Binance Research: Bitcoin Enters a "New Era"

Original title: "A New Era for BTC"

Original source: Mac Naggar, Binance Research

Original translation: MarsBit

Key Takeaways

Despite smart contracts  Layer‑1  constantly making headlines, Bitcoin has retained its dominance on the cryptocurrency market cap charts.

Nevertheless, Bitcoin's sustainability is worth discussing. How will the declining block rewards (halved every four years) and relatively low transaction fees affect Bitcoin's security model? While Bitcoin has maintained its lead, will this continue in the future without the Bitcoin native smart contract market?

The ordinals and inscriptions that appeared in early 2023 may have some answers. With this latest innovation, we are not only witnessing the birth of “Bitcoin NFTs”, but also a resurgence of excitement and attention across the Bitcoin ecosystem as a whole.

Inscriptions have had a notable impact on Bitcoin’s on-chain metrics, with transaction fees trending upward. Perhaps most importantly, the pace of innovation is accelerating, with developers releasing updates left, right, and center.

With increased activity on Bitcoin and a plethora of new use cases, the question of scalability naturally follows. How will Bitcoin handle the increased traffic? Enter Bitcoin Layer 2.

While the Lightning Network continues to grow and focus on its payments use case, Stacks and Rootstock provide Bitcoin developers with access to layers to execute general-purpose smart contracts. Rootstock has EVM compatibility, while Stacks' upcoming sBTC solution may ultimately provide a highly trust-minimized way to move BTC from Layer 1 to Layer 2. Rollkit's take on sovereign Bitcoin rollups is also interesting and worth a closer look.

A maturing Bitcoin smart contract market, Bitcoin rollups, and the upcoming Bitcoin halving are some of the key themes we conclude this report with.

Introduction

While smart contract platforms like Ethereum, BNB Chain, and Solana continue to make headlines, a quick glance at the cryptocurrency market capitalization (“Market Cap”) makes one thing clear:

 Bitcoin Still Dominates.

While Bitcoin’s dominance has trended downward from 60‑70% in 2020 and 2021, the cryptocurrency pioneer still commands a large portion of the market. This is a testament to the conviction of Bitcoin HODLers in holding onto the asset, given the relative lack of smart contract functionality on Bitcoin’s Layer 1 (“L1”) blockchain. It will also show that Bitcoin is more likely to be used for its original purpose as a form of hard currency than for non-monetary use cases, given the network’s relative lack of DeFi, NFT, and infrastructure markets. While we’ve seen a degree of innovation, with the Lightning Network and Stacks being notable examples, nothing has come close to the level of the mentioned smart contract giants. While this may be by design, and due to the slow and cautious nature of the Bitcoin network (ultimately a major selling point), it’s still worth noting. This is particularly concerning due to ongoing questions about Bitcoin’s security model. Bitcoin attracts miners through two economic incentives: coinbase rewards and transaction (“tx”) fees. Coinbase rewards, sometimes called block rewards, are halved approximately every four years and will eventually be reduced to zero. Ultimately, therefore, Bitcoin’s transaction fees will be the only compensation for miners, the security budget for L1 blockchains. Given Bitcoin’s limited use cases, primarily for asset transfers, these fees represent a very small percentage of miner revenue and are worth watching in the long run.

Things are changing all the time. In January of this year, the Ordinals protocol went live. Ordinals can record arbitrary data (images, videos, text, etc.) on the Bitcoin blockchain, creating digital artifacts or effectively NFTs. The total number of inscriptions is now over 600K and growing rapidly. With this change, excitement around Bitcoin is once again high, with increased attention paid to projects building around the network and the entry of major players such as Yuga Labs and Magic Eden. Not only has Bitcoin been affected through its mempool, transaction fees, and block size, there has also been a cultural shift in the way people view Bitcoin. Existing projects are gaining traction, while new builders are pouring into the ecosystem. It seems that there is suddenly an organic demand for Bitcoin block space.

In this report, we provide a brief update on Bitcoin’s recent performance, dive into ordinals and inscriptions, discuss Bitcoin’s nascent layer 2 (“L2”) ecosystem, and provide our expectations for what’s next for Bitcoin.

What Happened to Bitcoin?

To bring you up to speed on what’s going on in the world of Bitcoin, we’ll focus on three main areas. On-chain metrics, mining, and recent technical upgrades. While not exhaustive, we think having a handle on these key areas will provide you with the necessary knowledge to better understand the rest of this report.

On-chain Metrics

First, let’s take a closer look at Bitcoin’s daily transaction data. After easing off from the highs of the 2021 bull run, which saw over 300,000 transactions per day, transaction activity remained around 250,000 per day for much of 2022. This trend was recently broken, and in 2023, daily transactions have finally begun to rise. Daily transactions are now back above 300K due at least in part to the increased activity that ordinals and inscriptions are bringing to the blockchain (more on that in the Ordinals, Inscriptions, and NFTs on Bitcoin section)

What about Daily Active Addresses? Similar to Bitcoin’s daily transaction data, Bitcoin’s daily active addresses have fallen significantly from their 2021 highs, peaking at around 1.2M. After hitting the roughly 900K mark in 2022, Bitcoin’s daily active addresses have increased slightly this year, currently sitting at around 1M per day.

