Bitcoin Layers: Tapestry of a Trustless Financial Era is a research report on developments occurring throughout the Bitcoin Ecosystem. The report was authored by the team at The Spartan Group, Kyle Ellicott, and a number of experts who offered their feedback and insights and generously gave their time reviewing the final version you read today. This segment is the second of a series of four posts of the report.

Authors / Contributors

Kyle Ellicott , Yan Ma, Darius Tan, Melody He

The Evolving Bitcoin Thesis

Since Bitcoin’s inception in January 2009, its role and potential have significantly evolved. Many initially considered Bitcoin an inflationary hedge, a SoV, and a beacon of hope in democratizing financial systems. Its role in shaping the future of decentralized applications (dApps) has only recently become a focal point. By 2023, nearly fourteen years after its launch, this evolution became evident as Ethereum saw growing success with applications and Bitcoin’s dominance as an asset grew over Ethereum, and developers introduced numerous infrastructure “layers” above the Bitcoin core network (Layer-1 or L1). These Bitcoin Layers, enhancing scalability and programmability, capitalize on Bitcoin’s stability and security while tapping into its over $850B+ and growing unproductive capital without altering the L1. We are now seeing significant advances in Bitcoin layers, allowing them to act on the BTC asset and inherit Bitcoin’s reorg security and finality while overcoming its limitations in programmability and performance. Going forward, these additive infrastructure layers, unique to the Bitcoin Ecosystem, will become the cornerstone upon which many will look to build their applications.

Despite this progress, much of the necessary infrastructure remains in the development and experimental stages. The journey is not without precedent. In 2017, early NFT and token projects flooded the Ethereum network, resulting in slowed transactions and high transaction fees. This has reinvigorated the developer community’s ambition to construct more robust infrastructure, providing the necessary scalability and flexibility for the network to support even a fraction of the potential applications’ demands. The Ethereum community debated and experimented with several approaches and settled on a layered approach to performance and scalability, leading to well-utilized Ethereum (Layer-2 or L2) with billions in total value locked (TVL). The experience with Ethereum provides valuable insights for Bitcoin in scaling, growth, and decentralization for applications and their underlying networks.

Similar to Ethereum, Bitcoin experienced a pivotal moment with the introduction of Ordinals and a shift towards “Building on Bitcoin’’. Bitcoin recently had a comparable moment, almost six years later, thanks to the release of Ordinals (based on Ordinal Theory and the ability to inscribe data on the Bitcoin chain) and the newfound culture shift of “Building on Bitcoin”. This shift has sparked a development revolution in infrastructure and scaling layers on top of Bitcoin’s L1. We’re now seeing not only new protocol & token standards (BRC-20, etc.) but also the development of new Bitcoin L2s that have begun to unlock the Bitcoin Economy and provide a sneak peek into the potential of unlocking $850B+ of dormant capital and the industry’s most stable and trialed technology to date. As a result, the Bitcoin Thesis is being redefined: no longer just a SoV or an asset, Bitcoin is emerging as a fundamental infrastructure within its own expanding economy. Drawing parallels to Ethereum’s growth trajectory, the Bitcoin ecosystem will likely experience user adoption surges driven by viral use cases that kickstart the flywheel. This, in turn, will attract more developers and increase the ecosystem’s application TVL. Considering Bitcoin’s $850B market capitalization is about 3.1 times that of Ethereum’s $270B, while its application TVL is currently only a tiny fraction at about $320 Million compared to Ethereum’s $76B, this scenario presents a potential 740-fold growth opportunity for the Bitcoin ecosystem to reach the similar level of maturity on the application front as Ethereum, not counting additional liquidity influxes once the ecosystem gains momentum.

Massive Market Potential of Bitcoin Smart Contracts

The Network vs the Asset

To understand the changing narrative, a distinction needs to be drawn between Bitcoin, the Network (i.e., Bitcoin Core, Bitcoin L1, Bitcoin Blockchain), and BTC, the digital asset. There has been constant confusion for many as the term “Bitcoin” itself can refer to both, which are vastly different while deeply related. To help avoid confusion, this report adopts the standard of capitalizing Bitcoin when referring to the network and using BTC for the token or digital asset.

