How does Bitcoin scale? Understand the progress of Bitcoin off-chain scaling technology and investment status

In the Bitcoin off-chain scaling space, there has been significant growth in investments in Lightning Network infrastructure and user services, while the sidechain narrative has mostly shifted to interoperability.

Written by: Mohamed Fouda, cryptocurrency researcher and investor, member of TokenDaily research team, PhD from Northwestern University

Compiled by: Perry Wang

In 2017, the cryptocurrency bull run triggered a surge in transaction volume, which overwhelmed the Bitcoin and Ethereum networks. Both networks were plagued by problems such as congestion, transaction delays, and high fees. In response to these problems, people proposed multiple expansion plans or turned their attention to off-chain and Layer 2 implementations.

Most entrepreneurs, researchers, and investors believe that Layer 2 (L2) solutions have few disadvantages: they only require fine-tuning of the consensus layer and avoid centralization of the underlying protocol. At the same time, these solutions seem to have many advantages. These solutions include Bitcoin's Lightning Network, Ethereum's Raiden, which can be called a true L2 solution, and sidechain solutions such as Bitcoin's RSK and Ethereum's Plasma Chains.

Between 2018 and 2019, there was a lot of active activity around L2 development.

In the case of Bitcoin, the Lightning Network (LN) mainnet was launched in March 2018. In the case of Ethereum, multiple L2 variants, including state channels, such as SpankChain, Plasma/Plasma Cash, and Loom Network have also been launched.

However, with the ongoing bear market in 2018-2019, on-chain activity has declined significantly. Without going into details, the reason is obvious: as speculation in these networks disappeared, the market demand for expansion solutions became weaker and weaker. As the market conditions gradually improved in the third and fourth quarters of 2019, we found that L2 solutions began to receive more attention - on the one hand, it was expected that the new bull market would bring network congestion, and on the other hand, it was hoped that more features such as privacy protection would be added to the underlying protocol.

We will be writing a series of articles that will examine the current trends in off-chain networks and assess their investability. We will also examine the popularity and use of off-chain solutions over the past two years. This is the first of two articles. The first article will focus on the Bitcoin ecosystem, and the second article will observe the off-chain trends of Ethereum.

Capacity comparison of Lightning Network, Liquid Sidchain and RSK

Lightning Network

The Lightning Network (LN) is by far the most important and discussed off-chain scaling solution. Since the LN whitepaper was released in 2015, the project has been hotly discussed and debated. Since its launch, LN has grown impressively in terms of number of channels, network capacity, and use cases. However, entrepreneurs and investors are still wondering what kind of business opportunities are most valuable in the LN ecosystem. They are exploring: building liquidity hubs to charge routing fees, providing integration and user services on LN, payment channels implemented with LN, and investing in LN infrastructure.

Providing liquidity in LN

Since the goal of LN is to create a payment network, especially for micropayment services, the most obvious entrepreneurial opportunity is to build a payment-related business: provide multiple LN nodes with hundreds of channels, provide routing for payments, and earn fees. Initially, people thought that this service could generate enough income to cover operating costs and generate risk-free profits.

Opponents of this view are quick to point out the technical risks and the inherent capital inefficiency of LN, whereby supposedly risk-free profits can only be realized when fees are high or transaction volumes are high. The past two years have shown that the skeptics have been proven right so far. At present, it is impossible to build a profitable business just by charging LN routing fees.

In theory, running nodes and routing payments on the LN should be just one part of a larger profitable business, similar to running a Bitcoin full node. Teams like LNBIG, the operator of the largest liquidity provider in the LN, are banking on this idea. LNBIG currently operates 25 public nodes and controls about 50% of the total capacity of the LN.

LNBIG’s anonymous founder told The Block that the investment may have been a loss so far, but they are betting on the future popularity of LN.

Annualized ROI for providing liquidity to LN in 2018. Source: BitMEX Research

If you’re interested in more rigorous data on the economics of providing liquidity in LN, you can take a look at this detailed analysis published by BitMEX Research in March 2019, based on their own experience with LN fees. The main conclusion of the report is that in the first year of LN’s launch, under optimal conditions, such as channel rates, the annualized return on investment from routing fees was only about 1%, and this return does not include the on-chain fees required to open channels.