Another metric we can look at and seek to assess is development activity in the Bitcoin ecosystem. If we look at the full-time developer (“dev”) data for the top ecosystems, Bitcoin’s recent history looks relatively tame. Of the top 10 most valuable ecosystems, Bitcoin ranks near the bottom in terms of the number of full-time developers.

Between 2021 and 2022, Bitcoin saw a 4% decline in full-time developers. This ties with Tezos as the worst performer, while the group average is +17%.

Between 2020 and 2022, Bitcoin saw a 15% increase in full-time developers. This is the lowest of the group, while the group average is +252%.

What does this mean?

What the first two charts show us is that Bitcoin has maintained steady network activity in 2022. While steady network activity is commendable during a generally challenging year, it is worth noting that Bitcoin’s daily transactions have not shown strong strength, similar to levels observed in 2017. Daily addresses show stronger sustained growth. Bitcoin’s performance has been very weak in terms of development activity, which is perhaps not surprising given the seeming lack of opportunity in the ecosystem.

However, one thing we should be keenly aware of is that both daily transactions and daily active addresses have increased since January 2023. While not reflected in the year-end developer data for 2022 in Figure 5, we are seeing a renewed interest in developing on Bitcoin. A

Over the past few months, many new product launches and updates have gone live (covered in more detail in the Bitcoin Serial Numbers, Inscriptions, and NFTs section).

 Mining

We'll assume you know the basics of mining, but if not, take a quick look here.

It's been quite an eventful year for Bitcoin mining. Throughout 2022, miners have had to deal with a triple whammy of sorts. Rising energy prices (impacting the day-to-day operation of mining rigs), rising interest rates (increasing debt payments/making borrowing more expensive to survive), and falling Bitcoin prices (meaning less profitability for miners' output) have caused the Bitcoin mining sector to struggle. While many miners went bankrupt, some were bought out at bargain prices, while others have managed to barely survive.

While traditionally most miners sell a portion of their mined Bitcoin to cover expenses, many of them are HODLing in order to benefit from price increases over the long term. Due to the dire situation last year, many miners were forced to sell off a large portion of their Bitcoin inventory, further increasing selling pressure and also meaning that miners had to sell at extremely low prices.

Nevertheless, the situation has improved in 2023. While energy prices have not really slowed down, the price of Bitcoin has been rising, improving the rewards for miners that are still operating. In addition, as mentioned in the introduction, a core problem with Bitcoin's security budget is the limited transaction fees generated by the chain. This means that miners rely almost entirely on block rewards. In fact, as we can see below, over the last year, transaction fees have averaged only 1‑2% of total miner rewards. However, note that this has changed since the beginning of this year. Transaction fees are now trending towards 2‑3% of total rewards, and Hashrate Index data even shows some days with fees exceeding 5%. While not a major move, it is definitely a change in the right direction. To what extent this change is due to ordinals and inscriptions is a matter of debate, although on-chain metrics suggest that they are at least partially behind the growth.

Recent Technical Upgrades

Since 2017, Bitcoin has undergone two major upgrades: Segregated Witness (“SegWit”) in 2017 and Taproot in 2021.

Segregated Witness

SegWit is a 2017 Bitcoin soft fork upgrade. SegWit divides Bitcoin's transaction structure into two parts: transaction data and witness data. It also

changed the way block size is measured, introducing the concept of block weight, making witness data only 25% as important as transaction data. This effectively means that Bitcoin's block size has increased, and it has become easier and cheaper to store data in the Witness portion of a transaction. Essentially, SegWit allows Bitcoin's maximum block size to increase from 1MB to 4MB (1MB of transaction data and 3MB of witness data).

Taproot

Taproot is a 2021 upgrade to Bitcoin that is also a soft fork. Taproot consists of three different Bitcoin Improvement Proposals (“BIPs”); BIP 340, BIP 341, and BIP 342, bringing more privacy, scalability, and composability to the blockchain. The two main impacts of Taproot are allowing advanced scripting in the Witness portion of a block, and removing the data limit between the two parts of a block, allowing up to 4MB of data in the Witness portion.

Bitcoin’s Serial Numbers, Inscriptions, and NFTs

A Short History Lesson

It may be surprising to learn, but NFTs on Bitcoin actually predate NFTs on Ethereum (and arguably, predate the invention of Ethereum itself!). The 2012 open source project Colored Coins(1) differentiated regular Bitcoins from “colored” Bitcoins. In hindsight, this project was clearly ahead of its time and lost, but was the first of its kind and introduced a method that captured the attention of the relatively small crypto community from 2012 to 2014.

The next notable project worth mentioning is Counterparty. Founded in 2014, Counterparty is built on top of Bitcoin (somewhat similar to L2 solutions) and allows users to issue and trade tokenized digital assets. Counterparty is responsible for launching the decentralized exchange (“DEX”) long before current market leaders like Uniswap and Curve, as well as the now famous Rare Pepe series. Rare Pepes was released on Counterparty in 2016 and is perhaps the most famous Bitcoin NFT of all time.

Counterparty and Rare Pepes undoubtedly accelerated efforts to build infrastructure around NFTs, including wallets and marketplaces, and played an important early role in the nascent NFT space.

