Monday, May 27, 2024

Understanding The “Bitcoin L2 Trilemma”

In the realm of Bitcoin’s Layer 2 solutions, there is a complex challenge known as the “Bitcoin L2 Trilemma,” which revolves around the trade-offs between off-chain networks, decentralized sidechains, and federated sidechains. These different approaches to scaling Bitcoin each have their own advantages and drawbacks, presenting a dilemma for developers and investors. While off-chain networks offer scalability and privacy benefits, they lack the comprehensive functionalities of smart contract blockchains like Ethereum. Decentralized sidechains allow anyone to participate in consensus and foster community building, but the introduction of an extra token can complicate the user experience. Federated sidechains, on the other hand, provide a streamlined user experience by avoiding a new token, but they require trust in selected entities. Despite the challenges, exploring these different solutions is crucial for the development of Bitcoin’s Layer 2 ecosystem.

Understanding The Bitcoin L2 Trilemma

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1. Off-Chain Networks

Off-chain networks, such as Lightning and RGB, offer an alternative approach to blockchain technology. Unlike traditional blockchains, off-chain networks save data off-chain, stored by users. This means that there is no universal public ledger, making data and smart contracts less accessible and interactive compared to smart contract blockchains like Ethereum or Solana. Additionally, off-chain networks require users to run their own nodes or infrastructure in order to be fully decentralized, which can be a barrier to adoption due to the complexity involved. However, off-chain networks offer scalability and privacy benefits that go beyond what can be achieved with blockchain technology, making them suitable for specific use cases, particularly for scaling payments.

2. Decentralized Sidechains

Decentralized sidechains, such as Stacks, Interlay, and Layer-0 solutions, provide a way for anyone to participate in consensus by mining blocks. These sidechains typically introduce a new token issued by the protocol to supplement their security budget. Miners compete to earn the native token, which is then used by users to cover gas fees when executing smart contracts. The hope is that increased usage and network effect will drive up the demand for the token and make it economically sustainable. However, the introduction of an extra token can complicate the user experience. Additionally, some Bitcoin maximalists may view these efforts as competition with Bitcoin and criticize them as scams. Despite these challenges, decentralized sidechains offer the potential for community building and capital raising for research and development efforts.

3. Federated Sidechains

Federated sidechains, such as Liquid, RSK, and Botanix, compensate miners or validators either through the company behind the development effort or through user fees. In these sidechains, there is no new token introduced, unlike decentralized sidechains. This arrangement ensures that miners and validators are compensated for their work, as mining costs money in Proof-of-Work consensus models and there is a risk of capital being slashed in Proof-of-Stake models. While federated sidechains provide a more streamlined user experience and avoid the complications of introducing a new token, they rely on trust in the selected entities. Efforts are being made to automate and democratize membership through hardware solutions, but this introduces a new reliance on the trustworthiness of the hardware being used.

Additional Insights: Mining vs. Bridging

There is a distinction between sidechains like RSK and Liquid. RSK employs merged mining and has achieved significant adoption from Bitcoin miners, with 64% of Bitcoin’s hashrate as of February 2022. On the other hand, token-based sidechains are building decentralized bridges that use their native token as collateral. This includes projects like sBTC by Stacks, as well as Interlay and various Layer-0 sidechains. By leveraging the native token as collateral, these sidechains incentivize an open-membership bridging protocol for the Bitcoin asset. A newly introduced solution called BitVM, presented in a white paper, aims to provide a more trust-minimized approach for federated bridges and eliminate the need for hardware-based solutions.

Three Potential Solutions to Solve the Trilemma

There are several potential solutions being explored to address the trilemma. Bitcoin soft forks are one approach, but they may take a considerable amount of time to gain traction. Validity Rollups, also known as zk Rollups, show promise and have received positive feedback from some Bitcoin Core developers. However, effective implementation remains a challenge. Merged Mining, particularly with the significant adoption demonstrated by RSK, is intriguing, but it still relies on a trusted bridge or advanced hardware configurations for support. BitVM presents a potential solution to make federated bridges more trust-minimized and eliminate the need for hardware-based solutions, and it is worth monitoring its progress in the coming months.

The Question of EVM (A Topic for Another Day)

Many sidechains opt for the Ethereum Virtual Machine (EVM), including RSK, Botanix, and various Layer-Zero solutions. This decision allows for faster market entry and compatibility with exchanges and Ethereum-centric blockchain infrastructure. However, some projects, such as Stacks and Starkware, have developed their own virtual machines to improve on the EVM in specific areas. While adopting the EVM can provide easier integration with existing infrastructure and applications, it also comes with the risk of losing the network effect. Alternative virtual machines offer the opportunity for developers to create unique applications and differentiate themselves from the market leaders on Ethereum.

Abolish All Tokens

When considering whether to introduce a token, practical concerns play a significant role. Even on Ethereum, where Layer-2 Validity Rollup solutions don’t require a token due to smart contract support on Layer 1, projects like Optimism and Arbitrum have chosen to introduce tokens. These tokens help strengthen community ties and provide funding for development. This market-based evidence complicates the decision between having a token and not having one. BASE, a Layer-2 Ethereum initiative by Coinbase, has gained traction without having its own token, but the possibility of introducing a token in the future remains open. The decision to have a token or not is akin to the startup equity vs. corporate equity dilemma, with no clear-cut answers.

Final Thoughts

The Bitcoin Layer 2 (L2) space is an exciting and evolving landscape. Protocols like Ordinals, BRC-20, and Runes are attracting more Web3 developers to build on Bitcoin. As investors in Web3, the focus should be on applications and infrastructure rather than token trading. Off-chain networks offer unique advantages for specific use cases, while decentralized sidechains provide opportunities for community building and capital acquisition. Merged Mining and BitVM present potential solutions to the trilemma. The Bitcoin Frontier Fund aims to strategically invest in all three corners of the trilemma by supporting promising efforts from exceptional teams. Ultimately, the goal is to contribute to the development of the Bitcoin L2 ecosystem and drive innovation in the space.