Bitcoin’s Scaling Solutions: The Difference Between Layer-2 and Sidechains

The Truth About Bitcoin Layer-2 Projects: Separating Hype from Reality

by Faruk Imamovic
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Bitcoin’s Scaling Solutions: The Difference Between Layer-2 and Sidechains
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Bitcoin layer-2 projects have recently captured the attention of venture capitalists, raising questions about the legitimacy of these scaling solutions. With an increasing number of Bitcoin scaling solutions, it's crucial to understand their true nature, functionality, and security implications.

Expanding Bitcoin Layer-2 Ecosystem

Research from Spartan Group showed that Stacks, Lightning, RSK, and Liquid were the main Bitcoin layer-2 projects. However, the landscape has rapidly evolved, with 73 Bitcoin scaling solutions now being developed, totaling $3.61 billion in value as of June 7, according to BTCL2 data.

Despite the rise of Bitcoin layer-2 projects, the term "layer 2" remains contentious. Most of these projects are structurally more similar to sidechains than true layer-2 solutions. Sidechains operate parallel to the native blockchain and do not inherit its security, whereas true layer-2 solutions should run on top of the native chain and inherit its security properties.

Bai Yu, head of CKB Ecosystem Fund, argues that calling sidechains "layer 2" is a marketing ploy. "A true L2 should operate on top of the base layer, inheriting its security, while a sidechain is a separate blockchain with its own security model,” Yu says. This terminology can be misleading, driven more by marketing than technical accuracy.

Technical Differences and Security Implications

Mikko Ohtamaa, co-founder of Trading Strategy, emphasizes that the real test of a true layer-2 solution is whether users can retrieve their funds without anyone else's permission. Sidechains do not support the parent chain’s native asset directly. Instead, assets like Bitcoin are transferred via pegging mechanisms, locking them in the origin chain and representing them with equivalent tokens in the sidechain.

Ethereum scaler Optimism, considered a true layer-2, locks native ETH on the main chain. Optimism is a rollup, meaning transaction data is periodically committed back to Ethereum, anchoring its security to the main chain. For sidechains, security depends on the new chain’s rules and could be compromised in an attack.

The Ethereum community defines layer 2 as “a separate blockchain that extends Ethereum and inherits the security guarantees of Ethereum.” However, most Bitcoin layer-2 projects do not fit this definition. David Schwed, COO of Halborn, states there is no consensus on the technical requirements for a layer-2 protocol, aside from addressing first-layer scalability.

Future Prospects for Bitcoin Layer-2 Solutions
Future Prospects for Bitcoin Layer-2 Solutions© Getty Images
 

The Role of Multisignature Wallets

Most Bitcoin layer-2 solutions use multisignature cross-chain bridges to convert Bitcoin between the native chain and layer 2. A multisignature wallet structure involves a group of entities controlling the locking and unlocking of assets, adding oversight but also requiring trust. "Withdrawal requests from users are not entirely permissionless and require confirmation from nodes," says Cipher Wang, CEO of UTXO Stack.

Punk3700, developer behind BVM, highlights that Ethereum’s smart contracts allow for transaction verification, whereas Bitcoin lacks this capability, leading to reliance on trust. Sidechains often use oracles or cross-chain communication tools to maintain consistency with the main blockchain, introducing complexity and potential risks. If these tools are compromised, they can affect the integrity of sidechain transactions.

Demand and Venture Capital Interest

The launch of Ordinals non-fungible tokens on Bitcoin initiated a development boom in infrastructure and scaling layers. According to IntoTheBlock, the seven-day average for Bitcoin transactions peaked on May 20. GeniiData reported that on June 6, Runes accounted for over 61% of Bitcoin transactions, Ordinals for about 8.5%, leaving just 30% for other transactions.

This surge in demand for scaling solutions has attracted significant venture capital investment. In the first quarter, VCs invested $2.49 billion in crypto firms, with layer-2 projects accounting for 7% of this total. Galaxy Digital tracked 13 fundraising rounds by Bitcoin layer-2 projects, estimating that the actual amount raised was likely much higher than the reported $34.7 million.

Future Prospects and Current Limitations

Bitcoin’s scripting language limits its support for advanced smart contracts and operations like rollups. Developers have introduced methods such as soft forks to enable sophisticated applications. A common solution is launching sidechains with their own consensus mechanisms and often their own native tokens for transaction fees.

If a sidechain shuts down, users may be unable to withdraw their assets from the first layer, though multisig wallet controllers might assist in recovery. Edan Yago, strategy head at Sovryn, argues that funds in most Bitcoin layer-2 projects are not secured by Bitcoin’s proof-of-work network, disqualifying them as true layer 2s.

The Lightning Network is a notable exception, using a system of channels for offchain transactions, with opening and closing transactions confirmed by Bitcoin’s proof-of-work. There is growing support for re-enabling “OP_CAT,” an operation code enhancing Bitcoin’s scripting capabilities, removed by Satoshi Nakamoto in 2010. StarkWare announced a $1-million fund for using OP_CAT and zero-knowledge proof technology to help scale Bitcoin. Currently, Bitcoin cannot use ZK scalers like ZK-rollups due to scripting limitations, but some projects use light clients for verification.

As the Bitcoin ecosystem evolves, distinguishing between true layer-2 solutions and sidechains is vital. While the appeal of being labeled a layer-2 solution is strong, technical and security aspects are crucial for the network's growth. Users and developers must remain vigilant about the structures and security models of these scaling solutions to ensure Bitcoin’s safe and efficient development.

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