What Are Bitcoin Layer-2s and How Do They Work?

Read more about Bitcoin Layer-2s — a new class of protocols bringing scalability and programmability to the Bitcoin network.

Jul 06, 2023

Key Takeaways:

  • Bitcoin Layer-2s are protocols built on top of the Bitcoin blockchain.
  • They provide scalability to the Bitcoin network by processing transactions off the main blockchain.
  • In addition, these protocols can solve other technical difficulties and provide functionalities to Bitcoin, such as enhancing programmability, improving privacy, or unlocking new utilities.
  • Major Bitcoin scaling solutions today include the Lightning Network, Rootstock, Stacks, Liquid Network, and rollups.

Introduction: Why Does Bitcoin Need Layer-2s?

Bitcoin currently is the most recognised and capitalised digital asset, known as ‘digital gold’ for its qualities as a store of value. While the Bitcoin blockchain was initially designed as a secure and decentralised payment system, its limitations have prevented it from wider adoption so far. 

The Bitcoin network battles a scalability problem and suffers from slow transaction speeds, low throughput, and rising transaction costs. Compared to other blockchains, it has a limited capacity to handle large amounts of transaction data within a set time frame. Bitcoin has an average block creation time of 10 minutes and average throughput of seven transactions per second (tps) — a fraction of that of Visa, for example, or other blockchains like Solana.

Meanwhile, the network congestion drives up fees for transactions. For reference, the average transaction fee for Bitcoin in 2016 was ~US$0.07. Currently, this has jumped to $31, with a record high of nearly $63 in April 2021.

Additionally, due to its limited scripting language, Bitcoin does not support complex smart contract functionality like Ethereum does. Bitcoin’s base layer was not specifically designed to develop smart contracts and applications, as it was originally created as a peer-to-peer (P2P) digital payment system. In other words, functions for decentralised finance (DeFi) and non-fungible tokens (NFTs) have so far hardly been developed on the Bitcoin blockchain.

This is where Layer-2s come in.

What Are Bitcoin Layer-2s?

Bitcoin Layer-2 solutions refer to protocols built on top of Bitcoin’s base layer. These protocols are developed to provide scalability to the Bitcoin network by processing transactions off the main blockchain (mainchain). They can also solve other technical difficulties and provide additional functionalities to Bitcoin.

These Layer-2s can help improve Bitcoin’s overall performance, all while benefiting from its security and network effects.

Advantages of these Layer-2 solutions to Bitcoin include: 

  • Improved scalability by helping overcome Bitcoin’s limitations around transaction throughput, block confirmation time, and transaction costs.
  • Enhanced programmability through implementation of complex smart contract functionality.
  • Inherited high-level security provided by the Bitcoin network, as the base layer remains untouched.
  • Expanded capabilities to Bitcoin, unlocking new utilities on other verticals like payments, DeFi, NFTs, and other market venues. 

Bitcoin-based protocols like the Lightning Network, Rootstock, Stacks, Liquid Network, and Bitcoin rollup projects bring scalability and programmability to the Bitcoin network. Collectively, they demonstrate what the next phase of growth for the network could look like.

Below is an overview of their functionality:

Bitcoin Layer 2s Overviewjul11

Most-Used Bitcoin Layer-2s

Lightning Network for Instant Bitcoin Payments

Lightning Network is a Layer-2 payment protocol built on top of the Bitcoin blockchain. It was designed as a scalability solution to reduce network congestion using payment channels to handle Bitcoin micropayments off-chain. Lightning Network allows a channel to be established directly between two parties who want to make a transaction, where it is able to bypass the main blockchain. 

Lightning Network enables multiple transactions to be conducted without needing global consensus and confirmation on Bitcoin’s mainchain. As a result, transactions are nearly instant, and the fees are lower. It has thus far provided an effective solution to the issue around Bitcoin’s scalability with the capability to handle high-volume transaction processing with ease.  

Multi-party transactions and payment routing are securely carried out on Lightning Network through hashed timelock contracts (HTLCs), a smart contract that enables the recipient to receive funds once certain conditions are met within a certain time period (or block time). 

For more details on how the Lightning Network works, read Bitcoin Payments: What Is the Lightning Network?

Rootstock for Faster and Cheaper Transactions

Rootstock is a Layer-2 solution that allows for faster and cheaper transactions by processing them off the main Bitcoin blockchain. It is a smart contract platform based on the Ethereum Virtual Machine (EVM) model, but is connected to the Bitcoin blockchain through a sidechain.

The Rootstock blockchain uses the Proof of Work (PoW) consensus mechanism, and blocks are mined through merged mining, a process where miners can simultaneously mine both Bitcoin and Rootstock while using the same hashing algorithm and sharing the same computational power. Rootstock features a ~30-second block confirmation time and throughput of around 10 to 20 tps. Transactions in Rootstock are confirmed and bundled before being sent to Bitcoin’s base layer for settlement. 

