Interpretation of Bitcoin Layer 2, solving the "impossible triangle" dilemma

Original Title: "UNDERSTANDING THE 'BITCOIN L2 TRILEMMA'"

Author: Trevor Owens

Compiled by: Frank, Foresight News

As a venture capitalist, I stand from a "token agnostic" perspective. Since we invest at the early stages of new technology development, we are investing in equity rather than tokens, thus only proportionally acquiring the corresponding tokens. We firmly believe that for tokens to be effective, they should play a crucial role.

Essentially, removing the token should undermine the core value proposition and underlying architecture. Using tokens merely for the sake of having a token, or avoiding the use of tokens without reason, would be a dangerous signal. However, in most Web3 projects, there are numerous tokens launched just to have a token.

Projects that might have succeeded fail due to the unsustainability of their token economics, leading to significant economic losses for investors. In contrast, within the Bitcoin community, you will find developers wasting countless hours on unsolvable technical issues, which I refer to as "token-less token" solutions—I liken this approach to "trying to have sex without having a relationship," as both methods seem unreasonable.

Now, let’s delve into the three aspects of this impossible triangle dilemma:

1. OFF-CHAIN Networks

For example, the Lightning Network and RGB.

These solutions are not blockchains but networks that store data off-chain (user-stored), where there is no universal public ledger, significantly reducing the accessibility and interactivity of data and smart contracts. Therefore, users cannot experience the comprehensive functionalities that smart contract blockchains like Ethereum or Solana can offer.

They also require users to run their own nodes or infrastructure for complete decentralization, which leads to significant user experience barriers in terms of adoption. Nevertheless, the scalability and privacy advantages offered by this approach far exceed what blockchain technology can provide, making it the best choice for specific application use cases, especially large-scale payments.

2. Decentralized Sidechains

For example, solutions like Stacks, Interlay, Layer-0, etc.

Decentralized sidechains allow anyone to participate in consensus (i.e., mining) as they supplement their security budget with new tokens issued through the protocol, giving rise to a competitive miner market—miners expend resources to compete for the native tokens of the blockchain network, which are then used by users to pay gas fees when executing smart contracts.

It is expected that as usage increases and network effects strengthen, the demand for tokens will rise, making them economically sustainable. However, introducing additional tokens may complicate the user experience. Additionally, Bitcoin maximalists generally attack this, labeling it a scam, as these tokens are seen as competitors to Bitcoin.

This situation often makes life more difficult for developers. On the positive side, having tokens can foster community building and facilitate fundraising to support extensive research and development efforts.

3. Merged Sidechains

For example, solutions like Liquid, RSK, Botanix, etc.

In this case, without tokens, the only compensation for miners (or validators) can come from the companies behind the development work or from user fees generated by the blockchain network, but these fees are typically negligible in the initial years until the network is widely used.

This compensation for miners is necessary because, in proof-of-work consensus models, mining incurs costs, and in proof-of-stake, there is also a risk of capital being diluted. Even Bitcoin and Ethereum, each with over 100 million users, primarily fund their network security through token rewards.

To address this issue, merged sidechains do not allow mining to be open to everyone. For instance, Liquid has formed a group of 15 crypto service providers, including exchanges, OTC desks, and infrastructure providers. While this approach can operate well, it requires trust in the selected entities.

At the same time, to become more decentralized over time, an age-old dilemma arises: how to attract a large user base and generate substantial fees while operating within a trusted group? Currently, efforts are underway to design hardware solutions to automate and democratize membership, shifting trust to the hardware used.

So what are the advantages of merged sidechains? A simpler user experience, as these sidechains use a token pegged to BTC to pay network fees, thus avoiding the potential backlash from Bitcoin maximalists against new tokens. However, it remains uncertain whether this group of Bitcoin users will actually engage in the Web3 use cases enabled by these sidechains.

Other Insights: Mining vs. Cross-Chain

It is crucial to recognize the distinction between RSK and Liquid. The former employs merged mining, and as of February 2022, it has achieved an impressive 64% of the BTC hash rate. However, RSK adopts a merged mining and hardware-centric approach to build cross-chain bridges.