• Bitcoin the Network went live shortly after the October 31st, 2008, release of the famed whitepaper introducing a Peer-to-Peer Electronic Cash System. Its genesis block was then mined on January 3, 2009. Since its release, the network has remained stable, while other networks have experienced downtime, attacks, and more, proving its viability as the ultimate L1. Bitcoin has shown that it can provide trust without a centralized intermediary and act as the ultimate decentralized settlement layer for transactions, assets, and future applications. However, it has been difficult to develop applications other than the BTC asset itself on Bitcoin due to its lack of flexible programmability and the inability to write trustlessly to the network from outside it. Bitcoin is different from Ethereum in this important way: it does not natively support the smart contracts that enable decentralized applications to use BTC as the asset or settle their transactions on the Bitcoin L1.
• BTC, the digital asset, has traditionally been considered a SoV and an inflationary hedge against turbulent global financial markets. For the first time, its creation provided for a digital, permissionless, censorship-resistant, and scarce global asset. It has remained the top crypto-asset, with a market capitalization of more than $850B and $1.25 Trillion at its peak in November 2021. Yet even today, more than a decade later, BTC remains largely a SoV with little other utility or ability to move beyond that without further developments.

Bitcoin layers provide a solution to this problem. BTC, the asset, is the initial use case of the Bitcoin L1. If Bitcoin layers, such as Bitcoin L2s, can run smart contracts that can use BTC as their asset, the Bitcoin L1 can retain its key benefits of security, durability, and decentralization while allowing infinite experiments to take place on other Bitcoin layers. Applications using BTC as their asset can run L2 rails and settle their transactions on L1. These L2 rails can also inherit an increasing amount of security from the L1 while providing much faster and more scalable transactions. This makes “Building on Bitcoin” possible and redefines the Bitcoin Thesis to make it an asset and a fundamental infrastructure for an expanding Bitcoin economy.

Building on Bitcoin

Building on the Bitcoin blockchain has presented unique opportunities and challenges over the years. Unlike other blockchains, Bitcoin began as an asset or ‘money,’ not as a platform for applications, while others began explicitly as application platforms. To grasp why Bitcoin’s evolution into a mature ecosystem was delayed relative to other ecosystems, it’s essential to look back at its beginnings:

• The Bitcoin network welcomes all, regardless of background or technical knowledge. Bitcoin’s code is open-source and can be duplicated and modified. This openness has fostered a culture of experimentation without any single group or individual dictating the direction of the blockchain.
• Limited interoperability of the network resulted in distinctive derivatives. The derivations of Bitcoin are entirely separate networks with their own separate assets and lack “backward compatibility” with the original Bitcoin network. Consequently, in its current state, BTC assets are confined to the Bitcoin network and cannot be directly removed or transferred to other blockchain networks.
• Lack of programmability creates significant hurdles for building. Bitcoin is not flexibly programmable since it does not provide smart contracts, which hinders its use as a development platform for applications. This, together with its severe performance limitations, is a key challenge when viewing Bitcoin as a platform to build upon.
• Bitcoin L1 needs help with speed and scale. The capability of the Bitcoin network to confirm transactions quickly or to handle large amounts of transaction data on its platform in a short span of time is very limited. Records (known as blocks) in the Bitcoin blockchain are necessarily limited in size and frequency by the critical desire to preserve decentralization. The on-chain transaction processing capacity of the Bitcoin network is limited by the average block creation time of 10 minutes and the original block size limit of 1 megabyte, with an average transaction confirmation time of 10 to 30+ minutes, none of which come close to sufficing for most applications.

Addressing these characteristics involves understanding the Blockchain Trilemma. Applying it to Bitcoin’s L1 reveals a network that is decentralized (a) and secure (b) but lacks direct scalability (c), processing only about 3 to 7.8 transactions per second (TPS). This limitation highlights the need for alternative solutions or additional layers to compensate for the network’s inherent sacrifices.

The urgency for scalable solutions led to the early creation of the Ethereum network, which, despite lacking Bitcoin’s security and decentralization, achieved significant growth by providing necessary scalability solutions for application developments like L2s (i.e., Arbitrum, OP Mainnet, etc.), Subnets (i.e., Avalanche’s Evergreen), etc. Similar trade-offs have been made across the industry, sparking a wave of development focused on scaling solutions such as Sharding, Nested Blockchains, State Channels, Supernets (i.e., Polygon Edge), App-Chains, and L2s (or sidechains, as some prefer).