After the Counterparty and Rare Pepes NFTs (and a few other smaller collections), the still very young NFT market turned to Ethereum. In 2017, we saw the creation of Cryptopunks, and later in the year we saw the launch of Crypto Kitties from Dapper Labs.

Nevertheless, the real boom in NFTs began in late 2020 and early 2021, with $69 million in Beeple NFT sales in March 2021.

(2) is a highlight. The next big move for Bitcoin NFTs came in December 2022, when the first serial inscription was minted.

How do serial numbers and inscriptions work?

ORD, an open source software that can run on top of any Bitcoin full node, can track individual Satoshis based on what founder Casey Rodarmor calls "Ordinal Theory." Satoshis ("sats") are the smallest unit of the Bitcoin network, with 1 Bitcoin = 100,000,000 sats. Ordinal theory assigns a unique identifier to every person on Bitcoin. Furthermore, these individual sats can be “inscribed” with arbitrary content, such as text, images, videos, to create “inscriptions”, Bitcoin-native digital artifacts (3) also known as NFTs.

“Individual sats can be “inscribed” with arbitrary content, such as text, images, videos, to create an “inscription”, Bitcoin-native digital artifacts (3) also known as NFTs.”

Earlier we talked about Bitcoin’s recent technical upgrades: SegWit and Taproot.

SegWit allows cheaper data to be put into the Witness section of a transaction, effectively increasing the block size, while Taproot allows advanced scripting in the Witness section. Combined, these two updates are critical to Inscriptions, as they allow up to 4MB of arbitrary data to be stored in the Witness section of any Bitcoin block. This constitutes an upper limit of 4MB for any Bitcoin inscription.

How do Inscriptions compare to the NFTs we’re used to?

Fully On-Chain: The inscription is stored directly on the Bitcoin L1 chain. A common criticism of the most popular group of NFTs, namely ERC‑721 NFTs, is that many of them have their metadata stored on platforms like IPFS, Arweave, or sometimes completely centralized Web2 servers. These solutions may not be fully reliable and rely on external factors to continue to exist. On the other hand, the inscription will exist as long as Bitcoin exists. This adds a layer of permanence; a quality that is very attractive to many types of collectors.

Immutable: Since they are stored directly on-chain, inscriptions are always guaranteed to be completely immutable. While many current NFTs are immutable, many of them can also be modified or deleted by the contract owner. This is not possible with inscriptions and adds to their sense of permanence.

Ordering: Given that inscriptions are inscribed on individuals using ordinal theory, this means that each inscription is technically ordered. There is the 500th inscription and the 9999th and so on. This is a unique feature of most current types of NFTs and adds different levels of value; another feature that may be very attractive to collectors, such as those collecting inscriptions below 100k or the first inscription after a block halving, etc.

Scarcity/Size Limits: As mentioned earlier, through the combination of SegWit and Taproot, Bitcoin blocks can store up to 4MB of data. This sets an effective upper limit on the size of a Bitcoin inscription and the number of inscriptions that can be inscribed on a Bitcoin as a whole, which gives us ~210GB per year if the entire 4MB space is a single inscription, assuming approximately 144 Bitcoin blocks are mined per day. Most smart contract-based NFTs have no such upper limit and can theoretically mint an unlimited number of NFTs.

How Are Bitcoin Metrics Affected?

As mentioned in the recent technical upgrade, Taproot was adopted earlier this year as serial numbers and inscriptions began to become more popular.

Average Block Size:

Inscriptions and ordinals have fueled unprecedented demand for Bitcoin block space. This is made very clear by the dramatic rise in average block size in early February 2023 (from 1.2MB in January to over 2MB now).

Inscriptions and ordinals have fueled unprecedented demand for Bitcoin block space

Bitcoin Mempool Growth: If we look at data for Bitcoin’s mempool, we can see a similar pattern. Remember, the mempool is essentially a waiting room for unconfirmed transactions waiting to be put into a block.

Bitcoin's total number of unconfirmed transactions, or mempool transaction count, has been rising in early 2023. Without two peaks last year, the mempool held about 5,000 transactions on average. This number has been rising steadily in February and March and is now approaching the 25K mark. Compared to 2022, this appears to be a more permanent increase in the mempool rather than a temporary spike.

Impact on Bitcoin Transaction Fees:

 As mentioned earlier in the mining section, Bitcoin's relatively low transaction fees have been a problem and remain a long-term problem as block rewards drop approximately every four years, i.e., every halving.

Ordinals and inscriptions have a positive impact on Bitcoin transaction fees. As you can see below, Ordinal fees have been growing steadily over the past few months and have averaged approximately 10% more than non-Ordinal transaction fees over the 3-month period.

In fact, the cumulative fees paid for the minting of Ordinals Inscriptions now exceed 150 BTC(4). Assuming Ordinals continue to gain adoption, this could generate sustainable demand for Bitcoin blockspace and ensure Bitcoin miners become less reliant on pure block rewards given this additional revenue stream.

A notable spike in Bitcoin full node runners: As mentioned in How Ordinals and Inscriptions Work, the ORD software is required to enable tracking of individual sats in order to view the Bitcoin chain from an ordinal theory perspective. This means that while solutions like the Ordinals Marketplace have emerged for casual users, for a user to have full control over the entire Ordinal process and “mint” inscriptions, they must run a full Bitcoin node (not a lightweight node). This factor (along with others) has led to a surge in the number of accessible Bitcoin nodes. The more active Bitcoin nodes there are, the more decentralized the Bitcoin network is. So while this may just be a one-time spike, the upward momentum is certainly encouraging and positive for the Bitcoin network as a whole.

