Bitcoin L2s

Summary

Since 2021, Layer 2 (L2) projects building on Bitcoin has increased over sevenfold. From 2021 to 2024, the number of Bitcoin L2 projects has increased from 10 to 75. More than 36% of all venture funding in Bitcoin L2s was allocated in 2024 and, since 2018, crypto venture firms have invested a total of $447m into Bitcoin L2 projects. Bitcoin L2s will leverage their raised capital to develop robust applications and new use cases for BTC, aiming to attract significant liquidity from both native BTC holders and existing wrapped BTC markets. This report estimates that over $47bn of BTC could be bridged into Bitcoin L2s by 2030. Our total addressable market (TAM) analysis for Bitcoin L2s considers the current market share of all wrapped versions of BTC used in DeFi, native BTC parked in Bitcoin L2s, and BTC locked in staking protocols. As of November 20, 2024, these segments account for 0.8% of all BTC in circulation. By 2030, we estimate that 2.3% of BTC’s circulating supply will be bridged into Bitcoin L2s to interact with new Bitcoin DeFi ecosystems, fungible tokens, payment apps and more.

Introduction

Since Bitcoin’s inception, discussions about Bitcoin’s future have included the concept of scaling through layers. Hal Finney described the concept of “Bitcoin Banks” in 2010, in which “bitcoin-backed banks… [could issue] their own digital cash currency.” Tether launched on the Omni Network, one of the first Layer 2s, in 2014, an initiative that was described as “Bitcoin 2.0”. Disputes about whether Bitcoin should scale the base layer in lieu of performant L2s reached a head during the “Blocksize War,” which mostly resolved in August 2017 with the enablement of SegWit on Bitcoin and the separate launch of Bitcoin Cash. SegWit made the payments-focused Lightning Network possible, and for several years Lightning has been the most prominent L2. Two notable Sidechains launched in 2018 – Blockstream’s Liquid (focused on asset issuance and payment confidentiality) and Rootstock (an EVM compatible sidechain).

The rise of Ordinals brought tokenization activity back to Bitcoin’s base layer in 2023 and helped to reignite interest in building applications on Bitcoin. That resurgent interest, coupled with advancements in Rollup development inside the Ethereum development community, has led to a wave of new Bitcoin Layer 2s, mostly utilizing Rollup technology (both optimistic and zero-knowledge). While Lightning has seen some success enabling fast, inexpensive payments, developers have struggled to develop yield generating applications for BTC on the blockchain itself. A large part of the difficulty has been due to Bitcoin’s inability to support general purpose smart contract applications. Bitcoin’s base layer is not Turing-complete, and therefore, cannot execute smart contract logic necessary for most DeFi apps. However, future upgrades could enable features that improve multi-party custody, which would allow for more robust bridging and Layer 2 schema. While Bitcoin upgrades enabling Turing-complete capabilities have not materialized and are not likely, and in lieu of performant and trust-minimized Layer 2s, some bitcoin holders are already using their BTC to operate in DeFi or earn yield by bridging the asset to other Turing-complete blockchains like Ethereum. Wrapped Bitcoin (WBTC) on Ethereum represents the largest share (62%) of all wrapped versions of BTC. The wrapped versions of BTC used in Ethereum DeFi is representative of a sizable demographic of BTC holders looking for more productive use cases for BTC.

The $9bn+ of wrapped BTC on Ethereum (WBTC, tBTC, cbBTC) may be indicative of user demand to use BTC in DeFi applications. WBTC, tBTC, and holders of other bridged BTC are more likely than other cohorts to move and use BTC on new Bitcoin L2s given that they are familiar with operating with wrapped BTC assets on other chains. Bitcoin L2s will likely prioritize developing attractive BTC-denominated yield generating applications to entice existing wrapped BTC users on Ethereum to move funds to new Bitcoin L2s. Wrapped BTC holders are also likely to use Bitcoin L2s because they have already demonstrated a propensity to value utility over decentralization. All Bitcoin L2s at their launch will be more centralized systems than Bitcoin L1, though some will feature comparable decentralization to existing Ethereum L2s.

The ability to use BTC in DeFi apps without exiting the Bitcoin ecosystem is a significant selling point for Bitcoin L2s. It may reduce frictions in the user experience for bridging BTC and offer more secure alternatives to using BTC in DeFi beyond the solutions that exist today. A key benefit of Bitcoin DeFi on Bitcoin L2s is that BTC serves as both the native gas asset and the focal point of DeFi development. Historically, native assets have demonstrated greater utility on their home blockchains compared to external networks. For instance, ETH's substantial borrowing demand in Ethereum DeFi apps stems from its integral role as the native gas token for Ethereum, as well as its widespread adoption as the primary unit of account for NFT and fungible token trading. The evolution of DeFi ecosystems on platforms like Ethereum and Solana has illustrated a crucial principle: robust DeFi economies are built around a blockchain's native asset.

