Bit by Bit: Building on Bitcoin

Aug 16, 2024  •  Written by Amy Zhao, Ram Varman, and Jomo Filart

Introduction

In 2009, an anonymous entity known as Satoshi Nakamoto introduced Bitcoin, the world’s first decentralised cryptocurrency. It enabled peer-to-peer currency transfers without an intermediary, such as a bank.

Due to its early origins, anonymous founding team, a vast network of miners, and absence of traditional fundraising, Bitcoin has become the most decentralised cryptocurrency. It is extremely difficult for a malicious actor to rewrite transactions on the Bitcoin network, as no single person controls it. Even if collusion occurs among multiple individuals, orchestrating an attack to compromise the network's accuracy is challenging due to its decentralisation. To understand how decentralised Bitcoin is, consider the Nakamoto coefficient, which represents decentralisation with a number. The coefficient represents the number of parties/node operators that, together, control more than a third of the entire network. Bitcoin’s Nakamoto coefficient is estimated to be around 7000. The second most decentralised network as per the Nakamoto coefficient at the time of writing is the Mina protocol at 151. Other notable names include Solana at 18 and BNB at 7. Bitcoin is unique because it is especially decentralised.

Apart from decentralisation, Bitcoin is also special due to its fundamental characteristics. There is a limited supply of  21 million bitcoins/BTC, which makes it an attractive hedge against inflation and economic instability. This is why Bitcoin is often called “digital gold”.

In summary, Bitcoin is:

  1. Functionally simple – it enables peer-to-peer currency transfers
  2. Decentralised – it is far ahead of every other cryptocurrency
  3. Secure – it remained immune to attacks and has been secure for over 15 years

These factors have led Bitcoin to receive the highest level of regulatory clarity. It has been classified as a commodity, which signals that institutions recognise its decentralised nature. It also had its ETFs approved in Jan 2024, which integrates Bitcoin into traditional financial markets.

Here’s the base case: Bitcoin has established a baseline level of credibility, which continues to grow. If we can build applications on top of Bitcoin, they will benefit from second-order effects.

However, this is easier said than done. Bitcoin was not originally intended to be a base layer for other applications.

Firstly, transactions on Bitcoin are expensive and slow

If I send 5 BTC to you, the transaction must be recorded on the Bitcoin network. More precisely, this transaction must be (1) included on the ledger and (2) the updated ledger must be distributed across thousands of computers. Including a transaction on a ledger entails numerous miners competing to solve cryptographic puzzles to validate and confirm transactions – it is resource-intensive and expensive. Ensuring the ledger is distributed also slows down how many transactions we can process per second. Computers run by the average person do not have unlimited storage capacities. Here we observe Bitcoin’s focus on decentralisation which leads to trade-offs in cost and speed.

Secondly, Bitcoin is unfriendly towards smart contracts

Assume that we want to do more complicated things beyond peer-to-peer money transfers. For example: we want to program a vending machine on top of the Bitcoin network. Depending on the value entered, the vending machine outputs a product, and the number of products left in the vending machine is continually tracked by the Bitcoin network. This vending machine is analogous to a smart contract: a set of processes that executes automatically based on a set of rules, given a certain trigger.

Bitcoin does not directly support smart contracts, and this limitation arises from two intentional design choices.

  1. Bitcoin employs a restricted, stack-based scripting language that is purposefully non-Turing complete, which lacks advanced features like loops and complex conditionals. In other words, it is difficult to code complex logic on Bitcoin. Only simple operations like digital signatures, time locks, etc. are supported.
  2. Bitcoin uses an Unspent Transaction Output (UTXO) model to track state – i.e., the current status of all information stored on the blockchain – which is efficient for tracking wallet balances but poor for tracking states for other kinds of transactions.

These architectural decisions prioritise security and predictability at the cost of programmability. Hence, while Bitcoin excels at secure value transfer, it is very unfriendly towards supporting complex, state-dependent logic necessary for smart contract applications. Networks like Ethereum came later on as a solution to these limitations.

