Bitcoin Ecosystem Layer (II): Awakening of the Bitcoin Economy

Original Title: Bitcoin Layers: Bitcoin Economy Awakened (Part 2 of 4)

Original Author: Spartan Group et al.

Translation by: 0xNirvana

The Continuously Evolving Bitcoin Narrative

Since its inception in January 2009, Bitcoin's role and potential have undergone significant evolution. Initially, many viewed Bitcoin as a tool for hedging against inflation, a means of storing value (SoV), and a hope for democratizing the financial system. It wasn't until recently, in the fifteenth year since Bitcoin's launch, that the network's role has regained attention—specifically as a platform for shaping future decentralized applications (dApps). This evolution is particularly noteworthy at this stage for several reasons: Ethereum has achieved remarkable success in applications, Bitcoin's dominant position as an asset relative to Ethereum has not diminished but rather strengthened, undoubtedly influencing expectations for the Bitcoin network. Inspired by this, developers have introduced numerous infrastructure "layers" on top of the Bitcoin core network (Layer-1 or L1). These Bitcoin ecosystem layers leverage Bitcoin's stability and security while aiming to unlock over $850 billion in dormant assets and growing, without altering L1, by enhancing scalability and programmability. Today, we are all witnesses and participants in the significant advancements of the Bitcoin ecosystem layers, hoping these layers can impact BTC assets, fully inherit Bitcoin's reorganization security and finality, while overcoming its limitations in programmability and performance. Looking ahead, these unique infrastructure layers added to the Bitcoin ecosystem will become the cornerstone for many application entrepreneurs.

Despite the progress made, many necessary infrastructures remain in development and testing phases. Notably, the journey the Bitcoin ecosystem is experiencing is not without precedent. In 2017, early NFT and token projects flooded the Ethereum network, leading to slowed transaction speeds and a significant increase in transaction fees, which sparked the developer community's ambition to build stronger infrastructure. Even though their efforts could only support a small fraction of the massive potential application demand on the Ethereum network, developers aimed to provide the necessary scalability and flexibility for the network. At that time, the Ethereum community discussed and experimented with various methods and ultimately decided to adopt a layered approach to enhance its performance and scalability, leading to the widely used and accepted Ethereum Layer-2 (L2) we see today, with its total value locked (TVL) reaching billions of dollars. Therefore, Ethereum's experiences in scalability, ecosystem growth, decentralized applications, and its underlying network can serve as valuable lessons for Bitcoin.

Similar to Ethereum's pivotal moment in 2017, the introduction of Ordinals in 2023 marks a significant cultural turning point for "building on the Bitcoin ecosystem." This shift has sparked a developer renaissance, focusing on building infrastructure and scaling layers on top of Bitcoin L1. We are now witnessing not only the emergence of new protocols and token standards (such as BRC-20) but also the development of new Bitcoin L2s, which are beginning to unlock the potential of the Bitcoin economy, allowing us to glimpse the dormant capital worth over $850 billion that may be unlocked, relying on the industry's most stable and tested technology to date. Thus, the Bitcoin narrative is being redefined: Bitcoin is no longer merely a store of value or an asset; it is realizing its significance as infrastructure within its expanding economy.

Drawing a parallel to Ethereum's growth trajectory, the Bitcoin ecosystem is likely to experience a surge in user adoption, driven by viral use cases that can kickstart a growth flywheel. This, in turn, will attract more developers and increase the ecosystem's application TVL. Considering Bitcoin's market capitalization of approximately $850 billion, about 3.15 times that of Ethereum's $270 billion market cap, and in contrast, the current Bitcoin application TVL is only $320 million, while Ethereum's application TVL is $76 billion. In other words, these figures suggest that to reach a maturity level similar to Ethereum at the application layer, the Bitcoin ecosystem may have a potential growth opportunity of 740 times. Furthermore, we must consider that once the ecosystem gains momentum, there may be additional liquidity influx.

The Huge Market Potential of Bitcoin Smart Contracts

The Battle Between "Network" and "Asset"

To deeply understand the evolving new narrative, we need to distinguish between Bitcoin digital assets (BTC) and the Bitcoin network (i.e., Bitcoin Core, Bitcoin L1, Bitcoin blockchain). Many people are confused by the term "Bitcoin," as it can refer to both the network and the token. While closely related, they are fundamentally different. To avoid confusion, this report uses "Bitcoin" when referring to the network and "BTC" when discussing the token or digital asset.

