Analyizing the impact of second layers on Bitcoin’s ecosystem

Nearly 15 years after Bitcoin instigated the digital monetary revolution, its perception is now nestled as sound money. Following dozens of hard forks and developer attempts to tweak Bitcoin’s core code, the pioneering cryptocurrency settled on decentralization and sound incentive structure for miners.

Both were vital for Bitcoin to power through market crashes, media attacks, and government attempts to ban it. Yet, even with the effective increase of its block size to 4 MB in 2017 via the SegWit upgrade, Bitcoin’s wider adoption as daily currency cannot rely on its mainnet:

• Larger block size would reduce transaction fees as more transactions per block could be processed. But this would lead to larger computing and storage demands, triggering network centralization.
• By the same token, larger block size would increase Bitcoin mainnet throughput above the present 7 transactions per second. Therefore, this would lower fees as network activity (adoption) increases.

In other words, Bitcoin’s status as decentralized sound money is innately opposed to its status as frictionless currency with negligible transaction fees and high tps throughput. However, this is only true if we focus on Bitcoin’s mainnet – the first network layer.

The Lightning Network (LN) emerged as the second layer to address Bitcoin’s scalability problem in 2015. Enabling near-instant and low-cost payments on top of Bitcoin’s mainnet, LN is paving the road to scaling Bitcoin from store-of-value into frictionless currency. With AI in the mix, more refined trading strategies could come into play.

Nonetheless, just as Bitcoin’s block size determines the level of network decentralization, so do have to distinguish between types of second layers possible. Whether they are open or closed, they offer different advantages and drawbacks.

Understanding Second Layers in Bitcoin

The status of “sound money” contains a degree of fragility. To be regarded as such, Bitcoin has to maintain a conservative approach to changes. In turn, this limitation has to be neutralized via second-layer solutions.

Bitcoin Sidechains

From sidechains and drivechains to Lightning Network, they are complementary in their effort to extend Bitcoin’s smart contract functionality and scalability. Case in point, Rootstock (RSK) is a sidechain that uses Ethereum Virtual Machine (EVM) to port Solidity-written Ethereum contracts into RSK.

Developers could then create decentralized applications (dApps) on Bitcoin, which has largely been delegated to proof-of-stake (PoS) blockchains like Ethereum, Avalanche, Solana, Cardano, etc. RSK brings the promise of DeFi but without forsaking Bitcoin’s mainnet security.

Another sidechain called Liquid Network, created by Blockstream, focuses on fast settlements of digital assets, from stablecoins to security tokens. This confidential form of settlement and issuance has its own technique to interact with Bitcoin mainnet:

• Liquid Network issues its own native asset Liquid Bitcoin (L-BTC), a pegged, wrapped version of BTC.
• Without calling for intermediaries, users can then swap Bitcoin for other assets on P2P exchanges.
• Not only is L-BTC auditably backed 1:1 by BTC, but final settlements can occur 10x faster.

Just like Polygon for Ethereum, these sidechains are independent with their own miners but still anchored to the Bitcoin blockchain. Therefore, they can scale independently of Bitcoin mainnet. In contrast to this second-layer scalability approach, drivechains are directly linked to Bitcoin blockchain.

Bitcoin Drivechains

As a subtype of sidechains, experimental drivechains use Blind Merged Mining (BMM) to facilitate network consensus. For example, a small business wants to use BTC for its operations but Bitcoin mainnet is too slow (10-min block confirmation time) and too costly for frequent BTC transfers. Yet, the venture doesn’t want to renounce mainnet’s security benefits.

Here come drivechains. The entrepreneurs would create their own Bitcoin sidechain (drivechain) for their specific needs. They would do so by depositing some BTC into a smart contract that funds the drivechain’s operations. This amount could be withdrawn at any point.

Once established, drivechain’s smart contract issues a corresponding amount of drivechain tokens to be used among the business staff. With each transfer, parties can withdraw drivechain tokens back to Bitcoin.

This is all made possible with Blind Merged Mining (BMM) that anchors drivechains to the Bitcoin mainnet. Effectively, drivechain miners piggyback on actual Bitcoin miners, participating in Bitcoin consensus and ensuring that all transactions are equally secured.

Lightning Network

As previously noted, Lightning Network is at the forefront when people think of scaling Bitcoin. It’s a network of payment channels that enables off-chain transactions. These channels open by funding smart contracts with BTC. As long as they are funded, the channels remain open.

