Author: Gabe Parker, Galaxy; Compiled by: Five Baht, Golden Finance

Abstract

Bitcoin-based Layer 2 (L2) projects have increased more than sevenfold since 2021, from 10 to 75. Over 36% of all Bitcoin L2 venture capital was allocated in 2024, with crypto VCs investing a total of $447 in Bitcoin L2 projects since 2018. Bitcoin L2 will use the funds raised to develop powerful applications and new use cases for BTC, aiming to attract significant liquidity from local BTC holders and the existing wrapped BTC market. The report estimates that more than $47 billion in BTC could be connected to Bitcoin L2 by 2030. Our total addressable market (TAM) analysis of Bitcoin L2 takes into account the current market share of all wrapped versions of BTC used in DeFi, as well as native BTC deposited in Bitcoin L2 and with BTC locked in the staking protocol. As of November 20, 2024, these portions account for 0.8% of all BTC in circulation. By 2030, we estimate that 2.3% of the circulating supply of BTC will be bridged into Bitcoin L2 to interact with the new Bitcoin DeFi ecosystem, fungible tokens, payment applications, and more.

Foreword

Since the birth of Bitcoin, discussions about the future of Bitcoin have included the concept of layered expansion. Hal Finney described the concept of "Bitcoin banks" in 2010, in which "Bitcoin-backed banks...[could issue] their own digital cash currencies." Tether was introduced to Omni Network in 2014 ( Launched on one of the earliest Layer 2 networks), the initiative has been described as "Bitcoin 2.0". The controversy over whether Bitcoin should scale the base layer instead of high-performance L2 came to a head during the "block size war", which came to a head with the launch of SegWit on Bitcoin in August 2017 and the separate launch of Bitcoin Cash. The war was mostly resolved. SegWit enables the payment-centric Lightning Network, which has been the best-known L2 for many years. Two notable sidechains were launched in 2018 – Blockstream’s Liquid (focused on asset issuance and payment confidentiality) and Rootstock (EVM-compatible sidechain).

The rise of Ordinals brought tokenization activity back to Bitcoin's base layer in 2023 and helped reignite interest in building applications on Bitcoin. This renewed interest, combined with the ROL within the Ethereum development communityAdvances in lup development have triggered a new wave of Bitcoin Layer 2, mainly utilizing Rollup technology (optimistic and zero-knowledge). While the Lightning Network has seen some success in enabling fast, cheap payments, developers have struggled to develop revenue-generating applications for BTC on the blockchain itself. A large part of the difficulty is due to Bitcoin's inability to support general-purpose smart contract applications. Bitcoin’s base layer is not Turing complete and therefore cannot execute the smart contract logic required by most DeFi applications. However, future upgrades may enable features that improve multi-escrow, allowing for more robust bridging and layer 2 architecture. While a Bitcoin upgrade enabling Turing-complete functionality has yet to be realized, nor is it likely, some Bitcoin holders are already using their BTC to operate in DeFi or earn income by bridging assets to other Turings , rather than the high performance and trust-minimized layer 2 of a full blockchain like Ethereum. Wrapped Bitcoin (WBTC) on Ethereum accounts for the largest share (62%) of all wrapped versions of BTC. The wrapped version of BTC used in Ethereum DeFi represents a large number of BTC holders looking for more efficient BTC use cases.

Over $9 billion worth of wrapped BTC (WBTC, tBTC, cbBTC) on Ethereum may be indicative of user demand to use BTC in DeFi applications. Holders of WBTC, tBTC, and other bridged BTC are more likely than other groups to transfer and use BTC on the new Bitcoin L2 because they are familiar with operating wrapped BTC assets on other chains. Bitcoin L2 will likely prioritize the development of attractive BTC-denominated yield-generating applications to entice existing wrapped BTC users on Ethereum to move funds to the new Bitcoin L2. Wrapped BTC holders may also use Bitcoin L2 as they have shown a tendency to value utility over decentralization. All Bitcoin L2 launches will be more centralized systems than Bitcoin L1, although some will have decentralization capabilities comparable to existing Ethereum L2.

The ability to use BTC in DeFi applications without exiting the Bitcoin ecosystem is an important selling point of Bitcoin L2. It could potentially reduce friction in the user experience of bridging BTC and provide a safer alternative to existing solutions for using BTC in DeFi. A major benefit of Bitcoin DeFi on Bitcoin L2 is that BTC is both a native Gas asset and the focus of DeFi development. Historically, native assets have demonstrated greater utility on their native blockchains compared to external networks. For example, ETH in Ethereum DeFi applicationsThe heavy lending demand within the program stems from its integral role as Ethereum’s native Gas token, as well as its widespread adoption as the primary unit of account for NFT and fungible token transactions. The evolution of the DeFi ecosystem on platforms like Ethereum and Solana illustrates an important principle: powerful DeFi economies are built around the assets native to the blockchain.