As a smart contract platform, Rootstock extends Bitcoin’s capabilities for further programmability and utility by implementing smart contract functionality. It also promotes interoperability with Ethereum through RSK Virtual Machine (RVM), which is based on EVM. It enables execution of Ethereum smart contracts on Rootstock and interoperability with Ethereum applications. RVM also enables developers to code using Ethereum’s smart contract programming language, Solidity

Another key feature of Rootstock is its use of the RSK Infrastructure Framework (RIF), which provides a set of decentralised infrastructure services that can be used by developers to build and deploy decentralised apps (dapps) on the Rootstock network. 

Stacks for Bitcoin Smart Contracts

Stacks is an open-source Layer-2 blockchain that introduces smart contracts and dapps to the Bitcoin blockchain. Its support of microblocks allows for faster transaction processing and increased throughput.

To put things into perspective: the Bitcoin blockchain works on an approximate 10-minute block time, while microblocks can convey transaction status in a matter of seconds, which helps decrease latency for interacting with the Stacks blockchain. 

Stacks is also intertwined with Bitcoin through Proof of Transfer (PoX), an innovative consensus model that allows every Stacks transaction to settle on Bitcoin’s base layer. This means that Stacks’s blocks are inherently tied to Bitcoin blocks and inherit Bitcoin’s security (without altering the Bitcoin network in any way).

How Proof Of Transfer Mechanism Worksjul11

Improved Network Performance With Liquid Network

Liquid Network is a Layer-2 sidechain that aims to improve the Bitcoin network’s performance and functionality. Originally intended to be a scaling solution and an asset issuance platform, Liquid operates independently of Bitcoin, working on its own global ledger and consensus mechanism. 

Liquid is capable of confirming transactions in two minutes with a 60-second block time and two-block finality. This makes its transaction throughput significantly faster than the Bitcoin network, a critical aspect for users who intend to make time-sensitive transactions. 

Liquid operates on a consensus mechanism called Strong Federation, which relies on a subset of its members (a group of crypto-native organisations), called ‘functionaries’, for validating transactions and signing blocks. This system reduces confirmation time in Liquid, while a centralised structure is responsible for the chain’s governance and improved performance.

Two Way Peg In Liquid Network 1jul11
Functionaries secure the private key during peg-ins and verify peg-out transactions

Rollups on Bitcoin

Besides Layer-2s, rollups are another option to scale Bitcoin.

Rollups assist with scaling Layer-1 blockchains like Ethereum, mainly by processing transactions off-chain; bundling multiple transactions together into one, single transaction; and sending it back to the mainchain. This process allows the blockchain to secure the rolled-up transaction batch as if it were a single transaction, helping the network process more transactions.

Over the years, the community has been exploring how this approach can be directly applied to Bitcoin, and solutions today come in the form of validity and sovereign rollups. According to research, validity rollups have the potential to help improve Bitcoin’s transaction throughput by up to 100 times, which can be applied to Lightning Network, as well. They could implement an execution environment that supports more flexible smart contract languages and enhance smart contract functionality on Bitcoin without having to shift complexity to the mainchain. 

Another rollup type on Bitcoin is sovereign rollups. Unlike Optimistic and ZK rollups in the Ethereum network, sovereign rollups do not utilise a settlement layer or require smart contracts. They manage their own execution and settlement, and only use the underlying Layer-1 blockchain for consensus and data availability (unlike other rollup types that rely on the blockchain to determine a rollup’s validity). 

In general, rollups on Bitcoin are experimental and still in their infancy; much remains to be seen in terms of applying rollups to Bitcoin.

Challenges of Bitcoin Layer-2s

Bitcoin Layer-2s provide solutions to some of Bitcoin network’s limitations. However, they also have their unique set of challenges. 

Lightning Network, for example, can encounter issues around route payments and route liquidity. Specifically, the reliability of routes may be compromised when the routing node does not have enough open channels to other good routing nodes. In other cases, parties might experience unattributed payment routing failure when they end up using faulty nodes without even being aware there’s a problem. Additionally, channels that do not have enough route liquidity or funds can ultimately cause payments to fail.

Compared to Bitcoin’s base layer, Layer-2 solutions like Liquid Network can be considered highly centralised. Bitcoin has thousands of distributed miners in charge of block production and securing the network, while Liquid runs a federated system where only 15 functionaries sign transactions and keep the network operational.

In theory, this reduces confirmation time on Liquid, but its centralised design means it is subject to the control of a few parties. 

Final Words on Bitcoin Layer-2s

Lightning Network, Rootstock, Stacks, and Liquid Network are just a few examples of scaling solutions on Bitcoin today. Along with rollups and other emerging Layer-2 solutions, each of these protocols provides value to the Bitcoin network and has the potential to help drive adoption to the wider Bitcoin ecosystem. 

Due Diligence and Do Your Own Research

All examples listed in this article are for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained herein shall constitute a solicitation, recommendation, endorsement, or offer by Crypto.com to invest, buy, or sell any coins, tokens, or other crypto assets. Returns on the buying and selling of crypto assets may be subject to tax, including capital gains tax, in your jurisdiction. 

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