In contrast, token-based sidechains are building decentralized cross-chain bridges and using their native tokens as collateral. Examples in this regard include sBTC being advanced by Stacks, as well as alternatives from Interlay and several Layer-0 sidechains. By utilizing native tokens as collateral, this design provides an incentive model to maintain open membership in cross-chain protocols for BTC assets.

The recently launched BitVM through a white paper this month may propose a solution that minimizes trust in merged cross-chain bridges and eliminates the need for hardware-based solutions.

Three Potential Solutions to the Impossible Triangle

Many potential solutions require a Bitcoin soft fork, which may take considerable time to gain support. Drivechains are a recent controversial example, initially proposed in 2017, now at its peak, while Validity Rollup (or ZK Rollup) has brought hope and garnered more positive feedback from several Bitcoin core developers.

However, effective implementation remains a challenge and may even be a distant reality. Merged mining is intriguing, especially as RSK has demonstrated that Bitcoin miners will adopt it significantly even without compelling incentives. However, the absence of tokens still means relying on trusted cross-chain bridges or advanced hardware configurations that await market validation.

In the coming years, BitVM may revolutionize merged cross-chain bridges alongside merged mining and potentially resolve the decentralization dilemma.

EVM Issues (Another Topic)

It is worth emphasizing that many sidechains choose EVM; RSK, Botanix, and many Layer-0 solutions have adopted this approach, accelerating market expansion and ensuring compatibility with exchanges and EVM-centric blockchain infrastructure.

In contrast, Stacks and Starkware (ZK Rollup) have designed their own virtual machines aimed at improving EVM in specific areas (such as determinism and ZK compatibility). This double-edged sword means they may lose network effects but could provide developers with a platform to create better applications and distinguish themselves from market-leading Ethereum applications.

Abolishing All Tokens

For most builders, decisions regarding tokens should be rooted in their consideration of real issues. Due to their support for smart contracts on Layer 1, Layer 2 Rollup solutions do not require tokens, yet leading projects like Optimism and Arbitrum also have tokens.

They leverage these tokens to strengthen community ties and fund development, further complicating the question of whether tokens are necessary based on market evidence. Coinbase's recently launched Layer 2 network, Base, has gained significant traction without launching a token, yet Coinbase has indicated that launching a token remains an option for the future.

Based on my past experience as a corporate innovation leader and entrepreneur, I liken the debate over tokens versus no tokens to the dilemma of startup equity versus corporate equity. In my book, "The Lean Enterprise," I highlight numerous examples of internal innovation attempts failing due to a lack of incentives proportional to the high risks and extensive R&D required by these projects.

Even Google, known for its innovation-focused corporate culture, has witnessed its employees forgo substantial stock options to start their own ventures, leading to the emergence of giants like Twitter, Instagram, Niantic, and Pinterest, resulting in a potential market cap loss exceeding $100 billion.

Layer 2 projects carry immense risks, with most projects destined to fail, and the funding required to develop them is substantial. Although the security benefits provided are not as strong as Validity Rollup solutions (like Optimism, Arbitrum, and Base), they cannot create new Bitcoins to fund the security budget of new blockchains or developer communities.

Polygon is a sidechain of Ethereum, and among all Ethereum scaling solutions, it still dominates in market capitalization and developer engagement. It is now shifting towards a ZK-based strategy, so even if zk-rollup itself does not require tokens, having a native token may provide a competitive advantage. As with all business-related matters, there are no clear answers.

Final Thoughts

The Bitcoin L2 space is fascinating, with protocols like Ordinals, BRC-20, and Runes attracting more Web3 developers to build on Bitcoin, intensifying competition. As Web3 investors, our focus remains on applications and infrastructure while trying to avoid token trading.

Currently, we are interested in off-chain networks and decentralized sidechains with unique application advantages, primarily because they offer open member consensus models, community building, and capital acquisition advantages. If BitVM successfully introduces a more minimal trust approach for merged cross-chain bridges, we are also optimistic about merged mining.

Importantly, both collateral-driven cross-chain bridges like sBTC and the BitVM approach are still in development. BitVM was just announced this month through a white paper and has sparked significant interest among developers, while sBTC has been in development for over a year with substantial resources invested. Ultimately, in addition to investing in Bitcoin L1 applications and infrastructure, the Bitcoin Frontier Fund also aims to strategically venture into these three areas.