The pace of innovation within the Bitcoin ecosystem has accelerated Since the launch of Ordinals, the pace of innovation and improvement in Bitcoin infrastructure  dApps has been remarkable. The likes of Hiro and Xverse(5) quickly added Ordinals support and released products like Ordinals Explorer (primarily for Stacks-based projects), and Gamma recently released their (6) Bitcoin NFT marketplace (formerly Ordinals marketplace(7)). In addition to incumbents like Magic Eden, they also followed up with their Bitcoin NFT marketplace the day after Gamma. Notable NFT studios Yuga Labs and DeGods Both released projects based on Ordinals last month.  

Debate in the Bitcoin Community

The emergence of Ordinals has sparked a debate within the Bitcoin community.

One camp believes that ordinals should not exist on the Bitcoin blockchain; more specifically, they believe that the true purpose of Bitcoin is to serve as a hard currency, not a legal tender, and to facilitate trustless peer-to-peer transactions. Peer-to-peer payments. In the eyes of these Bitcoin enthusiasts, any deviation from the currency/payment role undermines Satoshi's original vision for the network. They argue that data-intensive sequential transactions will only congest the Bitcoin network, drive up fees, and ultimately hinder peer-to-peer transactions. Pundits in this camp point to the fact that ordinal transactions are taking up a lot of block space and the recent rise in transaction fees as evidence to support their argument.

Bitcoin Transaction fees on the L1 network have indeed increased, something we have highlighted before. Specifically, between January 30 and March 28, the average Bitcoin fee per transaction increased by approximately 112%(8). However, this is not the problem we believe it is. Rather, as discussed, Bitcoin has long had a problem with low transaction fees, and as block rewards continue to decline, this means something for Bitcoin’s security budget. With increased transaction fees increasing miner revenue through increased block rewards, we finally have a miner revenue stream that is not dependent on rewards, but rather organic use of the blockchain. In response to the criticism that increased fees will discourage those who need to conduct peer-to-peer transactions, the response is simple; they should not be using the Bitcoin L1 chain to send payments; they should be using the Lightning Network (see the Lightning Network section for more information). As you can see below, fees on the Lightning Network have continued to decline over the past few months. Given that it is Bitcoin’s chosen solution for speed and security.

Peer-to-peer payments, cheaper fees are encouraging and suggest that higher transaction fees on Bitcoin L1 do not necessarily translate (at least not proportionally) into higher Lightning Network fees.

An opposing camp of Bitcoin maximalist crowds also argue that the Bitcoin network should be embraced for new use cases in order to achieve mass adoption and continued innovation. Supporters point to other major blockchains, such as Ethereum and BNB Chain, and the various businesses and use cases built on top of those networks. Why can’t Bitcoin do the same in its own unique way? They point to the increased usage of the network since the emergence of Ordinals, and the fact that developers have been consistently releasing updates while also welcoming new entrants from other parts of crypto, such as Yuga Labs and Magic Eden.

In addition, discriminating against specific use cases of the network would run counter to Bitcoin’s neutrality. It should be recognized that in any truly decentralized network like Bitcoin, debate is inevitable; decentralization allows louder voices in the network while creating an environment where disagreements are more likely to arise.

The Bitcoin network has remained secure over time through many different debates (e.g. the SegWit debate). It is only when debates become more intense, usually because changes to the network infringe on the core values or assets of a certain group of users, that Bitcoin

experiences a fork (e.g. the Blocksize wars). The ordinal debate does not appear to cause any fundamental damage to the Bitcoin network. However, the debate will still be worth watching as it will affect the purpose and use of the Bitcoin network in the long term.

Bitcoin Layer 2

Bitcoin’s proven security and network effects have attracted many developers who see Bitcoin as a critical blockchain base layer. These developers are building many different layer 2 (“L2”) projects on top of the Bitcoin base layer.

Currently, the TVL of Bitcoin L2 projects is just a fraction of Bitcoin’s $500B+ USD market cap. The top four most notable L2s in Bitcoin only comprise ~$352.65M in TVL, or ~.06% of L2 market dominance. This would seem to indicate that Bitcoin L2 is still in its early stages. This becomes even more apparent when comparing Bitcoin L2 market dominance to L2 market dominance on other chains. The Binance Research 2022 Full Year Report found that on Ethereum, scaling-specific L2s alone have a market dominance of +10%.

The relatively small amount of value locked on L2 also suggests that use cases beyond peer-to-peer transactions have yet to find product-market fit for Bitcoin. Since Bitcoin’s base layer does not have a Turing-complete, expressive smart contract engine such as the EVM on Ethereum, L2 is needed to add this kind of programmability to Bitcoin.

 If users actively demanded to participate in use cases for Bitcoin other than simpler peer-to-peer transactions, they would use Bitcoin’s L2 and add value to it, but this has not yet proven to be the case.

However, things have been developing behind the scenes.  Lightning has been steadily growing, while Stacks has been working on major upgrades to help grow the Bitcoin smart contract market.