For years, the focus has predominantly been on Ethereum and Ethereum Virtual Machine (EVM) compatible ecosystems. However, as of 2023, with recent upgrades to Bitcoin L1 and Ordinals, there’s been a noticeable shift. Developers are increasingly shifting their attention back to Bitcoin, particularly to address its scalability — a vital component of the Trilemma specific to Bitcoin L1.

Scaling Bitcoin: Key L1 Upgrades

Significant advancements in Bitcoin’s scalability began with the Segregated Witness (SegWit) update in July 2017. This upgrade marked a pivotal change by segregating the unlocking code into a dedicated section of each Bitcoin transaction. This reduced transaction times and increased block capacity beyond the initial 1MB limit set by Satoshi Nakamoto in 2010.

SegWit introduced a revised block size measurement using Weight Units (wu), later termed as vsize/vbyte, allowing a maximum of 4M weight units (4wu) per block, effectively expanding the block size to approximately 4MB. Designed for backward compatibility with all previous Bitcoin Core versions, this change improved transaction efficiency significantly.

Bitcoin: 1MB Block Size Capacity Factor. Source: Glassnode

SegWit accomplished this via a split data structure separating the “witness” data within a transaction, including the signatures & scripts, to an entirely new part of a Bitcoin block, known as “transaction data,” containing details of the sender, receiver, etc. The introductions of this structure split the new 4wu block size into:

• Witness data with each vbyte of counting for 1wu or 25% of the weight per vbyte compared to Transaction data.
• Transaction data with each vbyte of counting for 4wu or four times the weight per vbyte compared to Witness data.

How is SegWit Different? Source: Cointelegraph

Following SegWit, the next major upgrade was activated in November 2021, known as Taproot. It is a soft fork that removed limitations on maximums of per-transaction witness data footprints, leading to faster transactions, enhanced privacy through Merkelized Alternative Script Trees (MAST), and more efficient key signatures with Schnorr. Taproot also facilitated asset transactions on the Bitcoin L1, introducing protocols like Pay-to-Taproot (P2TR) and Taproot Asset Representation Overlay (Taro).

• Taro, powered by Taproot, is a proposed protocol for issuing, sending, and receiving assets on the Bitcoin L1 and Lighting Network, which in October 2023 activated its mainnet alpha launch.
• Schnorr signatures unlock key aggregation by introducing the ability to combine multiple public keys and signatures into one. Simply put, combining multiple signatures for verification rather than aggregating individually provides greater transaction efficiency.
• MAST hides any preset conditions tied to transactions. Unused outcomes are not published on-chain, giving added privacy and condensing the size of transactions, thus less data usage.
• P2TR adds a new method of spending Bitcoin with Taproot addresses.

These L1 upgrades laid the groundwork for further development of Bitcoin Layers, which has been happening quietly in the background. It wasn’t until the release of Ordinals that building on Bitcoin came under the spotlight again, marking a new era in Bitcoin’s scalability and functionality.

Ordinals Revived the Bitcoin Builder Culture

Despite the L1 upgrades, Bitcoin’s development activities experienced a period of stagnation following the conservative outcomes of the 2017 “Blocksize Wars” until 2022. This relatively slow development pace was largely attributed to the predominant focus on maintaining the Bitcoin core L1, with less attention given to the development of broader infrastructure necessary for an expansive ecosystem. Among the limited development activities on Bitcoin, efforts are primarily concentrated in nascent ecosystems like Stacks (175+ monthly active developers) and Lightning, which comprised a smaller segment of the industry’s developers.

The Bitcoin development landscape has undergone a significant transformation with the advent of Ordinals in December 2022. Ordinals, enabling the creation of immutable on-chain digital artifacts, has not only revitalized the Bitcoin developer community but is also projected to evolve into a substantial $4.5B market by 2025. A growing number of developers are moving beyond their exclusive focus on Ethereum. These developers are increasingly broadening their scope to include a framework for Bitcoin L2s. This pivotal development marks a resurgence in engagement and innovation within the Bitcoin ecosystem, setting the stage for a new era of growth and technological advancement.

Monthly Active Developers on Bitcoin. Source: Electric Capital

The introduction of Ordinals has had a profound impact on the Bitcoin network, particularly in the increase of transaction fees. In stark contrast to the relatively modest fees of 1–3 sats/vB seen in 2022, there has been a meteoric rise to 20x — 500x in May 2023, when Ordinals first took center stage. Fees have continued going up as much as 280% YTD in December 2023. This increase in fees is a clear indicator of heightened activity and interest in the Bitcoin network, playing a crucial role in rejuvenating the Bitcoin builders’ culture and ecosystem. While higher fees contribute positively to the long-term security budget of Bitcoin, surpassing current standards, they also reflect a growing demand for Bitcoin block space.