Early attempts at overcoming these limitations

Segwit, Lightning Network, and Taproot

The first major upgrade to Bitcoin was called Segwit, released in 2017. It allowed for Bitcoin transactions to occur more quickly. It also allowed for the modification of transaction IDs before confirmation on the blockchain. This allowed for the safe batching up of multiple transactions. Ultimately, multiple transactions that occurred off the blockchain could be condensed into 1 transaction that would then be stored on-chain.

This brought about the first Bitcoin Layer 2 (L2), the Lightning Network, launched in 2018. An L2 is a protocol that settles on the underlying L1 (in this case, Bitcoin is the L1).

Here’s a simplified illustration of what occurs in the Lightning Network: if I send 10 BTC to you, and you send 5 BTC back to me, there are usually 2 transaction entries. The Lightning Network creates a new mini-database, or ledger, between the two transacting parties. It settles the net result after a period (e.g., person A sent 5 BTC to person B), reducing the number of transaction entries on the main ledger from 2 to 1. The Lightning Network batches multiple transactions into one and records that single transaction on the Bitcoin blockchain. While there are trade-offs in decentralisation, the Lightning Network offers significant flexibility. For small transactions, users benefit from its speed and much lower transaction costs. Bitcoin’s transaction fees are about $1, while the Lightning Network's cost per transaction is $0.001.

The Lightning Network enables speed but not programmability or other fascinating use cases. With Lightning, I still cannot, say, send a stablecoin to you and have that transaction be secured by the Bitcoin network, much less program a smart contract on top of Bitcoin.

The taproot upgrade, activated in 2021, laid the groundwork for programming smart contracts on Bitcoin. Essentially, it relaxed the limitations of the amount of arbitrary data that could be placed inside a Bitcoin transaction.

Enter Ordinals

Thanks to Taproot, users could now inscribe data directly onto individual satoshis (100mn satoshis equals 1 bitcoin). More precisely, a satoshi could (1) be assigned a specific number for future reference and (2) be inscribed with data such as text, images, or complex files. This process effectively transforms a fungible satoshi into a non-fungible one, creating what is commonly known as a non-fungible token (NFT).

Ordinals have elicited mixed opinions. On one hand, Bitcoin ordinals can be considered superior to NFTs stored on other blockchains. Here’s why: when an NFT is stored on the Bitcoin network via inscription, the actual data – image, video, etc. – is stored on the blockchain. In contrast, non-ordinal NFTs generally store metadata/URL pointers on the blockchain as opposed to the actual data. So ordinals are less vulnerable to censorship, link rot, and data loss.

On the other hand, many in the Bitcoin community believe that forcing Bitcoin nodes to download and store images is a waste of resources. Below is a famous ordinal collection, the Taproot Wizards collection.

Some NFTs from the Taproot Wizard collections

And indeed, compared to a few months ago, ordinals are attracting less attention at the moment. From the graph below, we can see that fewer resources are being expended on creating ordinals and fewer ordinals are being created overall.

Less effort towards the creation of Bitcoin ordinals overtime (Source: Dune Analytics)

Concerns around ordinals deserving block space on the Bitcoin network are key drivers of this slow-down, but it is also worth zooming out and noting that this is not an ordinal-only phenomenon. Interest in NFTs has likely declined due to market oversaturation.

The drop in hype is not Bitcoin-ordinal specific—it is downtime for NFTs across the space (Source: The Block)

A repeated theme throughout this piece thus far is Bitcoin’s emphasis on security and decentralisation which makes it less scalable. This is why ordinals are being critiqued – many believe that images are not worth additional congestion on the Bitcoin network. This brings us to Bitcoin L2s.

Enter Layer 2s (L2s)

Understanding L2s

It’s worth gaining a general understanding of L2s before getting Bitcoin-specific. L2s can be confusing because different people have different definitions. In this piece, we will generalise L2s to consist of 2 main types: sidechains and rollups. At Ocular, we consider rollups to be true representations of L2s.

Sidechains

Sidechains are separate blockchains that do not settle their transactions on the main chain. In other words, not every transaction on the L2 can be verified directly on the L1.