The famous white paper of the Bitcoin network (Bitcoin: A Peer-to-Peer Electronic Cash System, by Satoshi Nakamoto) was published on October 31, 2008, introducing a peer-to-peer electronic cash system, and shortly thereafter, the Bitcoin network went live. Its genesis block was mined on January 3, 2009. Since its release, the network has maintained stable operation, while other networks have experienced downtime, attacks, and various issues, proving Bitcoin's viability as the ultimate L1 network. Bitcoin has demonstrated its ability to provide trust without centralized intermediaries and serve as the ultimate decentralized settlement layer for transactions, assets, and future applications. However, due to Bitcoin's lack of flexible programmability and the inability to write to the network without external trust, developing applications beyond the BTC asset itself has been quite challenging. Unlike Ethereum, a significant difference for Bitcoin is that it does not natively support smart contracts; without smart contracts, all development based on the Bitcoin network requires creating more tools to achieve similar functionalities. Smart contracts are a key feature that enables decentralized applications to use BTC as an asset or settle transactions on Bitcoin L1.

BTC (the digital asset) has traditionally been viewed as a means of storing value and a hedge against inflation in turbulent global financial markets. The emergence of BTC provided the world with a digital, permissionless, censorship-resistant, and scarce global asset. Throughout its existence, BTC's status as a top crypto asset has never been shaken, with its market capitalization currently exceeding $850 billion, peaking at $1.25 trillion in November 2021. However, even more than a decade later, the general public still primarily views BTC's function as a store of value as its main value. Unless BTC undergoes further evolution and innovation, it will be challenging to see BTC gain more utility, and the public's assessment of its value is unlikely to surpass current perceptions.

The Bitcoin ecosystem layers provide a solution to this issue. BTC assets are the initial use case of Bitcoin L1. If Bitcoin ecosystem layers, such as Bitcoin L2, can run smart contracts that use BTC as an asset, then Bitcoin L1 can retain its key advantages (such as security, durability, and decentralization) while allowing for unlimited experimentation on other Bitcoin ecosystem layers. Applications can use BTC as their asset, operate on L2 tracks, and settle transactions on L1. These L2 tracks can provide faster and more scalable transactions while gradually inheriting security from L1. This makes "building on Bitcoin" possible and redefines the Bitcoin narrative, establishing it as the infrastructure of a truly valuable and expanding Bitcoin economy.

Building in the Bitcoin Ecosystem

In recent years, the market has demonstrated that "building on the Bitcoin blockchain" can bring unique opportunities and challenges. Unlike other blockchains, Bitcoin was created to be viewed as an asset or "currency," rather than as an application platform. Other blockchains have explicitly entered the public eye as application platforms. To understand why Bitcoin's maturation process is slower compared to other ecosystems, it is essential to reflect on its initial conditions:

• The Bitcoin network is open to everyone, regardless of their background or technical knowledge. The Bitcoin code is open-source and can be copied and modified. This openness fosters a culture that encourages experimentation, with no single group or individual able to decisively influence the direction of blockchain development.
• The interoperability of the Bitcoin network is limited, leading to the emergence of unique derivative products. Bitcoin's derivative networks are entirely independent, possessing their own assets and lacking "backward compatibility" with the original Bitcoin network. Therefore, in the current state, BTC assets are confined within the Bitcoin network and cannot be directly removed or transferred to other blockchain networks.
• The lack of programmability poses significant obstacles to development. Since Bitcoin does not support smart contracts, it lacks flexible programming capabilities, which restricts its use as an application development platform. Coupled with severe performance limitations, viewing Bitcoin as a platform for construction presents a major challenge.
• Bitcoin L1 still requires assistance in speed and scalability. The Bitcoin network's ability to confirm transactions and process large amounts of transaction data in a short time is very limited. Due to the critical need to ensure decentralization, the size and frequency of records (also known as blocks) in the Bitcoin blockchain are restricted. With an average of one block produced every 10 minutes and an original block size of 1 megabyte, the on-chain transaction processing capacity of the Bitcoin network is affected, resulting in an average transaction confirmation time of over 10 to 30 minutes, which far exceeds the needs of most applications.

To address or improve these characteristics of Bitcoin, one must first understand the blockchain trilemma. Viewing Bitcoin L1 through this lens reveals that it is decentralized (a) and secure (b), but lacks scalability (c), with a transaction processing speed of only about 3 to 7.8 transactions per second. This limitation highlights the need to seek alternative solutions or additional ecosystem layers to compensate for the inherent flaws of the blockchain network.

