Off-chain scaling solutions for Bitcoin – Where are we now?

This bottleneck leads to scaling limitations involving high transaction fees and network congestion during periods of high on-chain activity. Various solutions have been proposed or activated in order to resolve this issue, some of them more controversial than others. PROPOSED SOLUTIONS TO THE SCALING PROBLEM Moving transactions off-chain have been a popular proposal to solve the scalability problem. Several projects are striving to unload the pressure from the Bitcoin blockchain. The Lightning Network and Blockstream’s Liquid Network have gained the most traction among the designated off-chain solutions. However, amidst the growth of decentralized finance, a third unexpected platform has taken a significant share of the off-chain market; The Ethereum Network. In this mini report we provide a quick overview of the recent development in the exciting off-chain space. TAXONOMY In general, a bitcoin transaction can occur both on-chain and off-chain. An on-chain transaction is signed, broadcasted, and settled directly on the Bitcoin blockchain. Off-chain transactions are more intricate and can be categorized into three main categories: 1) Layer 2: The transaction is signed but broadcasted to a to a separate network and netted outside of the Bitcoin blockchain 2) The “peg out”: The bitcoins are locked on the Bitcoin blockchain and “lifted out” into another system. This system may either be a sidechain (like Liquid and wBTC, which will be introduced later in this report), or a centralized database (like exchanges and custodian wallet providers). 3) Key Transfer: The bitcoin transfer is carried out as a one-time transfer of the private key outside of the Bitcoin blockchain THE LIQUID NETWORK The Liquid Network was launched by Blockstream in 2018 as a partial solution to the conundrum of scaling Bitcoin. The Liquid Network is a Bitcoin sidechain that aims to offer fast and confidential transactions between the major trading platforms. Transactions on the Liquid Network are finalized within minutes, with small fees and privacy optionality as the amounts sent can be disguised. Liquid anchors BTC on the Bitcoin blockchain which are then used on the Liquid sidechain as L-BTC tokens, backed 1:1 by BTC. A consortium including Blockstream, several large exchanges and hardware wallets hold the keys to the anchor addresses. Anyone can run a full node on the Liquid Network, but only the members of the consortium are eligible to create new liquid blocks. Liquid targets traders seeking to secure arbitrage profits between exchanges. Short-term price deviations between exchanges often vanish within minutes and by utilizing the fast transfers on the Liquid Network, traders are better positioned to exploit temporary mispricings. Following the launch of L-BTC, the amount of BTC locked into the Liquid addresses grew at a slow pace, but in December 2019 a clear trend shift occurred. Between December 1st 2019 and January 1st 2020 the number of L-BTC jumped by six-fold from 97 L-BTC to 600 L-BTC. The sharp growth has continued and since January 1st the L-BTC supply has increased by more than 400 percent to a total of 2476 L-BTC in circulation, indicating that the Liquid Network is in a state of a S-curve adoption with an influx of traders finding value in Liquids characteristics as a sidechain complement to Bitcoin. THE LIGHTNING NETWORK The Lightning Network works on top of the blockchain as a second layer payment protocol. Its value proposition is to enable streaming of money; instant off-chain (micro)transactions, in order to avoid blockchain congestion and to make BTC micropayments economically feasible by reducing fees. As a second layer protocol, the Lightning structure differs from other off-chain solutions. Where other solutions operate around a sidechain, a setup where bitcoins are “lifted out” of the Bitcoin blockchain and into another system, Lightning manages valid bitcoin transactions, but outside of the blockchain, in an entirely new infrastructure. The Lightning Network is based around a network of payment channels allowing participants to transfer value to other participants through a routing system, without having to make the transaction public on the blockchain. Initially, participants commit an amount to a payment channel, the funding transaction, which is on the blockchain. This enables the participant to access the Lightning Network. Bitcoin transfers on Lightning can be routed between multiple channels, allowing cheap and near instant transfers. Uncooperative behavior on the Lightning Network is punished through an incentive system, preventing bad behavior from participants. Payment channels on the Lightning Network are based on local consensus, making it possible to open private channels between parties that are not publicly broadcasted. This makes it difficult to measure the exact adoption of and activity on the Lightning Network, but findings by BitMEX Research indicate that 28% of the channels of the Lightning Network are private (as of 28th of January 2020). Following the launch of the Lightning Testnet, the protocol saw 14 months of continuous growth. By March 2019 the network had reached 40 000 open public channels, with a peak bitcoin capacity of 1100 BTC. But, since March 2019 there was a net reduction of public payment channels, and the Lightning Network capacity fell by 27 percent to 800 BTC in the months following the peak. Now the tide shows signs of turning again, as active public channels are on the rise and the network capacity once