The rabbit hole that is bitcoin is as deep as it is wide and as it continues to mature, improve and grows, so too does its complexity. Each year more people hear about Bitcoin and plan to own some, and with the user base and the demand for it, growing there are now several layers of Bitcoin available to support users journey into the unknown.
Each layer of Bitcoin serves a different purpose, and each use case and has its own pros and cons. Yes, I know this seems weird, but all money has layers.
Yes, I’ve said Bitcoin is fungible like all money. All Bitcoin is the same, and to an extent, yes, that is true. Bitcoin is fungible, and any UTXO’s can be combined in various ways to form an amount of Bitcoin.
In the fiat money world, for example, we have physical cash, we have bank deposits, credit, loans/bonds, equity/shares, financial derivatives and more. There are so many levels too many in the fiat system that all move in and out of the base layer; the most liquid form wish is cash.
How Bitcoin is layered
Bitcoin also has its own layers, and the types of Bitcoin depends on how close or how far you are to the base layer, or as we refer to as on-chain transactions.
As if Bitcoin wasn’t complicated enough, right?
I know you’re just learning, but I think it’s important to start to make the distinction.
The more people get into Bitcoin, the more they need to learn about the variations. Since they may choose a certain layer of Bitcoin, one that may not exactly be suited to their need or use for Bitcoin.
Bitcoin means different things to different people, and in my case, I hold Bitcoin deposits in different places for different uses.
As a Bitcoin holder, you need to know what layer you’re in and why and how much Bitcoin you’d like to keep at each layer.
This is the OG, the REAL Bitcoin if you will; this will be any Bitcoin that YOU own in a wallet where only you have access to the private keys. Base layer Bitcoin is a transaction that is settled on-chain and has been confirmed by the network to be in your wallets possession.
Base layer Bitcoin is ideal for the long term HODL and for those who want to take physical ownership of their Bitcoin. I personally would recommend keeping most of your Bitcoin in a base layer transaction; this can be within a hot wallet or cold storage, depending on the amount of Bitcoin or how long you plan to store it.
I personally hold most of my Bitcoin in offline cold storage.
Second layer Bitcoin
Bitcoin’s scalability has come under question over the last few years as we reach more users and with more users comes more transactions and with more transactions means a slower network.
To help remove some of the load on the base chain layer, second layer solutions like the Liquid Network and Lightning Network have been created to solve the problem of using Bitcoin at scale.
This is not on-chain Bitcoin, but Bitcoin that is locked into a payment channel and then used on a side-chain. This is great for quick and small transactions, and it’s always good to keep a Lightning Network-enabled wallet on hand to make a quick payment, tip a friend or send out an invoice to be paid in Bitcoin.
The second layer Bitcoin can always be converted back into the main chain at any time. You simply close the channel and send the Bitcoin to a wallet that you own on the base layer.
Reprensetive Bitcoin is Bitcoin that is locked into a Smart Contract to be used on another blockchain like Ethereum. It is commonly also known as wrapped Bitcoin or wBTC. This allows you to send Bitcoin to a smart contract and have the contract mint a token that represents the amount of Bitcoin you locked into the contract.
You can then use that wrapped token on any dapps built on the chain such as Ethereum, and when you’re done, you simply close the contract and claim your Bitcoin to be sent back to the base layer.
This type of Bitcoin is great for those who want to speculate in the DE-FI market and want to earn an income using their Bitcoin or tap into the vast array of dapps built on Ethereum.
As the saying goes in crypto
Not your keys, not your crypto
Bitcoin sent to exchanges don’t belong to you; they are in the custody of a third party, and all you see is a claim cheque or representation of the Bitcoin you sent. In fact, the Bitcoin you sent could be long gone and pulled off the exchange by another user, and you will get another Bitcoin another user has deposited into the exchanges pool of funds.
Custodial Bitcoin is not confirmed on the chain, and you are trusting a third party to be able to pay the claim you have in your wallet. This can lead to things like rehypothecation and fractional reserve Bitcoin and exchanges can even lock down their service should they dip below their reserve requirements.
I would never recommend leaving Bitcoin on an exchange unless you’re going to trade it, and once you’re done, I would say remove it off the site and make sure you take physical ownership of your Bitcoin.
Paper Bitcoin are things like CME futures, or GBTC the grayscale fund; you buy into contracts or funds that bet on top of Bitcoin. You never actually hold the real Bitcoin. You’re simply getting exposure to the market via a 3rd party service.
They buy and hold the Bitcoin, and you have a contract that claims that of their Bitcoin, some belongs to you. This is more for institutional investors who would rather offload regulation to a 3rd party or for those who want to have the backing of a custodial service but have exposure to Bitcoin.