This report defines the key characteristics of Bitcoin L2s and offers a high-level overview of the different types of Bitcoin scaling solutions. The report also gives a breakdown of the $447m of crypto VC investment in Bitcoin L2s since 2018 and offers a TAM analysis for the emerging Bitcoin L2s. Finally, the report shares key insights about the outlook for Bitcoin’s modular future.

What is a Bitcoin Layer 2?

Bitcoin L2s offer higher transaction throughput than Bitcoin L1 by implementing larger and faster blocks. Bitcoin L2s function as their own execution environments and can therefore circumvent the technical limitations that exist on Bitcoin L1, such as the lack of Turing-completeness. By functioning as independent execution environments, Bitcoin L2s can use their own consensus mechanisms, security frameworks, and virtual machines. For example, most Bitcoin L2s in production are EVM equivalent or compatible, enabling them to integrate apps from other EVM blockchains. (For more on EVM equivalency and compatibility, read Christine Kim’s report on Ethereum ZK-Rollups).

Another key defining factor of Bitcoin L2s is their bridge mechanisms, how users can move BTC from the base layer to the L2. Bitcoin L2s use a wide range of bridge frameworks including multi-signature and multi-party-custody (MPC) wallet schemes, and third-party bridges. Some Bitcoin L2s utilize Multi-sig/MPC wallet schemes with BitVM, an off-chain Turing-complete virtual machine that is 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 users to exit the bridge. MPC and multi-signature bridges typically require over 50% of signers to be honest for users to exit the bridge.

The main difference between Bitcoin L2 bridges and Ethereum L2 bridges is that the latter involves a smart contract account, and the former utilizes a Bitcoin public key address. In both cases, however, the smart contract account on Ethereum and the Bitcoin public key address are usually controlled by a set of private keys. Another key difference is that Bitcoin L2 bridges for Sidechains and Rollups do not have a unilateral exit, meaning the users can’t exit the L2 without trusting an intermediary. Ethereum rollups may include a function called a forced withdrawal, which enables anyone to submit their transactions directly to the L1 to withdraw funds from the rollup in the event that a sequencer goes offline or fails to include user transactions. State Channels are the only Bitcoin L2 with a trustless unilateral exit. Lightning Network bridges are constructed so that as long as the users have the most recent state of their balances, they can seamlessly withdraw funds back to the L1.

Bitcoin Rollups and Sidechains

There are two categories of Bitcoin L2 solutions that can support general purpose app development: Rollups and Sidechains. State Channels are another L2 solution being developed on Bitcoin, most notably the Lightning Network, but the technology is primarily used for enabling faster and cheaper peer-to-peer transactions on Bitcoin and cannot currently support Turing-complete smart contracts.

Sidechains: Sidechains are effectively independent blockchains, operating in parallel with the base layer through embedded connectivity with their own node operators and security mechanisms. Sidechain’s scale the base layer by creating a separate compatible blockchain with larger blocks and faster block times. Consequently, more transactions can be processed in a shorter time frame. Since Sidechains use their own consensus models, they do not rely on data availability layers and instead function as closed and independent execution environments. As Sidechains use their own consensus models, some critics argue that they aren't technically "Layer 2" solutions, but rather function as separate scaling Layer 1s (Ex: Polygon built on Ethereum is a Sidechain to Ethereum, not an ETH L2). However, Sidechains can be designed in various ways, and it's important to distinguish between those that align with the base layer and those that do not. Sidechains may post hashes of block headers or other data to the L1 as a way to “checkpoint” their own state to the L1.

Rollups: Rollups are blockchains that offload transactions from the base layer and execute them on a secondary layer. As a result, Rollups offer users 10x-100x cheaper and faster transactions. Rollups can facilitate higher transaction throughput than Sidechains by using transaction data compression algorithms that batch multiple transactions together.

Rollups also use a parent blockchain for data availability. The parent blockchain stores the Rollup’s state root, transaction data, or state difference. This data stored on the parent blockchain enables any full node to reconstruct the most recent state of the Rollup. Rollups may be designed to support a single application or offer general purpose functionality and host many applications.

Rollups update state roots in two ways. Validity Rollups (also known as zk-Rollups) create succinct cryptographic proofs that are immediately verified by the L1 upon receipt of the update, proving that the update is consistent with the correct execution of these transactions. Optimistic Rollups push state root updates to the L1 that are optimistically correct and offers verifiers a defined window of time to challenge the state root update.

For a deep dive on OP&ZK Rollups, read this report.