LN User Services

The second and probably the largest type of investment in the LN ecosystem is investment in user services. This area is very broad and includes all services that interact directly with customers. We can divide this area into three main sectors:

• LN-enabled micropayments

• Financial services on LN

• Services to improve user experience and integration with LN

In the first category of LN services, the first to appear is "micropayment service", which is actually the story that LN originally told. Publishing platform Y'alls and cryptocurrency gift card provider Bitrefill are the first merchants to provide such services in the LN network.

As LN grows, more and more tools are available to facilitate access to LN, including wallets that support the Lightning Network, such as Zap, Eclair, and BLW. Bitrefill has also begun to provide services and open channels to users, such as Thor channels. These products have made the LN ecosystem more mature, and further contributed to the rise of LN user services focused on finance, such as merchant services/Bitcoin cashback services (Fold), and LN-based Bitcoin "onboarding" services (River Financial and the currently suspended Sparkswap), as well as exchanges that integrate LN (Bitfinex, LN markets).

The LN user services sector is the most heavily invested vertical in the LN space for two main reasons.

1. The number of companies in the LN user service sector is greater than that in the other two vertical sectors. Statistically, more investment opportunities mean that these projects are more likely to receive financing.
2. The winners in this vertical may also capture markets outside of crypto.

For example, Fold mainly provides cashback services based on Bitcoin, but it has stepped out of the regular crypto community and targeted a wider mainstream population. As a result, LN is used as a tool with a better user experience to deliver Bitcoin rewards. With this market orientation, Fold raised $2.5 million in financing last September. Similarly, Bitrefill also successfully raised nearly $2 million in VC financing because it used LN to expand Bitcoin merchant services. Although this is a generally exciting part of user services based on LN, this road is not smooth. Some companies, such as Sparkswap, have successfully obtained VC financing, but later found that their business was too advanced. In the field of entrepreneurship, being too advanced is also a mistake.

Some financial channels using LN as a tool

Although this is a relatively new direction in the LN ecosystem, it is likely that it will become a major trend in the near future. The goal of this direction is to use the various features of LN, such as global coverage, instant settlement, and low fees, to target users outside the crypto field. In other words, companies in this direction often use LN as a payment channel running on the backend, and users do not need to know whether they are using BTC or LN. We can compare it to companies like Cash App or Venmo, which use protocols such as ACH and Swift at the bottom to enable the circulation of user funds.

One of the first projects to emerge in this vertical is Zap. Zap plans to use LN to settle everyday dollar payments, such as merchant payments or personal cash transfers. Using LN as a settlement layer has the benefit of instant settlement and low fees, which has the potential to replace traditional payment channels, which charge a fee based on the size of the funds, up to 15%. For example, Zap's Strike product achieves this goal without users or merchants having to use Bitcoin at all. This approach also solves the main obstacles to Bitcoin's adoption in the payment system, such as price volatility and unfriendly tax policies for Bitcoin payments.

LN Infrastructure

Investing in crypto infrastructure with venture capital, such as buying equity in companies that develop protocols, has always been a controversial topic in the crypto space. However, the use cases in this regard are actually very clear. In the case of LN, this means investing in teams that build and advance the LN protocol. There are three major startups in this vertical, namely Lightning Labs, ACINQ, and Blockstream. Since the key parts of LN have been built, these companies are committed to improving the experience of users and developers using LN. For example, Lightning Labs has developed tools such as Loop and Faraday to help node operators easily manage their channels. Similarly, ACINQ is developing API tools similar to Stripe to make it easy for companies to integrate LN.

When it comes to ROI, things get a little more complicated. For crypto-focused venture capital funds, it’s not clear whether providing services to LN developers is enough to build a profitable and sustainable business. Some argue that infrastructure projects are not directly profitable, and they are actually spending money on:

1. There is an opportunity to get earlier access and the latest insights, and then invest in closed source third parties that have integrated LN.
2. Leverage their existing Bitcoin positions by supporting LN, which promises to bring in large-scale users and merchants.

Regardless of the controversy, skepticism hasn’t prevented Lightning Labs or ACINQ from raising nice Series A rounds in the past few months. Lightning Labs raised $10 million in early February, bringing the company’s total funding to $12.5 million. Similarly, ACINQ closed an $8 million Series A round last October.

