Understanding Bitcoin Layer 2, the new Impossible Triangle trade-off

Deciphering Bitcoin's Layer 2 Navigating the Tricky Triangle of Trade-Offs

This article analyzes the trade-offs involved in different types of Layer 2 solutions that can be built on Bitcoin.

Original title: “UNDERSTANDING THE ‘BITCOIN L2 TRILEMMA'”
Author: Trevor Owens
Translation: Frank, Foresight News


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

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

Projects that could have been successful have failed due to the unsustainability of their token economies, resulting in significant economic losses for investors. In contrast, in the Bitcoin community, you will find developers spending countless hours on unsolvable technical problems. I call this approach “tokenless tokens,” which is comparable to “having sex without getting intimate.” Both approaches seem unreasonable.

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

1. OFF-CHAIN NETWORK

Examples include the Lightning Network and RGB.

These solutions are not blockchains themselves but networks that store data off-chain (stored by users). There is no universal public ledger, which significantly reduces the accessibility and interactivity of data and smart contracts. Therefore, 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 this approach far exceed what blockchain technology can provide, making it 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) by supplementing their security budget with new tokens issued through protocols. This has created a competitive mining market – miners spend resources to compete for the native tokens of the blockchain network, which are then used by users to pay for gas fees when executing smart contracts.

It is expected that as usage increases and network effects strengthen, the demand for tokens will increase, making them economically sustainable. However, introducing additional tokens may complicate the user experience. Additionally, Bitcoin maximalists generally attack this, calling it a scam, as these tokens are seen as competitors to Bitcoin.

This situation often makes developers’ lives more difficult. Considered from a positive perspective, having tokens can promote community development and facilitate fundraising to support extensive research and development work.

3. Federated Sidechains

Examples include Liquid, RSK, Botanix, etc.

In this case, without tokens, miners (or validators) can only be rewarded by the company behind the development work or by user fees generated on the blockchain network. However, these fees are usually negligible in the initial years until the network is widely used.

This compensation for miners is necessary because in the proof-of-work consensus model, mining requires money, and in proof-of-stake, there is also a risk of funds being slashed. Even Bitcoin and Ethereum, both 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, they have established a consortium consisting of 15 cryptocurrency business service providers, including exchanges, OTC traders, and infrastructure providers. While this approach can work well, it requires trust in the selected entities.

At the same time, as time goes by, an age-old dilemma arises: how to attract a large number of users and generate substantial fees while operating within a trusted group? Currently, efforts are also being made to design hardware solutions to automate and democratize membership, transferring trust to the hardware used.

So what are the advantages of federated sidechains? A simpler user experience, as these sidechains use tokens pegged to BTC to pay for network fees, thus avoiding the possibility of new tokens facing opposition from Bitcoin maximalists. Although it is still unknown whether 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 federated mining and as of February 2022, has obtained 64% of BTC’s hash rate, which is impressive. However, RSK uses federated mining and hardware-centric approaches to build cross-chain bridges.

On the contrary, token-based sidechains are building decentralized cross-chain bridges and using their native tokens as collateral. Examples include Stack’s sBTC, Interlay, and alternative solutions for Layer-0 sidechains. By using native tokens as collateral, this design provides an incentive model to maintain open membership for BTC assets across chains.

The newly launched BitVM this month through a white paper may propose a solution to further minimize trust in federated cross-chain bridges and eliminate the need for hardware-based solutions.

Three potential solutions to the impossible triangle

Many potential solutions require a Bitcoin soft fork, which could take a considerable amount of time to gain support. Drivechains is a recent controversial example, initially proposed in 2017 and now gaining traction. Validity Rollup (or ZK Rollup) brings hope and has received positive feedback from several Bitcoin core developers.

However, effective implementation remains a challenge and may even be a distant reality. Federated mining is interesting, as RSK has demonstrated that Bitcoin miners will adopt it in large numbers even without compelling incentives. However, the lack of tokens still means relying on trust-worthy cross-chain bridges or advanced hardware setups dependent on market validation.

In the coming years, BitVM may revolutionize federated cross-chain bridges in conjunction with federated mining, potentially resolving the decentralization dilemma.

EVM issues (another topic)

It’s worth noting that many sidechains opt for the EVM. RSK, Botanix, and several Layer0 solutions have adopted this approach, accelerating market expansion and ensuring compatibility with exchanges and EVM-based blockchain infrastructures.

In contrast, Stacks and Starkware (ZK Rollup) designed their own virtual machines aimed at improving the EVM in specific areas such as determinism and ZK compatibility. This double-edged sword implies that they may lose network effects but could provide a platform for developers to create superior applications and differentiate themselves from the market-leading Ethereum applications.

Abolishing all tokens

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

They utilize these tokens to strengthen community ties and fund development, further complicating the question of whether tokens are needed based on market evidence. Coinbase’s Layer2 network Base recently gained significant traction without launching a token, but Coinbase has stated 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 dilemma of startup equity versus corporate equity. In my book “The Lean Enterprise,” I emphasize numerous examples of internal innovation attempts failing due to a lack of incentives proportional to the high risks and extensive research and development required for these projects.

Even Google, known for its innovative corporate culture, has witnessed its employees giving up substantial stock options to start their own businesses, giving rise to giants like Twitter, Instagram, Niantic, and Pinterest, resulting in potential market value losses exceeding $100 billion.

Layer2 projects carry significant risks, and most of them are destined to fail. The amount of funding required to develop them is enormous. Despite not providing the same 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 in terms of market value and developer participation among all Ethereum scaling solutions. Now it is shifting towards a ZK-based strategy, so even though zk-rollup itself doesn’t require tokens, having a native token could potentially provide a competitive advantage. Like all things related to business, there is no definitive 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, striving to avoid token trading as much as possible.

Currently, our interest lies in layer-2 networks and decentralized sidechains with unique application advantages, primarily because they have open membership consensus models, community building, and capital acquisition advantages. If BitVM successfully introduces a more minimal trust approach to inter-chain bridges for cross-chain collaboration, we are also bullish on collaborative mining.

Importantly, both collateral-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 significant interest from developers, while sBTC has been in development for over a year and has invested considerable resources. Ultimately, in addition to investing in Bitcoin L1 applications and infrastructure, the Bitcoin Frontier Fund aims to strategically venture into these three areas.

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