Rootstock has also been receiving upgrades, and the addition of the sovereign rollup builder Rollkit is a great new feature.

The L2 solutions currently available on Bitcoin have different purposes, with some L2s attempting to scale the network further, while others attempt to add more expressive programmability. In this section, we’ll focus on some of the most notable Bitcoin L2s.

Lightning Network

Along the spectrum of the blockchain trilemma, Bitcoin’s implementation optimizes decentralization and security over scalability. As a result, Bitcoin generally has slower throughput and higher transaction fees than other L1 networks like Ethereum or BNB Chain. To maintain its dominance in the increasingly competitive L1 space and fulfill Satoshi’s ambition to create a practical payment system, Bitcoin needs to find a way to improve scalability.

The Lightning Network (9) was proposed by Joseph Poon and Tadge Dryja in 2016 to directly address Bitcoin’s scalability issues. The Lightning Network consists of “payment channels,” which are essentially just multi-signature smart contracts that facilitate transactions between two users. By using payment channels, users can conduct transactions off-chain, away from the Bitcoin blockchain. This means high throughput and low fees, as users do not have to compete for block space or wait for L1 consensus to make transactions.

Ultimately, once Lightning Network users decide they are done with a payment channel, they can choose to close the channel. Subsequently, the aggregated transaction summarizing the off-chain activity is settled on-chain to the Bitcoin network. In this way, the Lightning Network inherits both the security of Bitcoin and allows for amortized transaction fees and unconstrained transaction throughput.

Due to its unique design, the Lightning Network has a theoretical capacity to facilitate over 40 million transactions per second. This is a much greater capacity compared to other blockchains and even traditional payment rails.

In addition, the Lightning Network makes transaction fees negligible.

Lightning Network nodes are incentivized to route payment channel transactions by paying two types of fees: a base fee and a rate. At the time of writing, the median base fee for a transaction through a payment channel is just $0.000000572. The fee rate for sending a specific amount of BTC through a payment channel is also negligible, with a median of $0.000000005735/satoshi. As shown in Figure 21, both fees have continued to decline as the use of the Lightning Network increases and the competition to run Lightning Network nodes increases.

The potential of the Lightning Network to scale Bitcoin is being widely recognized. As Bitcoin usage has risen sharply since 2016 (as shown in Figures 3 and 4), many users have flocked to the Lightning Network to minimize transaction fees and make Bitcoin transactions more practical. As a result, the use of the Lightning Network has increased.

As shown in Figure 26, the number of Lightning nodes has been on an upward trend over the past few years. Similarly, the number of channels created on the Lightning Network has also increased.

Integration at the national and corporate levels has also promoted the use of the Lightning Network. For example, after El Salvador made Bitcoin legal tender in 2021, the Lightning Network network received public recognition from the government and was eventually compatible with the government-mandated Chivo wallet. On a corporate level, Twitter and Cash App have both added Lightning compatibility to their platforms.

The future looks bright for the Lightning Network, as many different projects and investors are working to build out the Layer 2 network.

For example, Jack Dorsey’s Bitcoin-focused startup Block recently launched a new venture capital arm called “c=,” which will focus on new funding tools and services on the Lightning Network. This is a significant expansion of the funding that Block has already provided to Spiral, an open-source collaborative of developers who are working on new implementations of the Lightning Network.

Spiral is building the so-called Lightning Developer Kit (“LDK”) implementation, which aims to make the UX of the Lightning Network more attractive to mainstream users.

Currently, the UX for setting up a Lightning Network node is difficult. Additionally, to send a payment on the Lightning Network, the recipient must be online (their Lightning Network wallet open). The LDK implementation addresses these issues and includes many other changes that will enhance the usability of the payment system.

Lightning Labs, the core team behind the Lightning Network, is also working hard to release the “Taro” update. Taro, an acronym for “Taproot Asset Representation Overlay,” will bring new assets to Bitcoin using Bitcoin’s Taproot update. More specifically, Taro leverages the Lightning Network, Bitcoin’s UTXO ledger model, and Taproot to create a private network for non-BTC asset transfers. Ultimately, Taro will allow users to issue and transfer synthetic assets, tokens, and NFTs on Bitcoin.

Finally, companies like Zeebeedee and Strike are coordinating with fiat onramps in different countries to onboard new user bases to the Lightning Network. Zeebeedee, which recently “launched a payments feature on its app that allows users to instantly send any amount to five jurisdictions, including Nigeria and Brazil.”(10) Strike, which has already expanded to El Salvador and other Central American countries, is now “expanding its international remittance service running on the Bitcoin Lightning Network” to the Philippines, one of the world’s largest remittance markets.

Stacks

Stacks calls itself a “Bitcoin layer.” While it’s definitely not a sidechain, it doesn’t quite fit all of the definitions of what most of us would call an L2 (more on that later). In short, Stacks is a blockchain that acts as a second layer for Bitcoin smart contracts. The Stacks chain uses STX tokens to incentivize miners and collect transaction fees, and relies on a novel Proof of Transfer (“PoX”)(12) consensus mechanism. Through PoX, the Stacks blockchain settles transactions on Bitcoin’s L1, allowing Stacks transactions to benefit from Bitcoin’s security. STX tokens can also be “stacked” to earn BTC-denominated returns.