This report defines the key characteristics of Bitcoin L2 and provides a high-level overview of different types of Bitcoin scaling solutions. The report also provides a breakdown of $447 million in cryptocurrency venture investments into Bitcoin L2 since 2018 and provides a TAM analysis of emerging Bitcoin L2. Finally, the report shares important insights into the future prospects of Bitcoin’s modularity.

What is Bitcoin Layer 2?

Bitcoin L2 provides higher transaction throughput than Bitcoin L1 by enabling larger, faster blocks. Bitcoin L2 acts as its own execution environment and therefore can circumvent technical limitations present on Bitcoin L1, such as the lack of Turing completeness. By acting as an independent execution environment, Bitcoin L2 has access to its own consensus mechanism, security framework, and virtual machine. For example, most Bitcoin L2s in production are EVM equivalent or compatible, enabling them to integrate applications from other EVM blockchains. (For more information on EVM equivalence and compatibility, read Christine Kim’s report on Ethereum ZK-Rollups).

Another key determinant of Bitcoin L2 is their bridging mechanism, i.e. how users can move BTC from the base layer to L2. Bitcoin L2 uses an extensive bridging framework, including multi-signature and multi-party escrow (MPC) wallet schemes as well as third-party bridges. Some Bitcoin L2s use a multi-signature/MPC wallet scheme with BitVM, an off-chain Turing-complete virtual machine compatible with Bitcoin. At a high level, BitVM bridges involve a 1-of-n trust assumption, where only 1 honest bridge operator needs to be online for a user to exit the bridge. MPC and multi-signature bridges typically require more than 50% of signers to be honest in order for a user to exit the bridge.

The main difference between the Bitcoin L2 bridge and the Ethereum L2 bridge is that the latter involves smart contract accounts, while the former uses Bitcoin public key addresses. However, in both cases, smart contract accounts on Ethereum and Bitcoin public key addresses are typically controlled by a set of private keys. Another key difference is that sidechains and Rollup’s Bitcoin L2 bridge do not have unilateral exits, meaning users cannot exit L2 without trusting the intermediary. Ethereum rollups may include a feature called forced withdrawals that allows anyone to submit theirEasy to submit directly to L1 to withdraw funds from the rollup in the event the sequencer is offline or unable to contain user transactions. State channels are the only Bitcoin L2 with trustless one-sided exit. The Lightning Network bridge is built to allow users to seamlessly withdraw funds back to L1 as long as they have the latest balance status.

Bitcoin Rollups and Sidechains

There are two types of Bitcoin L2 solutions that can support general application development: Rollups and Sidechains. State channels are another L2 solution developed on Bitcoin, most notably the Lightning Network, but the technology is primarily used to enable faster and cheaper peer-to-peer transactions on Bitcoin and does not currently support Turing-complete intelligence contract.

Sidechains: Sidechains are actually independent blockchains that run in parallel with the base layer through embedded connections with their own node operators and security mechanisms. Sidechains extend the base layer by creating independent compatible blockchains with larger blocks and faster block times. Therefore, more transactions can be processed in less time. Because sidechains use their own consensus model, they do not rely on a data availability layer but act as closed and independent execution environments. Because sidechains use their own consensus model, some critics argue that they are not technically a “layer 2” solution, but rather serve as a separate extension of layer 1. However, sidechains can be designed in many ways, and it is important to distinguish those sidechains that are consistent with the base layer and those that are not. Sidechains can publish hashes of block headers or other data to L1 as a way of "checkpointing" their own state to L1.

Rollup: Rollup is a blockchain that offloads transactions from the base layer and executes them on the auxiliary layer. As a result, Rollup provides users with 10x to 100x cheaper and faster transactions. By using a transaction data compression algorithm that batches multiple transactions together, Rollup can achieve higher transaction throughput than sidechains.

Rollup also uses a parent blockchain for data availability. The parent blockchain stores the Rollup's state root, transaction data, or state differences. The data stored on the parent blockchain enables any full node to reconstruct the latest state of the Rollup. Rollup can be designed to support a single application or provide general functionality and host multiple applications.

Rollup updates the state root in two ways. Validity Rollups (also known as zk-Rollups) create concise cryptographic proofs that L1 verifies immediately upon receipt of updates, proving that the updates are consistent with the correct execution of those transactions. OptimisticRollup pushes optimally correct state root updates to L1 and provides validators with a defined time window to challenge state root updates.

