Bitcoin operates as a decentralised network, meaning no single entity controls it. Transactions are recorded on a public ledger (blockchain), fostering transparency and trust.
The ledger is maintained by thousands of nodes distributed around the world, making it impossible to change or censor. These attributes resonate with users who value freedom from central banks and traditional financial institutions.
The market demand for reliable stateless money has seen Bitcoin expand to millions of users and graduate to a trillion-dollar asset class, and it shows no signs of slowing down.
Expanding a decentralised network to manage a larger and more active use base is a tricky proposition; while the base chain focused on reliability and security, Bitcoin’s global impact came with a caveat: scalability. The limited number of transactions the network can process hinders its widespread adoption.
Scaling versus a layer two
Since Bitcoin doesn’t have a single corporation managing the direction and how it scales, there has been no shortage of methods of using Bitcoin without touching the chain and directly using up block space. Broadly speaking, scaling can be seen as any transactions that don’t require final settlement on-chain.
Using this broader definition, digital asset custodians and exchanges can be seen as offering to scale since these entities are updating your claims on an internal database fully backed by underlying Bitcoin. Spot ETFs would also fall under this scaling method, where shares of Bitcoin IOUs are traded on top of a treasury of Bitcoin held in the shareholders name.
Using this type of scaling solution means you don’t have permissionless access to your funds; you have to issue a request and hope your custodian honours it.
To address this need for direct custodial scaling, developers have devised various solutions to add throughput or compress the number of transactions into a smaller footprint, each with its own trade-offs.
If we narrow our focus towards scaling solutions that can settle a state directly with the Bitcoin blockchain, we could look at the two avaialble side chains, Liquid and Roostock. Both chains are federated models; instead of having one entity managing the keys to the underlying Bitcoin, several federation members manage the treasury in a multi-sig and manage the peg-in and peg-out of Bitcoin.
These sidechains allow users to pre-fund them with on-chain Bitcoin and receive credit on the sidechain in the form of L-BTC (Liquid) and R-BTC (Roostock). Users can then transact on these sidechains, and when they wish to leave, they’ll need to either swap sidechain Bitcoin with another user for on-chain Bitcoin or request a peg-out with the federation members.
These sidechains offer users additional throughput and allow you to settle back to the chain, but not without the permission of a federation. This is where they don’t make the grade as a layer two but rather a scaling solution.
In the last few months, we’ve seen a bunch of so-called “Bitcoin Layer Twos” pop up, claiming to have solved the problem. However, upon reviewing all of them, none can offer users the ability to exit without someone else’s permission.
While the debates on what an L2 should be continue, the easiest way to evaluate these proposals and environments is to check if they offer a method of unilateral exit.
Beyond the base layer: Not all scalability solutions are created equal
Scaling solutions can take different forms. It could be a base chain change like increasing the block size, reducing transaction sizes, or adding covenants. However, modifying the base layer is always a last resort and is a hard sell as it could introduce complications to the primary ecosystem.
In contrast, L2 solutions accept Bitcoin’s limitations and operate on leveraging its security without altering its core protocol. An L2 allows users to settle peer-to-peer payments, with the option to delay settlement back to the base chain.
Imagine Bitcoin’s blockchain as a bustling highway with a toll gate. During peak hours, traffic grinds to a halt, and the toll gate puts up the price to discourage users from using the road right now. Layer 2 solutions act like bypasses, alleviating congestion on the main road (Layer 1) by processing transactions off-chain, and these toll gates charge a much lower fee.
You can ride on the roads as long as you like, and when you’re ready, take an off-ramp and get back on the main Bitcoin highway.
This enhances scalability without compromising Bitcoin’s core security features. While both L2 and scaling solutions aim to increase transaction throughput, there’s a crucial distinction: Any user can settle back to the base chain without a third party’s permission, ensuring the integrity and security of the system. Currently, the only two protocols that enable this for users are the Lightning network and (possibly) Statechains.
Unilateral exits: A safety net for the adventurous traveller
Think of a unilateral exit as an emergency exit on an L2 highway. It allows users to withdraw funds to Layer 1 in case of unforeseen circumstances.
This feature is paramount for several reasons:
- Security: If an L2 protocol experiences a security breach, a unilateral exit empowers users to reclaim their Bitcoin on the secure Layer 1.
- Flexibility: Unilateral exits ensure users aren’t locked into a specific L2 solution. If a better option emerges, they can seamlessly move their funds back to Layer 1.
- Decentralisation: The ability to exit freely fosters a competitive landscape, encouraging innovation and preventing any L2 solution from becoming a monopoly.
- Ability to bank run: Unilateral exit allows for a trust-minimised environment and reduces the risk of double spending since anyone can call back their funds and expose any leverage in that L2.
Lightning Network and unilateral exit in action
When you open a channel with a peer on the Lightning Network, the two parties choose to lock up funds to create the payment channel. If you no longer want to have a payment channel with a peer, you can issue a mutual close, or if the peer disagrees, you can still exercise a unilateral exit known as a forced close.
The Lightning Network enables what was previously not possible with trusted financial systems vulnerable to monopolies—without the need for custodial trust and ownership, participation on the network can be dynamic and open for all.
The road ahead: A thriving ecosystem of L2 solutions
The Bitcoin scalability landscape is teeming with promising L2 solutions, such as the Lightning Network, sidechains, VTXOs and rollups, each with its unique advantages and trade-offs. As this ecosystem evolves, prioritising L2 solutions that offer robust unilateral exits empowers users, reduces the need for trust, lowers the chance of regulatory attack and safeguards their Bitcoin holdings.