Consequently, many BTC transactions can be conducted between the parties, without each being broadcast to the Bitcoin mainnet for miner settlement. This off-chain approach leads to near-instant transfers, equal to mainstay Visa or MasterCard in-store payments.

RACE OF THE RAILS

Bitcoin #Lightning payments vs #fiat contactless payments at the #Gibraltar Bakery.

£2.20 loaded up on both PoS.

WHO WINS??

⁦@CoinCorner⁩ ⁦@CoinCornerMolly⁩ pic.twitter.com/b3ezy7FIeq

— Joe Nakamoto (@JoeNakamoto) July 25, 2022

When LN payment channels close, LN’s hashed timelock contracts (HTLC) roll all the conducted transactions into a single one, to be broadcasted back to Bitcoin mainnet. Using payment-focused HTLC instead of regular smart contracts makes LN more efficient and secure. After all, smart contracts are known for their complexity which can lead to bug/exploit vulnerability.

Open vs Closed Second-Layers

From understanding Bitcoin sidechains and drivechains, we can already see the implications. If an entity, or a group of entities, can create a sidechain for their specific needs, it is a closed second-layer scalability solution.

Given the nature of finance itself, closed second layers offer considerable advantages:

• Greater flexibility compared to Bitcoin mainnet, both in lower fees and transaction speed.
• Greater privacy compared to Bitcoin mainnet, by offering confidentiality.

On the other hand, open second-layers have their own pros:

• More decentralized, which leads to greater resistance to censorship.
• Greater transparency which leads to open audits, which in turn leads to greater public confidence and adoption.

However, open second-layers are more vulnerable to disagreements in the balance, which could lead to forks. Additionally, they are less scalable by the nature of their openness. After all, closed second-layers are brought into existence for specific tasks.

Yet, the very advantages of open second layers may introduce systemic vulnerabilities. For example, what happens if Bitcoin miners decide to run sidechains themselves? If most miners participate in merged mining (BMM), they would take control of drivechains, leading to loss of decentralized governance.

By the same drivechain token, BMM could lead to transaction censorship. Instead of providing a Bitcoin-powered DeFi ecosystem, drivechains could then form a centralized closed infrastructure mimicking TradFi.

Impact on the Base Layer and Bitcoin’s Ecosystem

Bitcoin’s dominance as the leading cryptocurrency is predictable, but its future remains uncertain, even to experts. When a novelty asset pops into existence, first-mover advantage takes hold. This is further amplified by the nature of digital assets themselves. While anyone can copy Bitcoin’s open-source code, the value derived from Bitcoin’s computing network makes this irrelevant.

This unique strength built Bitcoin into a $732 billion asset. Moving forward, in which direction will this promise of “sound money” turn?

Bitcoin scalability offers two choices: open or closed second layers. Just like Bitcoin mainnet itself, open ones are accessible to anyone. Yet, if anyone can access them, including miners, open systems could be gamed by miners.

Bitcoin miners could charge higher fees for transactions on some drivechains which they know the market perceives as more valuable. They could equally choose to refuse to mine blocks, either with or without external pressures. Those drivechains would then be left without confirmed transactions.

On a more granular level, Bitcoin miners could even collude with each other to select-mine approved transactions, effectively installing complete drivechain control. At the core of these issues is a new incentive structure.

Because Bitcoin miners can extract drivechain value without returning value in kind, Bitcoin’s sound money status would no longer seem as shiny.

Conclusion

The need to scale Bitcoin is not in question. While the block-size wars have seemingly ended, a new battlefront is opening. Multiple avenues lie ahead:

• Lightning Network is the least gameable system, as only payment channels hosting dApps can affect it. In turn, they can easily be recognized as such.
• In contrast, sidechains alongside drivechains leave gamification open-ended. The existing incentive structure for Bitcoin miners could attach itself to open second-layer sidechains and drivechains.

Counter-intuitively, this translates to a closed-approach as a preferable scalability pathway for Bitcoin. It would lead to less gamification by miners, leaving Bitcoin’s sound money reputation intact.

In practice, we will most likely see decentralized Lightning Network as the dominant, more neutral second-layer scalability solution. LN’s reliance on hashed timelock contracts instead of more complex smart contracts makes this neutrality possible.

On a smaller scale, drivechains will play their role, but on a case-by-case basis. At the end of the line, adoption is always limited by complexity. In this too, LN has an advantage over both sidechains and drivechains.

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