Bitcoin Average Transaction Fee Peaked in May 2023 Due to Ordinals. Source: ycharts

The surge in Bitcoin’s network usage has led to an increased strain on its infrastructure, manifesting in higher transaction costs and posing challenges in terms of affordability and practicality. This trend is particularly evident in cases where users face disproportionately high fees relative to the transaction amount. For example, a Bitcoin transaction worth $100 might incur a fee as high as $50, significantly diminishing its economic viability. Such a scenario extends to Lightning Network channels, where closing a channel with a similar transaction value becomes impractical due to excessive costs. The network faces the risk of further complications if transaction fees reach exorbitant levels, as much as 1,000 sats/vB. This situation underscores the urgent need for scalable solutions within the Bitcoin ecosystem to accommodate growing demand while maintaining transaction feasibility.

The Ordinals phenomenon, while reigniting developer interest in Bitcoin, also amplifies these limitations. Notably, Ordinals’ lack of support for fully expressive smart contracts has redirected developer focus towards other platforms. This underscores the need for more sophisticated scaling solutions within the Bitcoin ecosystem, ensuring its utility and relevance in the broader blockchain and financial sectors.

Strategic Imperative of L2 Solutions

As a result, L2 solutions are becoming increasingly essential for Bitcoin network’s functionality and success. L2s operate on top of the L1, enhancing scalability and reducing transaction costs by facilitating off-chain transaction channels. Unlike Ethereum, where L1 autonomously supports smart contracts, Bitcoin’s L1 relies on L2s for this functionality, due to its original design prioritizing security and decentralization. This reliance highlights the crucial role of L2 solutions in expanding Bitcoin’s utility beyond basic transactions, thereby bolstering its efficiency, scalability, and overall appeal in the digital asset landscape.

Bitcoin’s L2 solutions, though still in the early stages of development, are poised for significant growth. Presently, Bitcoin L2s do not exhibit the same maturity level as the scaling solutions of established alternative L1 networks such as Ethereum and L2s like Polygon. These networks have benefited from extensive development efforts since 2017, equipping their platforms with advanced tools (i.e., Starknet, ZKSync, etc.) and capabilities, reflected in their TVL figures, which range approximately between 9.0% and 12.5% of their market capitalizations. The expectation is that, over time and through continued innovation, Bitcoin’s L2 solutions will achieve similar levels of development, unlocking a comparable or greater L2 economy. Estimates suggest that Bitcoin L2s are set to manage a substantial portion of all BTC transactions in the foreseeable future, potentially handling over 25% of all BTC transactions, a significant increase from their current minimal share compared to Bitcoin’s L1 usage.

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Authors’ Notes (Feb. 8, 2024):

Some recent developments within Bitcoin’s L1 infrastructure have been geared towards simulating smart contract capabilities without establishing a dedicated smart contract layer. Innovations such as recursive inscriptions (BRC-420) and OrdiFi, alongside discussions on reinstating the ‘OP_CAT’ function through a soft-fork, exemplify efforts to facilitate complex transactions akin to DeFi, bypassing traditional smart contracts.

In contrast to the Ethereum Virtual Machine (EVM) — the cornerstone of EVM-compatible chains that promotes composability via a universal VM — Bitcoin’s framework lacks such a mechanism. This fundamental difference requires the deployment of additional tools and more complex integration strategies to deliver an equivalent user experience, potentially leading to scalability challenges similar to those faced by the base network. The ecosystem is already witnessing the emergence of smart contract integration to a varying degree, with expectations for further expansion.

Highlighting these advancements, the team behind BRC-420 recently unveiled the Merlin Chain, a Bitcoin-native L2 solution designed to mitigate scalability issues. Additionally, Ordz Games launched the first-ever Bitcoin-based game, utilizing the BRC-20 token $OG, which saw its Initial DEX Offering (IDO) on ALEX Lab’s launchpad for $ORDG, achieving an 81x oversubscription. In the subsequent segments of this series, we will delve into more of these innovations in detail, outlining the evolving landscape of the Bitcoin ecosystem.

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