 2017, Bitcoin’s wider adoption as a daily currency cannot rely on its mainnet:
- A larger block size would reduce transaction fees because more transactions could be processed per block. However, this would lead to greater computing and storage requirements and trigger network centralization.
- By the same token, a larger block size would increase the throughput of the Bitcoin mainnet above the current 7 transactions per second. Therefore, this would cause fees to decrease as network activity (adoption) increases.
In other words, Bitcoin’s status as decentralized, sound money is at odds with its status as a frictionless currency with negligible transaction fees and high TPS throughput. However, this only applies if we focus on Bitcoin’s main network – the first network layer.
The Lightning Network (LN) emerged in 2015 as a second layer to solve Bitcoin’s scalability problem. LN enables near-instant and low-cost payments on Bitcoin’s mainnet, paving the way for scaling Bitcoin from a store of value to a frictionless payment store of currency. With AI in the mix, more sophisticated trading strategies could come into play.
But just as Bitcoin’s block size determines the level of network decentralization, a distinction must also be made between possible types of second layers. Whether open or closed, they offer different advantages and disadvantages.
Understanding Second Layers in Bitcoin
The status of “sound money” has a certain fragility. To be considered as such, Bitcoin must maintain a conservative approach to change. This limitation must in turn be neutralized by second-layer solutions.
Bitcoin sidechains
From sidechains and drivechains to the Lightning Network, they complement each other in their efforts to expand Bitcoin’s smart contract functionality and scalability. Case in point: Rootstock (RSK) is a sidechain that uses the Ethereum Virtual Machine (EVM) to port Ethereum contracts written by Solidity into RSK.
Developers could then build decentralized applications (dApps) on Bitcoin, which has largely been delegated to Proof-of-Stake (PoS) blockchains such as Ethereum, Avalanche, Solana, Cardano, etc. RSK offers the promise of DeFi without sacrificing the mainnet security of Bitcoin.
Another sidechain created by Blockstream called Liquid Network focuses on the rapid settlement of digital assets, from stablecoins to security tokens. This confidential form of settlement and issuance has its own technique for interacting with the Bitcoin mainnet:
- Liquid Network is issuing its own native asset Liquid Bitcoin (L-BTC), a pegged, wrapped version of BTC.
- Without the involvement of intermediaries, users can then exchange Bitcoin for other assets on P2P exchanges.
- Not only is L-BTC proven to be backed 1:1 by BTC, but final settlement can also be ten times faster.
Just like Polygon for Ethereum, these sidechains are independent with their own miners, but still anchored to the Bitcoin blockchain. Therefore, they can scale independently of the Bitcoin mainnet. In contrast to this second-level scalability approach, Drivechains are directly linked to the Bitcoin blockchain.
Bitcoin drive chains
As a subtype of sidechains, experimental drivechains use blind merged mining (BMM) to facilitate network consensus. For example, a small company wants to use BTC for its business operations, but the Bitcoin mainnet is too slow (block confirmation time of 10 minutes) and too costly for frequent BTC transfers. Nevertheless, the company does not want to forego the security advantages of the mainnet.
Here come drive chains. The entrepreneurs would create their own Bitcoin sidechain (drivechain) for their specific needs. They would do this by depositing some BTC into a smart contract that funds the operation of the drive chain. This amount can be withdrawn at any time.
Once the Drivechain smart contract is set up, it issues an equivalent amount of Drivechain tokens that can be used by the company’s employees. With each transfer, the parties can withdraw Drivechain tokens back to Bitcoin.
This is all made possible by Blind Merged Mining (BMM), which anchors drive chains on the Bitcoin mainnet. In fact, Drivechain miners use real Bitcoin miners, participate in the Bitcoin consensus and ensure that all transactions are equally secure.
Lightning Network
As mentioned, Lightning Network is at the forefront when it comes to scaling Bitcoin. It is a network of payment channels that enables off-chain transactions. These channels are opened by funding smart contracts with BTC. As long as they are funded, the channels will remain open.
Consequently, many BTC transactions can be conducted between parties without each transaction being sent to the Bitcoin mainnet for settlement by the miner. This off-chain approach results in near-instant transfers equivalent to common in-store Visa or MasterCard payments.