Bitcoin Sidechain

Liquid

Blockstream introduced Liquid in late 2018 to solve the confidentiality problem of Bitcoin transactions. Liquid grew slowly in 2019, with less than 100 Bitcoin locked in its sidechain. However, since January of this year, the sidechain has seen a continuous inflow of several hundred Bitcoins per month, breaking the capacity of 1,600 Bitcoins in mid-April, which is more than the capacity of LN.

Liquid BTC (L-BTC) in circulation, source: https://liquid.net/

Blockstream currently lists 44 entities as members of Liquid, with some of the more prominent ones joining recently. Liquid is not gaining much traction among Bitcoin users at the moment. According to the Liquid block explorer, most sidechain blocks are empty or have only a few transactions in the single digits. While Liquid’s main focus has shifted to tokenized securities, the circulating market capitalization of tokenized assets on Liquid is still minimal. Tether (USDT), currently the largest security issued on Liquid, has a market cap of just $16.5 million. Liquid’s move to focus on issuing assets (tokens) has not been well received in the Bitcoin community, with many viewing this development direction as an attempt to copy Ethereum’s ERC-20 model. Such a low adoption rate is not what its investors would like to see, after all, Blockstream raised $55 million in its Series A round.

RSK

The ultimate vision of RSK is to replicate Ethereum on Bitcoin. To achieve this goal, RSK implemented a sidechain that is bidirectionally pegged to Bitcoin and uses a fork of Ethereum smart contracts to enable programmability of the pegged Bitcoin asset, which is called RSK Smart Bitcoin (RBTC). Similar to Liquid, RSK uses a Federation to ensure the bidirectional peg. The list of members of the RSK Federation is not public and can only be identified by public keys. Similar to Liquid, the RSK sidechain is also striving for greater mass adoption. Although RSK has been active since December 2018, the sidechain has only attracted about 160 Bitcoins. In 2019, the network of the sidechain averaged only 50 Bitcoins.

There is a Federation to ensure the two-way peg between Bitcoin and RSK

So far, RSK has performed below investor expectations. According to Crunchbase data, RSK Labs, the company behind the RSK project, has raised $7.3 million in venture capital. In addition, RIF Labs raised 22,000 bitcoins in the private token sale. RIF Labs and RSK Labs have merged to create IOV Labs. To make matters worse, there are more and more projects building interoperability between Bitcoin and various smart contract blockchains, which means that RSK has more and more competitors.

Interoperable Bitcoin Sidechains

At one point, many crypto investors believed that everything from privacy to programmability would be built as a layer on top of Bitcoin. So Liquid and RSK sidechains sounded like great investments. However, that view has changed recently. For investors considering adding programmability to Bitcoin, teams building bridges between Bitcoin and Ethereum or other smart contract platforms have proven to be better investment targets. Just look at the recent rise of TBTC. The Keep/TBTC team announced a few weeks ago that it had raised $7.7 million in financing to accelerate the development of the project.

TBTC is not a special case. In fact, almost all emerging smart contract platforms are considering how to build a Bitcoin sidechain/bridge to the platform. In the Cosmos ecosystem, Nomic Bitcoin Sidechain is a project worth paying attention to. The project uses the Tendermint technology stack to implement a Bitcoin sidechain. Once the Inter-Blockchain (IBC) protocol comes into effect, Nomic BTC (NBTC) can interoperate with other Tendermint assets. Similarly, Tezos fans have also started the tzBTC project, which is to mint BTC tokens in the Tezos blockchain.

In summary, we have witnessed a lot of experimentation and project construction in the field of Bitcoin off-chain scaling over the past two years. Investment in the LN field, especially investment in LN infrastructure and user services, has been growing significantly and is likely to continue to grow in the coming years.

On the other hand, sidechain projects built on Bitcoin have struggled to get enough attention and capture the imagination of many developers. The narrative about sidechains has mostly shifted to interoperability. The logic here is, "If I can already bridge to the same functionality, but with greater robustness and liquidity, why should I build it again?"

Keep in mind that we are still in the early stages of the industry, and much of what is written above may or will likely change in the next few years. However, we also believe that many of the trends we are tracking today will become the backbone of the next generation of financial systems in the future.