The classification of the market map above follows the following main characteristics:

Bitcoin Rollup: The execution layer that publishes proof and state difference data or transaction data into Bitcoin blocks.

Rollup not on Bitcoin: An execution layer that publishes proofs and state difference data or transaction data on Ethereum or an alternative DA layer.

Sidechain: The independent execution layer is compatible with the Bitcoin base layer and does not require DA from the parent chain.

Infrastructure: Data availability protocol and any wrapped BTC providers.

State channel: An off-chain execution environment without global state, only the initial and final state of the account balance is submitted.

ECASH: A managed state channel solution based on David Chaumian's Ecash proposal.

Virtual UTXO and CSV: A new iteration of the state channel and execution layer using client-side validation.

Effective chain: The execution layer is compatible with BTC and uses off-chain or alternative DA.

The market map does not include all projects in each category and is only a reference for the construction of different types of projects in the Bitcoin L2 ecosystem. As of November 20, 2024, Bitcoin’s L2 market consists of 40 Rollups and 25 sidechains. This report does not cover the State Channel, CSV, Drivechain or ECash protocols, which represent 10 projects in total.

Bitcoin L2 Ventures

As of September 2024, Bitcoin L2 has raised $174 million in funding from cryptocurrency venture capital firms. Among them, sidechains received the largest allocation at $105 million, followed by Rollups at $63 million. Notably, 39% of historical venture capital investment into Bitcoin L2 occurred in 2024 alone. Q2 2024 saw a significant shift, with Bitcoin L2 accounting for 44% of all cryptocurrency VC capital invested in L2 solutions across the industry, a staggering 159% quarter-on-quarter growth. Crypto VC investment in Bitcoin L2 surges in 2024, highlighting how traditional crypto VC (excluding Bitcoin-focused funds) has little exposure to Bitcoin before fundraising and early stages of development in 2024 ecosystem. As of November 2024, Bitcoin L2 has raised 2 Series A rounds, involving 30 disclosed transactions.

Bitcoin Layer 2 has attracted significant investment since 2018, with sidechains leading the way. Of the total $447 million invested in Bitcoin L2, sidechains accounted for the largest share, accounting for 64%. State Channels follows with 22% and Rollups with 14%. It’s worth noting that ECASH-based protocols such as Cashu and Fedimint are not included in the above table and have received a total of $27.2 million in venture capital. The electronic cash project does not meet our definition of Bitcoin L2, but it is worth considering as a potential infrastructure for the Bitcoin L2 space.

Potential market for Bitcoin L2

We believe that the directly available market for Bitcoin L2 is the packaged version of BTC in DeFi contracts and the native bridge to L2 The total supply of BTC and the BTC staking protocol. The demographics of “active” BTC supply are the focus of our TAM analysis. We believe this group of holders is most likely to associate BTC with the new L2 for profit opportunities.

As of November 20, approximately 0.8% of BTC in circulation (164,992 BTC) is actively in use. For the wrapped BTC market, $10 billion is locked in DeFi smart contracts and $247 million is locked in Bitcoin L2. For native Bitcoin, $3.4 billion is locked in staking protocols (Babylon, Bouncebit) and $1.5 billion is locked in Bitcoin L2.

If we assume that the share of circulating BTC supply using DeFi, L2 and Stake increases by 0.25% per year over 6 years, we estimate that the "active BTC supply" could grow to 471,806 BTC by the end of 2030 ( Approximately 3 times increase).

In comparison, 2.3% of Ethereum’s circulating supply (ETH, WETH, stETH, wstETH) is locked in DeFi smart contracts (excluding staking protocols). At current prices as of November 20, 2024, the model projects Bitcoin L2’s TAM to reach $44 billion by 2030.

If Bitcoin reaches $100,000 in 2030, Bitcoin L2’s TAM could reach $47 billion, assuming that 2.3% of the total Bitcoin supply is locked in Bitcoin L2 by 2030 middle.

Please note that this analysis provides a rough estimate of how much BTC supply could flow into Bitcoin L2 for yield; it does not take into account the Bitcoin L2 ecosystem The potential growth includes other crypto assets that will be issued on top of these L2s, such as runes, Ordinals, stablecoins, etc. Our TAM estimate relies on two key assumptions. First, we assumeThe percentage of BTC supply locked in Bitcoin L2 is likely to grow by 0.25% per year between now and 2030; second, we assume that the BTC price could reach $100,000 by 2030. Our view is that these are conservative estimates of Bitcoin L2 user demand and Bitcoin price over the next six years.

Also note that our predictions are dependent on the progress of Bitcoin’s DeFi and staking ecosystem on L2 while establishing legitimacy over the next 6 years. Crucially, if the new Bitcoin L2 DeFi yields are not attractive enough, the BTC supply wrapped on Ethereum may remain in the Ethereum ecosystem. The following section will focus on the minimum yield levels required for DeFi applications on Bitcoin L2 to compete with DeFi applications on Ethereum that accept BTC-wrapped versions.