The urgent demand for scalable solutions gave rise to the early development of the Ethereum network. Although Ethereum's security and decentralization are somewhat lacking compared to Bitcoin, it achieved significant growth by providing scalable solutions necessary for application development, such as Layer-2 networks (e.g., Arbitrum, OP Mainnet) and subnets (e.g., Avalanche's Evergreen). Throughout the industry, similar trade-off solutions have emerged, sparking a wave of development focused on scalability solutions, including sharding, nested blockchains, state channels, supernets (e.g., Polygon Edge), app-chains, and Layer-2 networks (also known as sidechains).

For years, the focus has primarily been on Ethereum and its compatible Ethereum Virtual Machine (EVM) ecosystem. However, by 2023, with the latest upgrades to Bitcoin L1 and the emergence of Ordinals, we are witnessing a shift in the industry's focus. Developers are redirecting their attention to Bitcoin, particularly to address its scalability issues—an essential component of Bitcoin L1's trilemma (security, decentralization, and scalability).

Bitcoin Scalability: Key L1 Upgrades

Significant advancements in Bitcoin's scalability began with the Segregated Witness (SegWit) update in July 2017. This upgrade marked an important change by separating the unlocking code into a dedicated part of each Bitcoin transaction, thereby shortening transaction times and expanding block capacity beyond the 1MB limit set by Satoshi Nakamoto in 2010.

SegWit introduced a revised block size measurement method using "weight units" (wu), later referred to as vsize/vbyte, allowing each block to contain up to 4M weight units (4wu), effectively expanding the block size to about 4MB. This change was designed to be backward compatible with all previous versions of Bitcoin Core, significantly improving transaction efficiency.

Bitcoin: 1MB Block Size Capacity Factors. Source: Glassnode

SegWit achieved this by splitting the data structure, separating the "witness data" (including signatures and scripts) from the transaction data in a new section of the Bitcoin block, which contains details such as sender and receiver information. This structural introduction divided the new 4wu (weight unit) block size into the following two parts:

• Each virtual byte (vbyte) of witness data counts as 1 weight unit (wu), with each virtual byte of transaction data counting as 4 weight units (wu), which is four times the weight of each virtual byte of witness data.

What is Different About SegWit? Source: Cointelegraph

Following SegWit, Taproot was another significant upgrade to Bitcoin, activated in November 2021. Taproot is a soft fork that removed the maximum limit on witness data for each transaction, enabling faster transaction speeds, enhancing privacy through Merkelized Alternative Script Trees (MAST), and achieving more efficient key signatures through Schnorr signatures. Taproot also facilitated asset transactions on Bitcoin L1, introducing protocols such as Pay-to-Taproot (P2TR) and Taproot Asset Representation Overlay (Taro).

• Taro is a protocol based on Taproot technology that supports issuing, sending, and receiving assets on Bitcoin L1 and the Lightning Network. The protocol launched its mainnet Alpha version in October 2023.
• Schnorr signatures enable key aggregation by introducing the ability to combine multiple public keys and signatures into one. In short, it combines multiple signatures for verification rather than aggregating each signature individually, thus improving transaction efficiency.
• MAST increases privacy by hiding preset conditions related to transactions and does not publish unused outcomes on-chain, enhancing privacy while reducing transaction size and thus lowering data usage.
• P2TR introduces a new way of making Bitcoin payments through Taproot addresses.

These L1 upgrades laid the groundwork for further development of Bitcoin ecosystem layers, which had been quietly progressing behind the scenes until the release of Ordinals, bringing Bitcoin's construction efforts back into the spotlight, marking a new era of Bitcoin scalability and functionality.

The Renaissance of Bitcoin Builders Triggered by Ordinals

Despite the L1 upgrades, Bitcoin's development activities experienced a stagnation period following the conservative outcomes of the "block size debate" in 2017, lasting until 2022. This relatively slow development pace was primarily due to the focus on maintaining Bitcoin Core L1, with less attention given to developing the broader infrastructure needed to build a vast ecosystem. Within Bitcoin's limited development activities, the focus was mainly on emerging ecosystems like Stacks (with over 175 active developers monthly) and Lightning, which only represent a small fraction of industry developers.

In December 2022, with the emergence of Ordinals, the development landscape of Bitcoin underwent a significant change. Ordinals allowed for the creation of immutable digital artworks on-chain, reactivating the Bitcoin developer community, and it is expected to evolve into a $4.5 billion market by 2025. An increasing number of developers are no longer limiting their focus to Ethereum but are expanding their horizons to include Bitcoin L2 solutions. This key development marks a revival of participation and innovation within the Bitcoin ecosystem, laying the foundation for a new wave of growth and technological advancement.