The Liquid Network is a good example of a Bitcoin sidechain. You can move BTC from the Bitcoin Network to the Liquid Network via a process called bridging. This entails BTC being sent to an address managed by a federation of “watchmen” – a pool of about 65 trusted members chosen by the community of exchanges, financial institutions, and bitcoin-focused companies. Then for every BTC transferred to this watchmen-managed address, the user receives a synthetic BTC called LBTC. It is a 2-way peg.

As you can tell, the security of the Liquid Network depends on these watchmen and their consistent credibility; the Liquid Network is not inheriting security from the Bitcoin L1. If a majority of the watchmen collude or are compromised, the security of the sidechain can be jeopardised. The main benefit of the Liquid Network is that it helps parties that require fast and private transactions without fully leaving the Bitcoin environment – transaction speeds are faster, and you also can transact stablecoins and other tokens along with LBTC on the network.

Rollups

We consider rollups as true L2s because every transaction is backed by a proof submitted to the L1; this proof may be verified directly on the L1. In rollups, a certain number of transactions gets rolled up into 1 transaction. This transaction is then submitted along with a validity proof to  the L1. The validity proof says: “Hey, I’ve checked these transactions and I can confirm they follow all the rules. You can check me and have cumulative certainty. You don’t need to check each one individually!”.

Illustrating the Link from L1 to L2 (Source: Limitless Insights)

Every transaction is secured by a proof that can be checked, so rollups inherit a high degree of security from the Bitcoin blockchain, and we can consider them to be genuine L2s. Rollups helping make Bitcoin more programmable include MerlinChain, BOB, BEVM, Bitlayer, and Botanix.

Other approaches

Stacks illustrates a non-rollup, non-sidechain approach that still inherits some degree of security from the Bitcoin L1.

How Stacks is intertwined with Bitcoin: Stackers receive BTC, Bitcoin miners receive STX, making these two blockchains intertwined (Source: Stacks Documentation)

Stacks is essentially a separate blockchain that calls on Bitcoin miners to validate its blocks in exchange for a reward. However, Stacks does not publish any proof or hash on the Bitcoin blockchain, so it is not tied to Bitcoin as directly as a rollup.

Other exciting attempts at programming on top of Bitcoin

B² Network

The B² Network is a good example of a genuine L2 which we can use to explore rollups in further detail. Transactions on B² are batched up and a verifiable proof stating that this batch is correct is generated. This  proof is then recorded on the L1 Bitcoin blockchain.

The proofs employed by B² are called zero-knowledge (zk) proofs, and they are oftentimes considered the best implementation of proofs because they can allow for on-chain verification of the validity of the batch without revealing its contents. Simply put, zk proofs ensure privacy. The B² Network is also EVM-compatible, meaning that code written for Ethereum can run the same applications on B². This makes B² appealing to current developers.

L2s like B² expand the Bitcoin ecosystem by enabling the development of user-facing platforms, such as Master Protocol.

Master Protocol

Master Protocol is a financial platform within the Bitcoin ecosystem, designed to facilitate interest rate swaps and yield farming for Liquid Staking Tokens (LSTs) and other yield-generating assets.

Master Protocol improves liquidity in the Bitcoin ecosystem in several key ways:

  1. Asset Aggregation: Asset Aggregation: Master Protocol functions as a user and asset aggregator, deeply integrated into the Bitcoin ecosystem. It consolidates various LSTs and yield-generating assets from different protocols and L2 solutions, creating a centralised hub for liquidity.
  2. Yield Market Platform: Yield Market Platform: The Master Yield Market, a core product of Master Protocol, packages Bitcoin ecosystem assets into Master Yield Tokens (MSY), which are then split into Master Principal Tokens (MPT) and Master Yield Tokens (MYT). This allows users to trade these tokens, effectively creating a market for yield and improving overall liquidity.
  3. Simplified Access: By aggregating multiple assets and protocols, Master Protocol simplifies interactions for users within the Bitcoin ecosystem. Users can access earning opportunities from various protocols without the need to constantly switch between them, thereby increasing engagement and liquidity across the ecosystem.
  4. Liquid Staking and Restaking: Master Protocol allows users to stake Bitcoin on various Layer 2 networks and receive LSTs as staking certificates. These LSTs can be reinvested or further staked to earn Liquid Restake Tokens (LRTs), enhancing investment capabilities and asset liquidity without affecting the original stake.
  5. Interest Rate Swaps: As an interest rate swap market, Master Protocol facilitates the trading of yield-bearing assets, which can help in managing liquidity risks and optimising capital efficiency.
  6. Ecosystem Synergy: By serving as a one-stop Bitcoin ecosystem yield trading centre, Master Protocol not only improves its adoption but also directs traffic and users to multiple Bitcoin ecosystem protocols, fostering overall ecosystem liquidity.
  7. Addressing Fragmentation: Master Protocol helps address the fragmentation caused by the growth of Bitcoin Layer 2 solutions, improving composability and operability within the Bitcoin ecosystem. This integration of various DeFi protocols and second-layer solutions enhances overall liquidity flow.

