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Jan 10, 2024
What are Bitcoin Layer 2 Solutions? The Innovative Layer with Broader Implications for DeFi
by Orderly Network
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The launch of Bitcoin in 2009 ushered in a new era of global technological and financial innovation. Since Bitcoin was launched, other blockchain solutions have since emerged. However, unlike Bitcoin, newer blockchain technologies have incorporated smart contracts, enabling them to perform more complex functions and power sophisticated decentralized applications.

Furthermore, blockchains such as Ethereum (the pioneer of DeFi) have since supported blockchain layer 2 solutions that address their inherent deficiencies, such as slow transaction processing, and high transaction costs, among others.

Recent activities on the Bitcoin network, however, point to the fact that it is undergoing a massive evolution. These developments include the introduction of Layer 2 solutions and smart contracts to Bitcoin, thus bringing the network on par with newer blockchain solutions while ushering in a new wave of decentralized usage to the Bitcoin network.

The Role of Layer2 Blockchain Solutions

Bitcoin layer 2 solutions may be a tad bit late to the party, but they are set to play a prominent role when the ecosystem is fully developed. Before fully diving into Layer 2s on the Bitcoin network, first, a mini explanation of the role that Layer 2 solutions play in blockchain overall.

Blockchain Layer 2 networks are protocols or networks built as layers on top of an existing blockchain. This has been the case with the Ethereum blockchain which currently hosts the most layer 2 solutions in Web3. Some of Orderly’s ecosystem partners like Optimism, Linea, and Arbitrum exist as Layer 2 solutions on Ethereum.

The major role of blockchain Layer 2 solutions is to address the inherent deficiencies in Layer 1 blockchains. They often offer solutions at reduced transaction costs (cost efficiency), while having the capacity to process transactions at several hundreds of thousands per second. Layer 2 solutions, however, rely on the underlining Layer 1 for security. Hence, the relationship between L1 and L2 is symbiotic - whereby L2s fix the inherent issues in L1s, and L1s offer security to L2s.

Recent Developments on the Bitcoin Network

For much of its existence, the Bitcoin network has served a single purpose, which is to serve as a means of exchange, barring the advent of wBTCs. Recent developments on the Bitcoin network, however, point to the emergence of new use cases that can bring Bitcoin on an equal footing with innovative use cases on newer blockchains.

Recently, we have seen the emergence of Bitcoin Ordinals, which are non-fungible tokens on the base layer of the Bitcoin network. There has also been a gradual emergence of Bitcoin Layer 2 solutions, with L2s like Stacks, Rootstock Infrastructure Framework (RIF), and Dovi leading the charge.

 BTC Dominance Chart

Fig1; BTC Dominance Chart. Source; Coingecko

The emergence of Bitcoin NFTs and the development of L2s contributed to Bitcoin’s dominance in 2023, rising from 38% market dominance to 50% by the end of last year. And, Bitcoin’s market leadership could still rise further when Bitcoin L2s are fully developed.

Just as with L2s on other networks, L2s on the Bitcoin blockchain are solutions that promise to address certain deficiencies on the Bitcoin network.

Bitcoin L2s will play a fundamental role in introducing smart contracts to the Bitcoin network. Smart contracts have been the building blocks of decentralized applications in web3; their introduction to the Bitcoin blockchain will significantly expand the scope of what the network is capable of and further and boost activities on the network.

In particular, L2s will address the prolonged scalability issues that have plagued Bitcoin. The average TPS (transaction per second) of the Bitcoin network currently sits at about 7 per second, a number dwarfed by Ethereum’s average TPS of 40,000 since its transition to the PoS mechanism, with the possibility of reaching up to 100,000 TPS. For DeFi to tap into the robust liquidity of Bitcoin, its overall scalability must be significantly increased. The emergence of L2s is certainly a step in the right direction to boosting scalability on the Bitcoin Network.

Lastly, Bitcoin L2s will cut gas fees on the Bitcoin network. L2s are known to charge fees as low as one cent per transaction. This is a significant upgrade from the huge transaction fees that have become synonymous with the Bitcoin network. Conversely, Bitcoin L2s are set to benefit from the decentralized and impenetrable security of the Bitcoin blockchain. They will be secured by the Bitcoin base layer and should boast the strongest security of all L2 solutions in Web3.

What Bitcoin L2s mean for DeFi

Bitcoin L2s might be coming a little later than their peers on the Ethereum blockchain. Nonetheless, they are set to benefit immensely from the reach, liquidity, and substantial market dominance of Bitcoin. When fully developed, Bitcoin L2s have the potential to greatly impact DeFi by pioneering innovative solutions, hence further cementing Bitcoin’s dominance in Web3.

BTC TVL Charts

Fig 2; BTC TVL Charts. Source: DefiLlama

At present, figures from Coinmarketcap estimate BTC’s market capitalization at $868 billion, with only $315 million of this amount in BTC DeFi TVL. This pales in comparison with Ethereum, which has a total DeFi value locked estimated at $28 billion. The presence of smart contracts and a well-developed L2 architecture is a major contributing factor to this TVL disparity.

Hence, the development of Bitcoin L2s should quickly introduce innovative DeFi products to the Bitcoin network. Project tokens that are compliant with the emerging BRC-20 standards are poised to grow, while products such as arbitraging, yield farming, and staking will also grow on the network. This is already evident with the emergence of protocols like Babylon.

There is no doubt that the Bitcoin L2 landscape is still nascent, yet it shows a lot of promise. L2s could also lay the foundation for the long-awaited interoperability that has, so far, eluded the Bitcoin network. In essence, a booming DeFi ecosystem on Bitcoin will inadvertently entrench BTC as the most dominant asset in cryptocurrency.

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