Developers can build a variety of dApps on the Stacks chain, with a particular focus on DeFi and NFTs. Stacks uses the Clarity programming language (13) for its smart contracts, which is designed for a number of reasons, including preventing some security risks common in Solidity, including reentrancy attacks.

Since the mainnet launch in January 2021, many different projects have been built or deployed on Stacks, including the Bitcoin Name Service ("BNS"), which has seen growing interest in 2022, with a notable spike this year.

What's next for Stacks?  

sBTC

This will introduce a trust-minimized, non-custodial two-way peg system, allowing users to “bridge” BTC from L1 to sBTC to the Stacks layer (pegged 1:1 to the BTC used to mint it). Users will be able to send BTC to a multisig wallet on L1 (controlled by a decentralized group of “stackers” who have locked up their STX to secure the Stacks chain) and mint an equal amount of sBTC on Stacks. This sBTC can then be used for DeFi, NFTs, etc.

Stacks considers this the final "piece" in their vision of a fully expressive Bitcoin execution layer and is looking to unlock US$500B+ of capital in Bitcoin with this solution.

sBTC will have full access to L2 level smart contracts and the team hopes this will take Stacks' DeFi and NFT use cases to the next level.

Satoshi Nakamoto Release

Nakamoto indicated that the Stacks chain will be upgraded soon to implement sBTC.

In addition, after the release, Stacks will use 100% of Bitcoin's security to determine the finality of the Stacks layer. In practice, this means that after the upgrade, in order to reorganize ("reorg") Stacks' blocks/transactions, an attacker will reorganize Bitcoin L1 itself. Given that Bitcoin is the most decentralized cryptocurrency to date, this is difficult to do, so being a Bitcoin layer adds a lot of security to Stacks.

While a detailed timeline has not yet been announced, these features will go live as early as the second half of 2023.

Benefiting from the discussion around Ordinals and what it means for increasing Bitcoin’s use cases, Stacks has seen a notable uptick in interest over the past few weeks.

Stacks has capitalized on this well, with co-founder Muneeb Ali recently doing multiple rounds on top crypto podcasts. Investors may also be ready for the upcoming Stacks upgrade

, with all eyes on sBTC and what it could bring to the market’s largest cryptocurrency.

Rootstock

Rootstock (“RSK”) serves as an EVM-compatible sidechain for general-purpose Bitcoin smart contracts. The RSK chain uses a unique variant of Bitcoin's Nakamoto consensus called Decor+. This enables RSK to be merge-mined with Bitcoin, which essentially allows RSK to be mined simultaneously with Bitcoin (historically 40‑50% of Bitcoin miners have chosen to also merge-mine RSK(14)).

Smart Bitcoin (“RBTC”) is the native currency in RSK and is used to pay transaction fees. It is pegged 1:1 to BTC (meaning RBTC also has a hard cap of 21M). Bitcoin L1 and RBTC are connected via “Powpeg”(15), a two-way bridge used to transfer Bitcoin between the two chains, which is called “pegging in” and “pegging out”. The bridge was initially managed by a consortium that managed multisig wallets (See our report, Wallets: A Deep Dive into Crypto Custody, for more details on the different types of wallets). RSK has since further decentralized the bridge, although the process still requires a level of trust as the peg request still requires at least 51% of online signers. The consortium still manages parts of the process (16), with members acting as notaries who protect the locked BTC and holding other communication-related duties. There are currently nine members (17) powering Powpeg.

The RSK Virtual Machine (“RVM”) and its compatibility with the EVM is a key advantage of RSK. This also means that RSK smart contracts can be written in Solidity. One of the most well-known RSK projects includes Sovryn, a non-custodial smart contract platform for lending and margin trading with Bitcoin. This is in line with one of RSK’s main goals, which is to enable DeFi on Bitcoin. A major milestone that RSK recently announced (18) was the removal of the 4,000 RBTC cap (expanding it to the entire 21 million Bitcoin supply). This is notable because RBTC’s supply has been trending towards the 4K mark, so its use in Bitcoin DeFi has been very limited. With the cap removed, Bitcoin’s entire 19M current supply is now eligible to be locked on RSK in exchange for RBTC. We can imagine that this news has attracted the attention of new developers, or perhaps re-engaged existing developers who can now see the growing possibility of RBTC. If we see any notable announcements of new dApps being launched on RSK, it will be important to monitor.

About Stacks’ sBTC and RSK’s RBTC

While sBTC has not yet been released, the main difference between its planned design and RBTC is decentralization. One factor mentioned in (19) is that their peg mechanism is not dependent on any centralized or pre-determined group of participants as in the first paragraph of the sBTC whitepaper, but rather relies on a decentralized sBTC setup that can be called a collateral bridge. While RSK has moved away from its centralized and economically incentivized group of signers. Stacks relies on federated origins, but there is still an element of trust in RBTC's architecture. Therefore, the RBTC solution can be closer to a federated bridge. This is in contrast to fully centralized solutions such as WBTC and theoretically trustless validity bridges such as Arbitrum and Optimism on Ethereum.

Another factor to consider is the choice of programming language between the two. RSK smart contracts are written in Solidity, while sBTC contracts will be written in Clarity. Given the use of Solidity in Ethereum, BNB Chain, and many other leading L1s, RSK may be able to attract more smart contract developers than Stacks compared to the relatively limited use of Clarity (mostly Stacks).

