Bitcoin's robust and decentralized design has made it a remarkable store of value, likened by many to digital gold.
Its capacity to process transactions, however, is inherently limited. This is not a weakness, but rather a design trade-off. With a rigorous focus on robustness, Bitcoin is designed to be a secure and immutable base layer—and it is optimized for that function. To serve a broader range of financial use cases, we need a layered approach, similar to traditional financial systems.
Traditional financial systems are inherently layered. At the base, you have central banks that issue currency and oversee monetary policy. On top, you have banks and various financial institutions providing services such as accounts, transfers, lending and investing. Payment networks, like credit card companies, make up yet another layer, facilitating transactions between consumers and businesses. This layered approach allows each element of the system to specialize by making different trade-offs, increasing the system's overall efficiency and functionality.
As interest in Bitcoin surges, more developers are focusing on creating layer-2 solutions to enhance its usability. Blockstream counts itself among those committed to building next-generation financial infrastructure based on Bitcoin’s strong foundation. As these solutions continue to evolve and mature, we can expect Bitcoin to serve an increasingly broad range of market needs.
Unlocking Bitcoin’s Potential: An Introduction to Layer-2 Protocols
Layer-2 protocols are instrumental in extending Bitcoin's functionality. Users ‘lock up’ their bitcoin on the main layer-1 chain and ‘unlock’ a representation of that bitcoin on the layer-2 network. There, bitcoin operates under new rules and inherits ‘superpowers’ which are not possible on the main layer-1 chain.
Benefits include things like faster transactions, enhanced privacy, and the ability to trade bitcoin for other digital assets or utilize smart contracts that automate financial processes. This flexibility enhances Bitcoin's usefulness, extending it from primarily a store of value to a versatile medium for financial activity.
There are trade-offs to enabling these superpowers, which is why they are not features available in Bitcoin’s base layer. A layer-2 may require a different degree of trust in centralized actors or operators of its network. It may involve dependence on a system that, compared to Bitcoin, is less battle-tested to perform reliably. It may require a commitment of capital to enjoy the benefit of network use. Users accept these trade-offs in return for the additional benefits the layer-2s provide.
In a layer-2, everything ultimately settles back to the mainchain. Whether it is aggregating a series of micro-transactions on the Lightning Network or trading bitcoin for a tokenized asset on Liquid, the eventual settlement of bitcoin occurs on Bitcoin's layer-1. This ensures the continued underlying security and immutability of Bitcoin, while letting users take advantage of extended functionality.
Looking Forward: Layer-2 and the Future of Bitcoin
The rise of layer-2 protocols results from a significant investment by businesses and developers around the world who seek to expand Bitcoin’s utility to meet a broader range of market needs.
Layer-2 technologies are gaining significant traction in the Bitcoin ecosystem, with several solutions standing out due to their unique value propositions and growing adoption.
The Lightning Network, for instance, is making strides as an aspiring 'payments layer'. It's designed to support a high volume of virtually instant payments, making it ideal for borderless commerce and remittances. The network has experienced impressive growth, with the number of nodes and overall network liquidity increasing at a rapid pace. This growth signifies the network's potential to propel Bitcoin as a viable form of payment for more and more businesses.
The Liquid Network, on the other hand, positions itself as an aspiring 'financial layer'. It enables the issuance of digital assets, such as tokenized securities, bonds, lending agreements and stablecoins on a platform where participants can trade these assets, and their bitcoin, securely, and privately. The volume and value of assets issued on the Liquid Network has more than doubled this year. The diversity of parties interested in building on the network underscores its potential to become a hub for financial transactions and digital asset management within the Bitcoin ecosystem.
Other layer-2 efforts have also garnered the attention of users and the backing of investors. Rootstock is a layer-2 smart contracting platform aimed at building an ecosystem of decentralized apps and services. Fedimint enables small federations of trusted experts to support their local communities with a ‘community banking’ solution featuring Bitcoin custody and payments built on a strong foundation of privacy.
It is a certainty that many more ideas and innovations will be explored, and the best of them will ultimately comprise the bedrock of a multi-faceted Bitcoin economy.
An earlier version of this article was originally published on Forbes at: https://www.forbes.com/sites/digital-assets/2023/09/13/bitcoins-layered-design-the-key-to-greater-utility