Research

All Things Bitcoin; Layer Cake

August 19, 2021
Steven McCormack

Remember Anthony Deden's investing preferences? We've established Bitcoin as a formidable source of truth, without central authority (independence). We've explored its allure as a digital store of value (scarcity). Now we dive into the network's ability to scale (and exhibit endurance). To start, let's throw some mud around. With the dogged pursuit of purity comes many sacrifices. Compared to traditional payment networks (Visa etc.), Bitcoin is pretty damn slow and clunky. Micro-payments are simple unfeasible. Each block is limited to 4 megabytes of transaction data, and takes (on average) 10 minutes to create. I have experienced a few hand-in-mouth moments myself whilst waiting for a transaction to complete. Truth can be stressful.

A Fork on the Road

This became such a bone of contention between early adopters that a civil war erupted. A group of miners (and their corporate cheerleaders) proposed a larger block size, to accommodate increasing demand (in techy terms, a blockchain fork). The Bitcoin community strongly rebuffed this change for good reason; power corrupts. Larger blocks would have increased the computing resource necessary to verify blockchain data, restricting participation to those with deep pockets. The result? Creeping centralisation and skewed motivation. To this day, almost anyone can spin up a full node and help secure the network (see services like Umbrel and myNode). No single party can exert undue influence on Bitcoin for its own advantage.

Capitalism, for Comrades

So what are we left with? Assets for the people, by the people (cheesy, I know). We have a robust protocol, but one that cares little for convenience or efficiency. And that presents a few issues for growth (and thus sustainability). It is like the British Labour Party in the 1980s; sticking true to its socialist ideals, and also completely useless at winning elections. Fortunately, an ecosystem has developed around Bitcoin that helps address the scalability conundrum. Enter the layer cake, my friends. A baking masterpiece that is worth the extra calories. I attribute much of my foundational knowledge here to Lyn Alden, the Master of Analysis. On that note, we shall proceed.

1) Base Layer (Bitcoin Network)

As we have discussed at length, value communicated (and verified) via the Bitcoin blockchain is extremely difficult to dispute. It is the arbiter for digital assets. And to perform this important role, we must accept Bitcoin's steady pace and diligence. But rest assured, we are not condemned to a lifetime of sluggish payments. For those seeking a snappier experience (and perhaps a little less security), we can export this base layer legitimacy to the next layer in the ecosystem; Lightning.

2) Second Layer (Lightning Network)

The Lightning Network is a parallel payments universe that ties in with the underlying base layer. Lightning uses smart contract capabilities to offer high speed, low fee micro-transactions without compromising Bitcoin's integrity. From my understanding, two parties can record a ledger entry on the Bitcoin blockchain for an agreed value of, say $50. Each party has contributed $25 to the transaction, which creates a $50 'channel' on Lightning. With their $25 opening balances, both parties can interact with each other however they like. A second ledger entry of $50 can record a closing of this 'channel' at any time. So instead of engaging the Bitcoin verification process for each and every value transfer, there are only two confirmed entries; the opening and closing statements.

In plain english (a la Alden), 'It’s like keeping a bar tab open and settling at the end of the night, or the end of the month, except it doesn’t rely on trust but instead relies on programmed smart contracts that ensure the bar tab is settled.'

The network is not just bi-directional. Lightning Network users can act as intermediaries between each other, always relying upon the base layer as the All Seeing Eye. Ultimately, Lightning is capturing the legitimacy exported from below. In their own words.

'Transactions can be made off-chain with confidence of on-blockchain enforceability. This is similar to how one makes many legal contracts with others, but one does not go to court every time a contract is made. By making the transactions and scripts parsable, the smart-contract can be enforced on-blockchain. Only in the event of non-cooperation is the court involved – but with the blockchain, the result is deterministic.'

What is the purpose of the Lightning Network for Bitcoin? — Bitpanda Academy
https://www.bitpanda.com/academy/en/lessons/what-is-the-purpose-of-the-lightning-network-for-bitcoin/

3) Third Layer (Liquid Network)

The Liquid Network is for the big dogs; trading desks, exchange platforms, wallet providers, payments processors etc. Liquid operates as a sidechain (essentially a separate, custom blockchain) to grease the wheels of the wider Bitcoin economy. It is specifically designed to support financial institutions, using smart contracts to settle rapid, high volume transactions. Blocks are created every minute, with additional privacy built-in to obscure transaction details from third parties. Users can interact with Liquid via a 'peg-in' transaction, where bitcoins are used to claim equivalent tokens (Liquid bitcoin) issued by the sidechain. River Financial compares this process to 'depositing cash at a casino in exchange for chips'. You can then convert your Liquid holdings back into bitcoins with a 'peg-out' transaction.

Again, this reduces pressure on the base layer to audit every single transaction that takes place. The sidechain takes the strain of value transfer at scale whilst referring only to the base layer blockchain for the final 'tallying-up' process. Liquid, just like Lightning, is importing Bitcoin's integrity.

docs.blockstream.com

4) Fourth Layer (Exchange Platforms)

Last, but not least, are the exchanges (Coinbase etc). I had not thought about these entities as a scaling mechanism until I read Lyn's recent research on Bitcoin's energy use (which I highly recommend). But it makes perfect sense. Such exchanges exhibit a similar dynamic to Lightning (supporting small payments), except you are relying upon their central database instead of a separate, decentralised network. Your transaction fees also contribute to their corporate profit.

Ultimately you are trading a little integrity for accessibility. Which is no bad thing; we all have to start somewhere, after all. My initial Bitcoin purchases were made via Coinbase, for example. Only when I transferred my holdings to a cold wallet did I experience the sweet taste of on-chain transaction.

Free Market Endurance

So there you have it, folks. Bitcoin can scale, just not in the way you might expect. Consider it like a stone hitting still water. Uncompromising integrity has ripple effects, dispersing truth through the digital asset ecosystem. It is a fascinating dynamic, and a powerful demonstration of free market ingenuity. Economic value is being unleashed by good ol' fashioned honesty. The happy outcome? Bitcoin's durability.

In short; the ecosystem simply cannot exist without its arbiter.

Signing out, Steven.

Photo by Leonard Reese on Unsplash

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