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Bitcoin Layer 2s: What They Are and How They Work

Beginner
Blockchain on an orange background
KEY TAKEAWAYS:
— Bitcoin is the world’s first, functional, and fully decentralized ‘peer-to-peer (P2P) money’, and now, the biggest blockchain by market capitalization.

— To maximize security and decentralization, the network compromised scalability which has caused high fees and slow transaction times as more users joined the network.

— Bitcoin Layer 2s aim to boost scalability while retaining the base layer’s decentralization and security standard, unlocking a better user experience, and new avenues for Bitcoin-powered innovations. 

Since its inception in 2008, Bitcoin (BTC) has captured the attention of individuals, governments, and traditional finance institutions alike. As the first decentralized cryptocurrency and the largest blockchain by market share, Bitcoin’s status as the flagship cryptocurrency is undeniable.

However, Bitcoin’s growth has not been all smooth sailing, as the network’s increased popularity has led to severe network congestion. At peak times, excessive fees and high wait times have made BTC unsuitable for small day-to-day transactions. These issues have laid bare the dire need for a scaling solution for Bitcoin to accommodate the increased pressure on the network. 

In this article, you will learn about what Bitcoin Layer 2s are, how they work, their key use cases, and some of the leading Bitcoin Layer 2 networks today.

What is Bitcoin Layer 2?

Layer 1 and Layer 2 are terms that help distinguish between different networks within a single blockchain ecosystem. A Layer-1 network – which can also be referred to as a “parent chain” or “mainnet” in different contexts – is the fundamental blockchain. By contrast, Layer 2 solutions are secondary networks built on top of Layer 1’s architecture. 

The purpose of a Layer 2 solution is to reduce the load on Layer 1 by bypassing its technical limitations while taking advantage of its strengths. Thus Bitcoin Layer 2s are networks that run on top of the main blockchain, primarily to increase its capacity to process transactions, but they can also increase usability in some other ways.

Think of Bitcoin as a professor with too many exams to grade transactions to process. A layer 2 blockchain is an effective teaching assistant that does a bulk of the work grading the papers, before returning them to the professor to be officially logged.

In the same way, Layer 2 processes transactions off-chain, before sending them back to be added to the Bitcoin blockchain.

Why Do Bitcoin Layer 2s Matter?

Increasing Scalability

The Bitcoin network takes about 10 minutes to finalize a single set of transactions  –  only seven transactions per second (TPS) on average. 

This clogs the network during peak traffic and spikes transaction fees. For instance, in April 2021, users paid over $62 per transaction. While this may not be an issue for large transactions, it quickly becomes impractical for micropayments and point-of-sale transactions.

What’s more, scaling the Bitcoin blockchain itself is effectively not an option, as this would require a trade-off in security or decentralization, per Vitalik Buterin’s concept of the Blockchain Trilemma

In essence, The Blockchain Trilemma is the idea that any blockchain network can only optimize for two out of three main pillars: decentralization, security, and speed/scalability. Therefore, as the Bitcoin network settled on the former two pillars, it had to compromise on scalability.

This wasn’t an issue when transaction volumes were low. But as more users worldwide adopted Bitcoin, the network’s inability to scale caused performance bottlenecks. Users experienced this network congestion in the form of high fees and long transaction times

Bitcoin Layer 2s improve scalability by processing transactions off-chain to unburden the Layer 1.

Increasing Utility

Given its purpose as a digital currency, Bitcoin’s design only caters to two specific use cases. Namely, it enables censorship-resistant, trustless P2P transactions, and it provides the tech stack for Bitcoin to remain a deflationary store of value.

Of course, this limited core functionality is one of Bitcoin’s key features, not a bug. It is part of what makes the network so robust and tamper-resistant. 

On the other hand, this lack of functionality can make it difficult for developers to innovate and build upon Bitcoin’s revolutionary technology stack by drastically expanding the functionality of the network, Bitcoin Layer 2s provides a viable way to unlock additional use cases. By utilizing Layer 2 networks, users with Bitcoin wallets can take advantage of web3 staples like smart contracts, DeFi services, and digital assets/NFTs  

So that explains what benefits Layer 2s intend to offer Bitcoin users, but how exactly do they accomplish this? 

How Do Bitcoin Layer 2s Work?

While the overall purpose of Layer 2s is the same, they differ in the way they help the Bitcoin network process transactions

State Channels

These are Layer 2 solutions that can help to enable users to bypass high transaction fees. In this method, users create end-to-end encrypted ‘channels’ to send and receive payments. These channels work as micro-ledgers that maintain records on all transactions that occur within them. 

State Channels keep all transactions within them off-chain, only reporting the opening and closing balance of participants to the main network when the channel closes. Thus, participants can make repeated transactions with individuals or businesses without having to pay high fees for every single transaction. 

