The blossoming Bitcoin Layer 2 Multiple solutions competing, overcoming the impossible triangle

Original article title: “UNDERSTANDING THE ‘BITCOIN L2 TRILEMMA'”

Written by: Trevor Owens

Translation: Frank, Foresight News

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As a venture capitalist, I take a “token agnostic” stance. Since we invest in the early stages of new technology development, we invest in equity rather than tokens, so we only receive equivalent tokens proportionally. We believe that for tokens to be effective, they should play a crucial role.

Essentially, removing tokens would undermine core value propositions and underlying architectures. Using tokens solely for the sake of having a token, or avoiding their use without reason, would be a dangerous signal. However, in many Web3 projects, there are numerous tokens launched just for the sake of having a token.

Projects that could have been successful fail due to the unsustainability of their token economics, resulting in significant economic losses for investors. In contrast, in the Bitcoin community, developers waste countless hours on unsolvable technical problems. I refer to these solutions as “tokens without token mechanisms.” I liken this approach to “attempting to engage in sexual activity without getting intimate.” Both methods are irrational.

Now, let’s delve into the three aspects of this impossible triangle dilemma:

1. OFF-CHAIN Networks

Examples include the Lightning Network and RGB.

These solutions are not blockchains but networks that store data off-chain (stored by users). There is no universal public ledger, which greatly reduces accessibility and interactivity with data and smart contracts. Users cannot experience the comprehensive functionality provided by smart contract blockchains like Ethereum or Solana.

They also require users to run their own nodes or infrastructure for full decentralization, leading to significant user experience barriers in adoption. Nevertheless, the scalability and privacy advantages offered by these approaches far exceed what blockchain technology can provide, making them the best choice for specific use cases, especially large-scale payments.

2. Decentralized Sidechains

Examples include Stacks, Interlay, Layer-0, and other solutions.

Decentralized sidechains allow anyone to participate in consensus (i.e., mining) as they supplement their security budget with new tokens issued through protocols, creating a competitive mining market. Miners spend resources to compete for the native tokens of blockchain networks, which are subsequently used by users to pay for gas fees when executing smart contracts.

People expect that with increasing usage and network effects, the demand for tokens will increase, making it economically sustainable. However, introducing additional tokens may complicate the user experience. Additionally, Bitcoin maximalists often attack this concept, calling it a scam, as these tokens are seen as competitors to Bitcoin.

This situation can make developers’ lives more difficult. On the positive side, having tokens can foster community development and facilitate fundraising to support extensive research and development work.

3. Federated Sidechains

Examples include Liquid, RSK, Botanix, and other solutions.

In this case, without tokens, the only reward for miners (or validators) can come from the company behind the development work or fees generated by the blockchain network’s users. However, these fees are usually insignificant in the initial years until the network sees widespread adoption.

This compensation for miners is necessary because mining costs money in proof-of-work consensus models, and there is also a risk of funds being slashed in proof-of-stake. Even Bitcoin and Ethereum, each with over 100 million users, primarily fund their network security through token rewards.

To address this issue, federated sidechains do not open mining to everyone. Taking Liquid as an example, it has formed a consortium of 15 crypto business service providers, including exchanges, OTC traders, and infrastructure providers. While this approach can work well, it requires trust in the selected entities.

Furthermore, to become more decentralized over time, an old challenge arises: How to attract a large number of users and generate significant fees while running trusted groups? Currently, efforts are being made to design hardware solutions that automate and democratize membership, shifting trust onto the hardware being used.

So what are the advantages of federated sidechains? They offer a simpler user experience because these sidechains use a token linked to BTC for network fees, avoiding the possibility of new tokens facing opposition from Bitcoin maximalists. Though it remains unknown if this group of Bitcoin users will actually participate in the Web3 use cases enabled by these sidechains.

Other insights: Mining vs. Cross-Chain

The key is to recognize the difference between RSK and Liquid. The former adopts a federated mining approach and, as of February 2022, has achieved an impressive 64% hash rate of BTC. On the other hand, RSK builds cross-chain bridges through federated mining and hardware-centric methods.