Gaining Market Share from BTC DeFi on Ethereum

Despite the use of new BTC wrapped versions in DeFi, this section only focuses on WBTC as the token accounts for 62% of the wrapped BTC market.

In order to capture significant market share from WBTC, the lending protocol on Bitcoin L2 must 1) provide higher supply yields by increasing BTC utilization (users borrowing BTC), 2) Provide sufficient stablecoin liquidity. Approximately 72% of all WBTC locked in DeFi contracts is deposited into lending protocols. The large proportion of WBTC in lending protocols suggests that this group of BTC holders is only interested in lending applications. In addition, for every $100 of WBTC deposited on Ethereum’s two major lending protocols, Aave and MakerDAO, approximately $50 of stablecoins are borrowed.

The large amount of stablecoin borrowing on AAVE and Maker against WBTC is clearly visible by looking at the average utilization of these deposit pools. On AAVE, the average WBTC utilization rate is 7.7%, meaning that 92.3% of deposited WBTC is used as collateral for stablecoin borrowing. As of November 2024, the average annual interest rate on WBTC deposits on AAVE is just 0.04%. For reference, WETH utilization on AAVE is 89%, and WETH deposits generate 2.3% annualized returns.

The utilization rate of ETH/WETH is much higher than that of WBTC. Use cases for WETH include DeFi, perp trading, staking, and NFTs. Lending applications on Bitcoin L2 aim to increase the utility of BTC by building a dedicated ecosystem for the asset, thereby providing higher yields. Some examples include ordinal and reliably built on top of Bitcoin L2Alternative Token Protocol.

The table below highlights the yields for depositing wrapped BTC into lending protocols and DEX pools on Ethereum.

Although depositing WBTC into a DEX pool can provide higher yields compared to loan pools, the risk of impermanent losses and yield fluctuations make DEX pools unreliable sources of income. As a result, 72% of WBTC’s DeFi contracts are allocated to lending protocols. To the extent that BTC borrowing on Bitcoin L2 exceeds WBTC borrowing activity on Ethereum, lending protocols on Bitcoin L2 will offer higher yields due to increased utilization of the underlying asset.

Summary

DeFi applications on Bitcoin L2 need to offer higher yields than Bitcoin DeFi on Ethereum in order to capture market share from the wrapped BTC market. Bitcoin L2 is only likely to succeed if it can take market share away from DeFi applications that accept tokenized versions of BTC such as WBTC, tBTC, and cbBTC. The vibrant DeFi ecosystem on Bitcoin L2 is the most important development for L2’s long-term adoption. This is evident when looking at the top applications for TVL on Ethereum L2 (Arbitrum, Optimism, and Base), which include lending, DEX, and derivatives platforms.

The trust assumptions of the new Bitcoin L2 bridge design are no weaker than those of the WBTC, cBTC, and tBTC bridge designs. WBTC holders need to trust BitGo’s consortium, which is a centralized entity, while BTC holders on Bitcoin L2 need to trust a relatively more decentralized set of bridge operators. While there is no one-sided exit on any Bitcoin rollup or sidechain, once this feature is developed, the bridge on the new Bitcoin L2 will be even less trustworthy than WBTC, cBTC, and tBTC.

In 2024, Bitcoin L2 received $174 million in venture capital, providing these projects with a platform to execute market strategies. Bitcoin L2, which has raised a significant amount of funding, will establish an ecosystem fund and use the funds to install existing EVM applications. Continued investment in the Bitcoin L2 ecosystem will play a vital role in the growth of the industry over the next 6 years. Once Bitcoin L2 goes into production on mainnet, crypto venture capital firms may turn to investing in early-stage native applications.

The emergence of Ordinals and BRC-20 in 2023 signals to cryptocurrency venture capital firms that there may be another way to invest in Bitcoin besides digital gold. As Bitcoin L2 matures and its user base grows, crypto venture capital firms will continue to deploy funds into Bitcoincurrency ecosystem.

Of the 75 Bitcoin L2s out there today, only 3-5 players may end up taking the lion’s share of the market. There will not be enough users, liquidity, and attention to allocate to 75 Bitcoin L2. We highlighted this point in our previous report on Bitcoin Rollup using Bitcoin for DA. L2, which has the most liquidity and revenue-generating applications, may be the only project that will survive in the next 6 years. Therefore, business development partnerships in infrastructure, liquidity bootstrapping, and market making will be critical in determining which Bitcoin L2s will be ahead of the rest.