Liquid Network

Liquid Network is a sidechain L2 that enables the settlement and issuance of digital assets such as stablecoins, security tokens and other financial instruments on top of the Bitcoin blockchain.

Unlike the other L2 solutions mentioned so far, Liquid Network is relatively centralized and secures itself through a joint consensus mechanism managed by 60 functional members. Functional members are tasked with validating blocks and adding transactions to the Liquid Network sidechain.

Similar to RSK, Liquid Network has a token called “L‑BTC” that is pegged 1:1 to BTC. At the time of writing, there are approximately 3,556 L‑BTC in circulation. The main and most prevalent use case for the token is in the Lightning Network, which has relatively higher transaction speeds and throughput compared to the Bitcoin mainchain. It should also be noted that users of Liquid Network can also use their L‑BTC for other Liquid Network-enabled applications, such as lending or purchasing security tokens.

Rollkit

Rollkit, developed by the Celestia team, is a modular framework for Bitcoin rollups. Today, many L1 chains, including Bitcoin, exist as a monolithic chain, meaning that consensus, data availability, and execution processes run on the same layer. Rollkit renders Bitcoin as a modular framework, meaning that Bitcoin's consensus and data availability processes are decoupled from its execution environment.

This modular framework and the Rollkit node software allow L2 Bitcoin developers to deploy a custom, Turing-complete execution layer on top of Bitcoin while being able to securely write to and read from Bitcoin's data availability layer.

How does it work? Rollkit allows developers to deploy sovereign rollups. These use Bitcoin as a consensus and data availability layer (providing the same level of security as Bitcoin for rollup transactions), and then provide an environment to execute complex transactions with your Bitcoin. These transactions, whether they are DeFi, NFT, or infrastructure-related, are bundled together and ultimately sent to Bitcoin L1 so they can be included in the Bitcoin ledger. Rollkit also takes advantage of Taproot and Segwit upgrades, which Ordinals and Inscriptions rely on. The execution environment is customizable and can even run the EVM on top of the Bitcoin network. Sovereign rollups are easy to launch because they don't have to maintain their own consensus or validator set. In this way, Rollkit’s so-called “sovereign rollups” retain and build upon Bitcoin’s L1 “sovereignty” while also adding scalability and Turing-complete programmability.

Although Rollkit is a fairly new version of Bitcoin’s L2, it has already attracted attention considering it was only released in February. For example, Eric Wall, a well-known Bitcoin thought leader, shared his thoughts on Rollkit and its potential:

“This is incredible. Instead of putting JPEGs on Bitcoin, you could use the same storage space that Ordinal Inscriptions use to put rollups on Bitcoin. This would allow any execution environment to run with the *same* data availability guarantees and block ordering as Bitcoin itself.”

An interesting concept to consider is the potential integration between Stacks’ sBTC and Rollkit. Rollkit provides a platform for developers to build execution-level smart contracts for Bitcoin. Therefore, Rollkit needs a way to move BTC from L1 to L2. Given that sBTC is a trust-minimized way to get BTC from L1 to another layer, it might be a reasonable idea to consider integration here. Users can transfer BTC from L1 to Defi's Rollkit rollup (for example), and then transfer it back using sBTC as the transfer medium.

What's Next for Bitcoin?

The Bitcoin Smart Contract Market

For years, Bitcoin has been plagued by a lack of developer tooling, slow and sometimes clunky infrastructure, and seemingly relatively limited innovation relative to smart contract giants like Ethereum, BNB Chain, and Solana. Finally, things appear to be changing.

Builders are finally having a relationship with their Bitcoin. Developers are staying up all night updating Sandship at a rate Bitcoin hasn’t seen in a while All of this is driven by organic demand. That’s the key part, when an ecosystem is going through a period where organic, real user demand essentially drives innovation and product development, a virtuous cycle ensues and things escalate quickly.

Organic demand for product updates – product innovation – more developer and user attention to the ecosystem – attention to big input names – creating further organic demand, etc.

With names like Yuga Labs, DeGods, and Magic Eden entering the Bitcoin NFT space within weeks of Ordinals, and Celestia building Rollkit to scale Bitcoin, the wheels are definitely turning. The questions we should be asking ourselves are; who is the next major brand to enter Bitcoin? What new dApp will launch on Bitcoin’s L2 that is taking the space by storm? What killer use case is a team that has been garnering attention with Ordinals currently working on?

We already have developers integrating Ordinals into wallets, creating Ordinal explorers, custom minting services, auction houses, and more. Still, it’s early days in the infrastructure space. This presents a huge opportunity for developers looking to create everything available on other smart contract platforms (including NFTs, and smart contracts more broadly) on Bitcoin.

Remember, Bitcoin has over $500B of capital deep in the BUIDL market. It’s clear that Bitcoin is a powerful force, and this largely dormant capital could have a sizable impact on the broader cryptocurrency market if it just takes off. Let’s see who can harness it.

The Case for Bitcoin Rollups

It feels like Ordinals and Inscriptions have reengaged and captured the attention of a large portion of the community. With increased on-chain activity and continued appreciation of Bitcoin’s L1 blockspace, the case for Bitcoin L2 is self-evident. All signs, from the increased block size, mempool, fees, to the innovation and excitement around the Bitcoin ecosystem, point to this.