again approaches 1000 BTC. THE ETHEREUM BLOCKCHAIN – TOKENIZED BTC Whereas Liquid and Lightning are created as solutions for scaling Bitcoin, an entirely different off-chain destination has spurred amidst the growth of Decentralized Finance (DeFi) - The Ethereum Network. The motivation of tokenizing bitcoin as an ERC-20 token is to enable functionality which is not natively supported on the Bitcoin blockchain, such as compatibility with the Ethereum DeFi ecosystem. A drawdown of tokenized bitcoin on the Ethereum blockchain is the current heavy usage of the Ethereum blockchain, leading to Ethereum fees being larger than Bitcoin fees in periods. If Ethereum successfully switches from PoW to PoS this issue might be reduced, until then tokenized BTC on the Ethereum Network carries similar scaling issues as Bitcoin. The true value in tokenized BTC on Ethereum is the smart contract integration, generating a bitcoin instrument that can be traded on decentralized exchanges and used as collateral on DeFi lending platforms. The hard money properties of bitcoin make it useful in the DeFi system, especially in the lending sector as collateral for loans. Wrapped BTC (wBTC) is the largest bitcoin token on Ethereum with 11 136 BTC being locked into the protocol. The wBTC token is completely centralized with custody being maintained by BitGo, but the tokens move freely on the Ethereum blockchain. The tokens can be bought, sold and transferred for free and BitGo cannot intervene in these transactions. Other solutions are also available using different custody implementations. One of them being the Synthetix based sBTC token, utilizing a bitcoin peg based on price feeds supplied by an oracle. Data from Nansen shows that 15 236 BTC are locked into tokenized Bitcoin protocols on the Ethereum Network. This is 4x the combined size of Liquid and Lightning. Following the rapid influx in DeFi innovations this year, the tokenized BTC supply has skyrocketed by 1372 percent year to date. CURRENT DISTRIBUTION OF OFF-CHAIN SPACE Currently, BTC tokenized on Ethereum dominates the off-chain space, accounting for 82% of the BTC supply being locked off-chain. It is important to note that the off-chain space is still in its very infancy with only 0.1% of the entire BTC supply being locked into off-chain solutions. We also note that there exist several other sidechain solutions beside those mentioned in this blog post, such as the RSK BTC sidechain and Binance BTCB, which also experience increased traction these days. LONG TERM IMPLICATIONS OF INCREASED OFF-CHAIN ADOPTION As the off-chain ecosystem grows, participants are left with increased optionality leading to a wider set of use cases for bitcoin. Some traders seeking faster transactions to secure temporary arbitrage gains will have an option to execute on the mispricings via services such as Liquid. Streaming services will have an ability to access instant microtransaction by utilizing the Lightning Network. Further, tokenized BTC creates opportunities to bridge BTC’s properties in a creative manner over to other protocols. The optionalities are ever expanding, but it is important to beware that these options all involve a trade-off; less decentralization and/or more complexity than when using the Bitcoin blockchain itself as the settlement layer. Appendix ON-CHAIN WORKAROUNDS TO DAMPEN THE SCALING PROBLEM Several solutions have been proposed to improve the scalability of Bitcoin. Some of the solutions have set the stage for epic debates in the crypto community, leading to hostile discussions and hard forks. The most notable hard fork is Bitcoin Cash. Bitcoin Cash implemented larger blocks to allow for more transactions to take place in each block. A more rapid block generation schedule has also been viewed as a potential workaround to avoid blockchain congestion. These solutions carry a trade-off, as the real bottleneck creating the congestions on the blockchain is the maintenance of a proper decentralized consensus. By increasing the block size, or reducing the time between each block, more computing resources and broadband will be required by the nodes validating each transaction, potentially leading to limitations regarding which nodes are able to get to speed on each transaction, which in turn leads to increased centralization of the blockchain as fewer nodes are able to validate the transactions. Less drastic changes to the protocol have been implemented as soft forks in order to make Bitcoin more scalable. The Segregated Witness (hereby SegWit) process is the most pronounced example of a successfully implemented soft fork to the protocol, where signature data is removed from the transactions, freeing up space or capacity to add more transactions to the chain. As digital signature data typically accounts for around 65 percent of the space in a transaction, SegWit could potentially increase the 1 MB limit for block sizes to a little under 4 MB. SegWit has seen large adoption since the SegWit activation of August 2017 and currently 48 percent of all spending transactions on the blockchain are sent via SegWit. Another workaround to reduce blockchain congestion and fees is the process of batching of transactions. Batching is the process of adding multiple transactions into one transaction and saw widespread use among exchanges during the frenzy of 2017. A report published in May 2018 by CoinMetrics found that approximately 12 percent of all transactions on the blockchain involved batching, while 40 percent of all outputs and 30-60 percent of all raw BTC output value involved batching.