RACE OF THE RAILS 🏃♂️
Bitcoin #Lightning payments vs. #Fiat contactless payments at #Gibraltar Bakery.
£2.20 top-up on both PoS.
WHO WINS?? ⚡️ 💵 ⚡️
@CoinCorner @CoinCornerMolly pic.twitter.com/b3ezy7FIeq
— Joe Nakamoto ⚡️ (@JoeNakamoto) July 25, 2022
When LN’s payment channels are closed, LN’s hashed timelock contracts (HTLC) combine all completed transactions into a single one that is sent back to the Bitcoin mainnet. By using payment-oriented HTLC instead of regular smart contracts, LN becomes more efficient and secure. Finally, smart contracts are known for their complexity, which can lead to bugs/exploit vulnerabilities.
Open vs. closed second layers
If we understand Bitcoin’s sidechains and drivechains, we can already see the impact. When an entity or group of entities can create a sidechain for their specific needs, it is a closed second-level scalability solution.
Due to the nature of finance, closed second layers offer significant advantages:
- Greater flexibility compared to the Bitcoin mainnet, both in terms of lower fees and transaction speed.
- Greater privacy compared to the Bitcoin mainnet through confidentiality.
On the other hand, open second layers have their own advantages:
- More decentralized, leading to greater resistance to censorship.
- Greater transparency leading to open audits, which in turn leads to greater public trust and acceptance.
However, open second layers are more vulnerable to balance sheet disagreements that can lead to forks. Additionally, they are less scalable due to their openness. Finally, closed second layers are created for specific tasks.
But it is precisely the advantages of open second layers that can lead to systemic vulnerabilities. For example, what happens if Bitcoin miners decide to run sidechains themselves? If most miners participated in merged mining (BMM), they would take control of the power chains, resulting in the loss of decentralized control.
For the same reason, BMM could lead to transaction censorship. Instead of providing a Bitcoin-based DeFi ecosystem, Drivechains could then form a centralized closed infrastructure that mimics TradFi.
Impact on the base layer and the Bitcoin ecosystem
Bitcoin’s dominance as the leading cryptocurrency is predictable, but its future remains uncertain even for experts. When a new type of asset is created, the first mover advantage takes effect. This is further reinforced by the nature of the digital assets themselves. While anyone can copy Bitcoin’s open source code, this is irrelevant due to the value derived from Bitcoin’s computer network.
This unique strength made Bitcoin a $732 billion asset. In what direction will this promise of “healthy money” develop in the future?
Bitcoin’s scalability offers two options: open or closed second layers. Open networks, like the Bitcoin mainnet itself, are accessible to everyone. However, if everyone can access it, including miners, open systems could be manipulated by miners.
Bitcoin miners could charge higher fees for transactions on some power chains that they know the market deems more valuable. They could also choose to refuse to mine blocks, either with or without external pressure. These drive chains would then remain without confirmed transactions.
At a more granular level, Bitcoin miners could even collaborate with each other to select approved transactions, effectively installing complete control over the power chain. At the heart of these problems is a new incentive structure.
With Bitcoin miners able to extract drivechain value without returning any value in kind, Bitcoin’s solid monetary status no longer seems so shiny.
Diploma
The need to scale Bitcoin is beyond question. While the bloc-sized wars appear to be over, a new battlefront is opening up. There are several paths ahead of us:
- Lightning Network is the least gameable system as only payment channels that host dApps can influence it. They are, in turn, easy to recognize as such.
- In contrast, sidechains alongside drivechains leave gamification open-ended. The existing incentive structure for Bitcoin miners could be linked to open second-layer sidechains and drivechains.
Counter-intuitively, this leads to a closed approach as the preferred scalability path for Bitcoin. This would lead to less gamification by miners and leave Bitcoin’s reputation as good money intact.
In practice, we will most likely see the decentralized Lightning Network as the dominant, more neutral, second-layer scalability solution. Using LN on hashed timelock contracts instead of more complex smart contracts makes this neutrality possible.
On a smaller scale, drive chains will play their role, but on a case-by-case basis. Ultimately, acceptance is always limited by complexity. Here too, LN has an advantage over both sidechains and drivechains.
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