The key development to watch for is whether there is any progress on Bitcoin’s two-way peg. As mentioned before, to have a fully trustless bridge between Bitcoin L1 and any L2 requires support at the opcode level, i.e. a soft fork. This will take time and will most likely just be a function of demand.

While we are seeing demand rising, one thing worth considering is that there is still a segment of the Bitcoin community that is opposed to any use case outside of hard currency. Given that Ordinals and Inscriptions are essentially unintended byproducts of the Segwit and Taproot updates, this could mean that Bitcoin Core developers and community members may be more resistant to the idea of a soft fork.

Upcoming Halving

Part of Bitcoin’s appeal is its fixed, programmable monetary policy. Unlike the monetary policy of traditional central banks, Bitcoin’s future monetary path is predetermined and fixed in open-source code. This provides Bitcoin users and miners with more predictability about future BTC issuance and prevents typical inflationary pressures found in most traditional economies.

More specifically, Bitcoin follows a monetary policy and a fixed issuance schedule until the maximum supply in circulation is 21 million Bitcoins. Since the genesis block, miners have been rewarded with newly issued Bitcoins. The amount of BTC issued is determined by the formula shown in Figure 32; every 210,000 blocks, the block reward is halved, meaning that BTC issuance decelerates over time.

Currently, the block reward, or the number of new BTC issued per block, is 6.25 BTC.

It is estimated that Bitcoin will have its next "halving event" sometime in March 2024 (i.e., when 210,000 blocks have been mined since the last halving event in May 2020). At that time, the block reward and the number of new BTC issued per block will be halved to 3.125 BTC.

As mentioned earlier, miners are primarily compensated for securing the Bitcoin blockchain through block rewards. If one holds the purchasing power of Bitcoin and the current fee market is fixed, then each halving event means that miners will effectively lose half of their income. Under these assumptions, halving events in this manner may be detrimental to miners and Bitcoin's security in the long run.

However, the recent rise in Ordinals and the surge in transaction fees could serve as an early indicator of a developing fee market. If the transaction fee market matures due to increased use cases for the Bitcoin network and more competition for block space, miners will not be so dependent on block rewards. In the long run, miners can be confident that transaction fees will compensate them enough to protect the Bitcoin network even if block rewards decline.

Concluding Remarks

Ordinals and inscriptions have brought new energy to Bitcoin development, instilling a new set of stakeholders with different voices and perspectives, and ultimately injecting energy and enthusiasm into an ecosystem that has been somewhat lagging in the age of monkey NFTs and perpetual exchange-driven DeFi markets.

Increases in transaction fees paid to miners ultimately incentivize blockchain security and mean that inscriptions and innovation based on them will increase Bitcoin’s long-term sustainability.

As to “what Bitcoin should or shouldn’t be used for”, at the end of the day there is no such social contract in the code, and if transactions are paid and by consensus, who’s to say they aren’t “what Bitcoin is for”?

There has been a clear shift in Bitcoin culture. People are excited. Watch this space carefully.

References

1) https://en.bitcoin.it/wiki/Colored_Coins

2) https://www.theverge.com/2021/3/11/22325054/beeple‑christies‑nft‑sale‑cost‑everydays‑69‑million

3) https://docs.ordinals.com/digital‑artifacts.html

4) https://dune.com/dgtl_assets/bitcoin‑ordinals‑analysis

5) https://www.xverse.app/blog/how‑to‑inscribe‑ordinal‑bitcoin‑nfts‑5‑eas y‑steps

6) https://www.hiro.so/blog/introducing‑the‑ordinals‑explorer‑and‑ordinals‑api

7) https://twitter.com/trygamma/status/1637862676402503681?s=20  

8)

9) https://cointelegraph.com/bitcoin‑for‑beginners/what‑is‑the‑lightning‑network‑in‑bitcoin‑and‑how‑it‑works

10) https://www.coindesk.com/tech/2023/03/28/zebedee‑debuts‑global‑payment‑server‑powered‑by‑bitcoins‑lightning‑network/

11) https://www.coindesk.com/tech/2023/03/28/zebedee‑debuts‑global‑payment‑server vice‑powered‑by‑bitcoins‑lightning‑network/

12) https://assets.website‑files.com/5fcf9ac604d37418aa70a5ab/60072dbb32d416d 6b3806935_5f1596b12bcc0800f3dcadcd_pox.pdf

13) https://docs.stacks.co/docs/clarity/#introduction

14) https://blog.rsk.co/noticia/rsk‑bitcoin‑merge‑mining‑is‑here‑to‑stay/

15) https://dev.rootstock.io/rsk/architecture/powpeg/

16) https://developers.rsk.co/kb/faqs/

17) https://rootstock.io/powpeg/

18) https://blog.rsk.co/noticia/rootstock ‑expands‑bitcoins‑defi‑functionality‑with‑remo val‑of‑the‑powpeg‑bridge‑locking‑cap/  

19) https://stx.is/sbtc‑pdf

20) https://twitter.com/ercwl/status/1632461930437681153

href="https://research.binance.com/static/pdf/a-new-era-for-bitcoin.pdf" target="_blank">Original link