Number of Monthly Active Bitcoin Developers. Source: Electric Capital

The introduction of Ordinals has had a profound impact on the Bitcoin network, particularly reflected in the increase in transaction fees. Compared to the relatively moderate fee levels of 1-3 sats/vB in 2022, transaction fees experienced an astonishing surge of 20 to 500 times when Ordinals began to gain attention in May 2023. By December 2023, its annual growth rate had reached 280%. This data surge significantly indicates a sharp increase in market activity and interest in the Bitcoin network, playing a key role in revitalizing the Bitcoin builder culture and ecosystem. Although higher fees contribute to increasing Bitcoin's long-term security budget, exceeding current standards, they also reflect the growing demand for Bitcoin block space.

Average Bitcoin Transaction Fees Peaked in May 2023 Due to Ordinals. Source: ycharts

The surge in Bitcoin network usage has placed immense pressure on its infrastructure, particularly reflected in rising transaction costs, while also presenting new challenges regarding affordability and practicality. This trend becomes particularly evident when users face disproportionately high fees relative to transaction amounts. For example, a Bitcoin transaction worth $100 might incur fees as high as $50, significantly diminishing its economic viability. The same situation extends to Lightning Network channels, as closing a channel of similar transaction value becomes impractical due to excessive costs. If transaction fees are too high, such as 1000 sats/vB, the network will face increasingly complex situations. Therefore, there is an urgent need for scalable solutions within the Bitcoin ecosystem to meet the growing demand while maintaining transaction viability.

The phenomenal Ordinals have reignited developers' interest in Bitcoin, but this has also further amplified Bitcoin's limitations. Particularly due to Ordinals' lack of support for fully expressive smart contracts, developers have shifted their focus to other platforms. This highlights the need for more complex scalability solutions within the Bitcoin ecosystem to ensure its utility and relevance in the broader blockchain and financial sectors.

The Strategic Necessity of Layer-2 Solutions

Thus, for the Bitcoin network to achieve functional enhancements and further success, L2 solutions are becoming increasingly important. L2 operates on top of L1, improving scalability and reducing transaction costs by facilitating off-chain transaction channels. Unlike Ethereum, where L1 natively supports smart contracts, Bitcoin's L1, due to its initial design emphasizing security and decentralization, relies on L2 solutions to provide this functionality. This reliance underscores the critical role of L2 solutions in expanding Bitcoin's utility, not limited to basic transactions but also enhancing its efficiency, scalability, and overall appeal in the digital asset space.

Although Bitcoin's L2 solutions are still in the early stages of development, they are expected to achieve significant growth. In contrast, mature alternative L1 scaling solutions like Ethereum and L2 solutions such as Polygon have reached higher levels of maturity. Since 2017, due to extensive efforts from developers, these networks have been equipped with advanced tools (e.g., Starknet, ZKSync) and functionalities, as reflected in their TVL data, which accounts for approximately 9.0% to 12.5% of their market capitalization. With ongoing technological advancements and continuous innovation, Bitcoin's L2 solutions are also expected to reach similar levels of maturity and may develop into an economic system that rivals or even surpasses existing L2 solutions. It is predicted that in the future, Bitcoin's L2 solutions will be able to handle a significant volume of Bitcoin transactions, potentially exceeding 25% of all Bitcoin transaction volume, representing a substantial leap compared to the current usage rate of Bitcoin L1.

Author's Update (February 8, 2024)

Some of the latest developments in Bitcoin L1 infrastructure aim to simulate smart contract functionality without establishing a dedicated smart contract layer. Innovations like recursive Ordinals (BRC-420) and discussions about re-enabling the "OP_CAT" function through soft forks are all intended to facilitate complex transactions similar to DeFi, bypassing traditional smart contracts.

Once again, it is emphasized that unlike Ethereum's EVM-compatible chains that achieve composability through a universal virtual machine, Bitcoin's framework lacks such a smart contract mechanism. This fundamental difference requires Bitcoin projects to deploy additional tools and more complex integration strategies to provide a user experience comparable to Ethereum. This may lead to experiments on L1 facing similar scalability challenges as the underlying network. Thus, different levels of smart contract applications have begun to emerge in the ecosystem and are likely to expand further.

For instance, the team behind BRC-420 recently launched Merlin Chain, a Bitcoin-native L2 solution aimed at alleviating scalability issues. Additionally, Ordz Games launched the first-ever Bitcoin-based game last year, utilizing the BRC-20 token $OG, which achieved an 81x oversubscription in its decentralized exchange offering (IDO) on ALEX Lab's Launchpad earlier this year. In the subsequent parts of this series, we will delve deeper into these innovations and outline the ongoing evolution of the Bitcoin ecosystem.