The categorization of the market map above follows these key characteristics:

Bitcoin Rollups: Execution layer that posts proof and state difference data or transaction data into Bitcoin blocks.

Rollups not on Bitcoin: Execution layer that posts proofs and state difference data or transaction data on Ethereum or alternative DA layer.

Sidechains: Independent execution layer compatible with Bitcoin’s base layer and does not need DA from parent chain.

Infrastructure: Data availability protocols and any wrapped BTC provider.

State Channels: Off-chain execution environments with no global state that only commit to the initial and final state of account balances.

ECASH: Custodial State Channel solution based off David Chaumian's Ecash proposal.

Virtual UTXO & CSV: New iterations of State Channels and execution layers that use client-side verification.

Validia Chains: Execution layers compatible with BTC and use off-chain or alternative DA.

The market map does not include all projects in each category and serves as a reference for the different types of projects building 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 State Channels, CSV, Drivechain, or ECash protocols, which represent a total of 10 projects.

Bitcoin L2 Venture Funding

Through September 2024, Bitcoin L2s raised $174m in funding from crypto VCs. Of this total, Sidechains received the largest allocation at $105m, followed by Rollups at $63m. Notably, 39% of all historical VC investment in Bitcoin L2s occurred in 2024 alone. The second quarter of 2024 saw a significant shift, with Bitcoin L2s capturing 44% of all crypto VC capital invested in L2 solutions across the industry—a staggering 159% QoQ increase. The surge in crypto VC investment towards Bitcoin L2s in 2024 highlights that traditional crypto VCs, excluding Bitcoin focused funds, had little to no exposure to Bitcoin’s ecosystem prior to 2024. The table below illustrates that many Bitcoin L2 projects who raised funds in 2024 are in the early stages of fundraising and development. Through November 2024, there have been 2 Series A rounds for Bitcoin L2s across 30 disclosed deals.

Since 2018, Bitcoin Layer 2s have attracted significant investment, with Sidechains leading the way. Of the total $447m invested in Bitcoin L2s, Sidechains received the largest share at 64%. State Channels followed with 22% of the capital, while Rollups secured 14%. It should be noted that ECASH based protocols like Cashu and Fedimint were excluded from the table above and received a total of $27.2m in VC funding. E-Cash projects do not fit our definition for a Bitcoin L2, but are worth including as potential infrastructure in the Bitcoin L2 sector.

Total Addressable Market for Bitcoin L2s

We view the immediate serviceable market for Bitcoin L2s as the total supply of wrapped versions BTC in DeFi contracts, native BTC bridged to L2s, and BTC staking protocols. This demographic of ‘active’ BTC supply is the focus for our TAM analysis. We view this cohort of holders as the most likely to bridge BTC to new L2s in search of yield opportunities.

Approximately 0.8% of BTC’s circulating supply, 164,992 BTC, is actively using DeFi as of November 20, 2024. 59% of this BTC is wrapped on Ethereum, 22% is locked on new Bitcoin staking protocols, and 10% is sitting on Bitcoin L2s. For the wrapped BTC market $10bn is locked in DeFi smart contracts and $247m is on Bitcoin L2s. For native bitcoin, $3.4bn is locked in staking protocols (Babylon, Bouncebit), and $1.5bn is locked on Bitcoin L2s.

If we assume that the share of the circulating BTC supply using DeFi, L2s and Staking increases by 0.25% annually over 6 years, we estimate that the “active BTC supply” could grow to 471,806 BTC by the end of 2030 (~3x increase).

This consistent conservative growth rate would result in 2.3% of BTC supply active in DeFi, Staking and Bitcoin L2s by 2030. For 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 the TAM for Bitcoin L2s at $44bn by 2030. If BTC reaches $100k in 2030, the TAM for Bitcoin L2s could then reach up to $47bn, assuming that 2.3% of total BTC supply is locked in Bitcoin L2s by 2030.

Note that this analysis serves as a rough estimate for how much BTC supply could flow into Bitcoin L2s in search for yield; it does not consider the potential growth of Bitcoin L2 ecosystems which includes other crypto assets that will be issued on top of these L2s like Runes, Ordinals, stablecoins, etc. Our TAM estimate relies on two key assumptions. First, we assume the percentage of BTC supply locked in Bitcoin L2s could grow by 0.25% each year from now until 2030 and second, we assume BTC price could reach $100k by 2030. Our view is that these are conservative estimates for Bitcoin L2 user demand and Bitcoin price over the next six years.