Master Protocol acts as a central hub connecting Bitcoin enthusiasts with various applications, supporting new app development, and enhancing the overall utility of Bitcoin's infrastructure. Additionally, it addresses the fragmentation caused by the growth of Bitcoin L2 solutions by improving composability and operability.

Babylon

Babylon is an innovative project within the Bitcoin ecosystem designed to extend Bitcoin's unmatched security to various Proof-of-Stake (PoS) chains, especially those in the Cosmos network.

By leveraging Bitcoin's robust Proof-of-Work (PoW) consensus mechanism, Babylon enhances the security of PoS chains through a process known as "restaking." This involves locking Bitcoin on its network and using it to secure other PoS chains, thereby providing economic security and enabling Bitcoin holders to earn staking rewards. The protocol uses advanced cryptographic techniques and consensus innovations to facilitate this process without the need for complex smart contracts.

Babylon's architecture is built on the Cosmos SDK and is compatible with Inter-Blockchain Communication (IBC), allowing seamless data aggregation and communication between the Bitcoin chain and other Cosmos application chains. By integrating Bitcoin's security features with the flexibility of PoS networks, Babylon Protocol is poised to play a crucial role in the future of the Bitcoin ecosystem, fostering a more secure, scalable, and interconnected blockchain landscape.

Next frontiers of Bitcoin programmability and areas we are watching

The Ocular team continues to intently follow the applications being built on Bitcoin and has identified the following areas to watch as innovation unfolds:

  1. More L2 Solutions: Improved L2s are needed to improve transaction speeds and reduce costs while maintaining Bitcoin's security.
  2. Smart Contract Platforms (remorachains): Initiatives like RSK (Rootstock) that enable Ethereum-like smart contract functionality on Bitcoin are becoming increasingly relevant. These platforms allow for the development of dApps and DeFi services on Bitcoin.
  3. Cross-Chain Compatibility: Platforms that allow applications from other blockchains (e.g., Solana) to operate on Bitcoin, represent an exciting investment opportunity in the realm of blockchain interoperability.
  4. DeFi on Bitcoin: As programmability increases, there's growing potential for a robust DeFi ecosystem on Bitcoin. Projects focusing on lending, borrowing, decentralised exchanges, and stablecoins built natively on Bitcoin could be interesting investment areas.
  5. Bitcoin-Native Application Platforms: These platforms aim to enhance Bitcoin's programmability while maintaining its core principles of security and decentralisation.
  6. ZK-Proof Technology: Projects implementing zero-knowledge proofs for Bitcoin could offer enhanced privacy and scalability features, making them attractive investment prospects.
  7. Custody Solutions: As programmability increases, there will be a growing need for secure custody solutions that cater to Bitcoin's expanding functionality while maintaining the "not your keys, not your coins" ethos.
  8. Developer Tools and Infrastructure: With the increasing focus on Bitcoin programmability, there's likely to be a surge in demand for developer tools, SDKs, and infrastructure to support this new wave of Bitcoin-based applications.

Conclusion

These areas represent the frontier of Bitcoin's evolution from a simple store of value to a more versatile and programmable platform. As the ecosystem develops, it's likely to attract more developers, users, and investors, potentially driving the next phase of growth in the Bitcoin and broader crypto market. As always, feel free to reach out to us at crypto@ocular.vc if you are building in the space.

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