In contrast, token-based sidechains are constructing decentralized cross-chain bridges and using their native tokens as collateral. Examples include sBTC, which Stack is currently advancing, as well as alternatives from Interlay and several Layer-0 sidechains. By utilizing native tokens as collateral, this design provides an incentive model to maintain an open membership cross-chain protocol for BTC assets.

This month, BitVM, which was newly launched through the whitepaper, may propose a solution to minimize trust in joint cross-chain bridges and eliminate the need for hardware-based solutions.

Three potential solutions to the impossible triangle

Many potential solutions require the Bitcoin soft fork, which may take a considerable amount of time to gain support. Drivechains are a recent controversial example, initially proposed in 2017 and now reaching its peak. Validity Rollups (or ZK Rollups) bring hope and have received more positive feedback from several Bitcoin core developers.

However, effective implementation remains a challenge and may even be a distant reality. Joint mining is intriguing, especially since RSK has demonstrated that Bitcoin miners adopt it extensively even in the absence of convincing incentives. Nevertheless, the lack of tokens still means relying on trustworthy cross-chain bridges or advanced hardware setups that depend on market validation.

In the coming years, BitVM may completely change joint cross-chain bridges along with joint mining and potentially solve the dilemma of decentralization.

EVM issues (another topic)

It is worth noting that many sidechains opt for EVM, such as RSK, Botanix, and many Layer0 solutions. This decision accelerates market expansion and ensures compatibility with exchanges and EVM-centric blockchain infrastructures.

In contrast, Stacks and Starkware (ZK Rollup) have designed their own virtual machines aimed at improving EVM in specific domains like determinism and ZK compatibility. This double-edged sword means they may lose network effects but could provide developers with a platform to create superior applications and distinguish themselves from the market-leading Ethereum applications.

Abolishing all tokens

For most builders, the decision regarding tokens should be rooted in their consideration of practical problems. Layer2 Rollup solutions, thanks to their support for smart contracts on Layer1, do not require tokens. However, head projects like Optimism and Arbitrum also have tokens.

They use these tokens to strengthen community connections and fund development, further complicating the question of whether tokens are necessary based on market evidence. Layer2 network Base, recently launched by Coinbase without introducing a token, has gained significant attraction. However, Coinbase indicates that introducing tokens in the future remains an option.

Based on my past experience as a corporate innovation executive and entrepreneur, I compare the debate between tokens and non-tokens to the challenge of startup equity versus corporate equity. In my book, “The Lean Enterprise,” I emphasize many examples of failed internal innovation attempts due to a lack of incentives proportional to the high risk and extensive research and development required by these projects.

Even Google, known for its innovative corporate culture, has witnessed its employees giving up huge stock options to start their own ventures, resulting in the birth of giants like Twitter, Instagram, Niantic, Pinterest, etc., leading to a potential loss of over $100 billion in market value.

Layer2 projects have significant risks, and most of them are destined to fail. The amount of funding required to develop them is immense. While they may not offer the same level of security benefits as Validity Rollup solutions (such as Optimism, Arbitrum, and Base), they cannot create new bitcoins to fund the security budget or developer community of a new blockchain.

Polygon is an Ethereum sidechain that still dominates the market value and developer participation among all Ethereum scaling solutions. Now it is shifting towards a ZK-based strategy, so having a native token may provide a competitive advantage, even though zk-rollup itself does not require one. Like all things related to business, there is no clear answer.

Final Thoughts

The Bitcoin L2 space is fascinating, with protocols like Ordinals, BRC-20, and Runes attracting more Web3 developers to build on Bitcoin, intensifying the competition. As Web3 investors, our focus remains on applications and infrastructure, while trying to avoid token trading.

Currently, our interest lies in off-chain networks and decentralized sidechains with unique application advantages, mainly because they have open member consensus models, community building, and capital acquisition advantages. If BitVM successfully introduces a more minimal trust approach for unified cross-chain bridging, we also see potential in unified mining.

It is important to note that both mortgage-driven cross-chain bridges like sBTC and the BitVM approach are still in the development stage. BitVM was just announced this month through a whitepaper and has generated strong interest from developers, while sBTC has been in development for over a year and has dedicated significant resources. Ultimately, in addition to investing in Bitcoin L1 applications and infrastructure, the Bitcoin Frontier Fund also aims to strategically enter these three areas.

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