Rollup Chains

Blockchain Rollups are a Layer 2 solution that takes numerous transactions off of Layer 1 onto a separate network, consolidates them into a single piece of data, and sends that single piece of data back to be added to Layer 1.

It’s important to note that there are two kinds of Blockchain rollups – Optimistic and ZK. In short, Optimistic rollups assume that all of the transactions bundled together are valid unless proven otherwise. In contrast, ZK rollups produce a single cryptographic proof called “validity proof,” which attests to the validity of the transactions bundled together. 

Sidechains

A sidechain is an independent blockchain with its own consensus mechanisms that connect to Layer 1 via a two-way bridge. This bridge is vital as it is what allows the transfer of assets between chains. Due to effectively being its blockchain, a sidechain can support other Layer 2 solutions on top of it.

Top Bitcoin Layer 2s

Innovators and developers in the Bitcoin ecosystem have developed several Layer 2 solutions over the years, exploring the concepts and avenues discussed so far. 

Here’s an overview of some of the best and most popular Bitcoin Layer 2s as of November 2023.

The Lightning Network

Launched in 2018, the Lightning Network uses ‘state channels’ to enable microtransactions on top of the Bitcoin Layer-1.

To use the Lightning Network, participants send and receive BTC payments through encrypted P2P channels that are essentially smart contracts. To illustrate, to send 0.1 BTC to your friend, , you’d create a channel with them and fund it with the required amount. And once all the transactions are complete, you can close the channel. The system stays efficient by only sending the channel’s opening and closing balances to the Bitcoin network. 

Rootstock (RSK)

Rootstock  (RSK) is a sidechain that pioneered smart contracts on the Bitcoin blockchain. It works through something called a two-way peg. To explain, when a user sends Bitcoin to Rootsock, it becomes a locked-up, smart Bitcoin on Rootsock (RBTC) in the user’s RSK wallet. Sending RBTC in the other direction allows the user to withdraw their Bitcoin from the regular network.

Rootstock claims to be able to process up to 300 TPS this way, a drastic improvement in Bitcoin’s transaction speed. The platform is also notable for its compatibility with Ethereum Virtual Machine (EVM). To clarify, EVM is a virtual computer responsible for executing smart contracts and updating the state of the Ethereum blockchain. In other words, Rootstock boasts compatibility with the entire ecosystem of Ethereum dApps.

Stacks Protocol

Stacks has become one of the top-performing Bitcoin L2s since going live on the mainnet in 2018 as Blockstack. The protocol enables self-executing smart contracts that you can deploy over Bitcoin without implementing a fork. To do this, the protocol uses microblocks for speed and a unique Proof-of-Transfer (PoX) mechanism to tie them to blocks on Layer 1. It provides an accessible, easy-to-use, plug-and-play method for running smart contracts and decentralized applications within the Bitcoin ecosystem. 

Liquid Network

 Liquid Network is a Bitcoin Layer 2 sidechain that runs on the open-source Elements blockchain platform. The network has its own native asset, Liquid (L-BTC), and is governed by a distributed federation of Bitcoin companies, exchanges, and other stakeholders. 

Much like Rootstock, the Liquid Network uses a two-way peg to convert BTC to L-BTC and vice versa.

Risks of Using Bitcoin Layer 2s

Although most existing Layer 2s inherit a high degree of security and reliability, they are not as battle-tested as Bitcoin yet when it comes to robustness. As somewhat independent networks, they introduce a new set of risks and challenges.

For example, in 2022, Lightning users experienced a unique ‘unattributed payment routing’ failure due to a bug. They ended up interacting with faulty nodes as a result, without being aware of the problem for a long time.

Moreover, Federated sidechains like the Liquid Network are still in their nascent stages of development and market adoption. Unlike Bitcoin, which has 1000s of miners worldwide, they have much fewer nodes (15, in Liquid’s case) signing and confirming transactions. That is to say that Bitcoin Layer 2s can often be more centralized than the main network.

BTC Layer 2s: A New Way to Explore Bitcoin

Layer 2 solutions take all the revolutionary benefits of Bitcoin technology and build upon it, drastically improving the network’s transaction processing capabilities. Though they certainly aren’t a perfect solution, they do address the problem at hand while retaining the decentralized security that has been instrumental to Bitcoin’s proliferation.

So what are you waiting for? The exciting world of Bitcoin Layer 2s is waiting to be explored. Thanks to Ledger Live, it’s never been easier to explore all that Bitcoin Layer 2 networks have to offer.  As always, the industry-leading security of the Ledger ecosystem means that you can safely store your own private keys and have full access to both your Bitcoin and Layer 2 native tokens. Not to mention that you can now create an account on Stacks Protocol, directly from Ledger Live. 


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