Also note that our projections are contingent on Bitcoin’s DeFi and staking ecosystems on L2s progressing forward while building legitimacy over the next 6 years. Crucially, the supply of wrapped BTC on Ethereum could stay in the Ethereum ecosystem if the DeFi yields on new Bitcoin L2s are not attractive enough. The following section will highlight the minimum level of yield DeFi apps on Bitcoin L2s need to compete with DeFi apps that accept wrapped versions of BTC on Ethereum.

Extracting Market Share from BTC DeFi on Ethereum

Although there are new wrapped versions of BTC used in DeFi, this section will only focus on WBTC as the token represents 62% of the wrapped BTC market.

To extract significant market share from WBTC, lending protocols on Bitcoin L2s must 1) offer higher supply yields from increased BTC utilization (users borrowing BTC), and 2) supply ample stablecoin liquidity for borrowing. Approximately 72% of all WBTC locked in DeFi contracts are deposited in lending protocols. The large share of WBTC in lending protocols suggests that this cohort of BTC holders are only interested in lending apps. Further, for every $100 of WBTC deposited on Ethereum’s top two lending protocols, Aave and MakerDAO, ~$50 of stablecoins are borrowed.

The large sums of stablecoin borrows against WBTC on AAVE and Maker is clear when observing the average utilization rate for these deposit pools. On AAVE, the average utilization rate for WBTC is 7.7%, implying that 92.3% of deposited WBTC is used as collateral for stablecoin borrows. As of November 2024, WBTC deposits on AAVE only receive an average of 0.04% APY. For reference, the utilization rate for WETH on AAVE is 89%, generating 2.3% APY for WETH deposits.

The utilization rate for WETH is much higher than WBTC because there is more utility for ETH/WETH compared to WBTC on Ethereum. Use cases for WETH include DeFi, perp trading, staking, and NFTs. Lending apps on Bitcoin L2s are positioned to offer higher yield from increased utility for BTC through building out specialized ecosystems for the asset. Some examples include Ordinals, and fungible tokens protocols built on Bitcoin L2s. For more information about Ordinals and other fungible token protocols being created on Bitcoin, read this Galaxy Research report.

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

While depositing WBTC into DEX pools offers higher yields compared to lending pools, the risks of impermanent loss and yield volatility make DEX pools an unreliable yield source. Consequently, 72% of WBTC in DeFi contracts are allocated to lending protocols. In the scenario borrowing BTC on Bitcoin L2s surpasses the borrowing activity of WBTC on Ethereum, lending protocols on Bitcoin L2s will offer higher yields from increased utilization of the underlying asset.

Outlook

• Defi apps on Bitcoin L2s will need to offer higher yield than bitcoin DeFi on Ethereum to extract market share from the wrapped BTC market. Bitcoin L2s are only likely to be successful if they can take market share away from DeFi apps that accept tokenized versions of BTC like WBTC, tBTC, and cbBTC. A vibrant DeFi ecosystem on Bitcoin L2s is the most important development for long-term adoption of L2s. This is clear when looking at the top apps by TVL on Ethereum L2s (Arbitrum, Optimism, and Base), which are lending, DEX, and derivative platforms.

• The trust assumptions for new Bitcoin L2 bridge designs are not materially weaker than bridge designs for WBTC, cBTC and tBTC. WBTC holders need to trust BitGo’s consortium, which is a centralized entity while BTC holders on Bitcoin L2s need to trust a comparatively more decentralized set of bridge operators. Although unilateral exits do not exist for any Bitcoin Rollup or Sidechain, once this feature is developed, bridging on new Bitcoin L2s will be significantly more trustless than WBTC, cBTC and tBTC.

• The $174m in VC funding Bitcoin L2s received in 2024 provides these projects with runway to execute go to market strategies. Bitcoin L2s that raised sizable capital will build out ecosystem funds and use this capital to onboard existing EVM applications. The continued investment into the Bitcoin L2 ecosystem will play a crucial role in the sector’s growth over the next 6 years. Crypto VCs may rotate into investing in early-stage native applications once the Bitcoin L2s in production launch on mainnet.

• The emergence of Ordinals and BRC-20s in 2023 signaled to crypto VCs that there may be another investment narrative to Bitcoin aside from digital gold. Crypto VCs will continue to deploy capital into the Bitcoin ecosystem as Bitcoin L2s mature and grow their userbase.

• Out of the 75 Bitcoin L2s today, only 3-5 players will likely end up eating the lion’s share of the market. There will not be enough users, liquidity, and attention to be allocated across 75 Bitcoin L2s. We highlight this view for Bitcoin Rollups using Bitcoin for DA in a previous report. The L2s with the most liquidity and yield generating applications will likely be the only projects that survive over the next 6 years. As a result, business development partnerships for infrastructure, liquidity bootstrapping, and market making will be crucial for identifying which Bitcoin L2s will take the lead over others.