Author: Gabe Parker, Galaxy; Compiled by: Wu Zhu, Golden Finance
Summary
Since 2021, Bitcoin-based Layer 2 (L2) projects have increased more than sevenfold, from 10 to 75. Over 36% of all venture capital for Bitcoin L2 was allocated in 2024, with cryptocurrency venture capital firms investing a total of $447 million in participation in Bitcoin L2 projects since 2018. Bitcoin L2 will utilize the funds raised to develop robust applications and new use cases for BTC, aiming to attract significant liquidity from local BTC holders and existing packaged BTC markets. The report estimates that by 2030, over $44 billion of BTC could connect to Bitcoin L2. Our Total Addressable Market (TAM) analysis for Bitcoin L2 considers the current market share of all packaged versions of BTC used in DeFi, the native BTC stored in Bitcoin L2, and the BTC locked in staking protocols. As of November 20, 2024, these portions account for 0.8% of all circulating BTC. By 2030, we estimate that 2.3% of the circulating BTC supply will bridge to Bitcoin L2 to interact with the new Bitcoin DeFi ecosystem, alternative tokens, payment applications, etc.
Introduction
Since the birth of Bitcoin, discussions about its future have included the concept of tiered scaling. Hal Finney described the concept of a 'Bitcoin bank' in 2010, where 'Bitcoin-backed banks... [could issue] their own digital cash currency.' Tether launched on the Omni Network (one of the earliest Layer 2 networks) in 2014, which was described as 'Bitcoin 2.0.' The debate over whether Bitcoin should scale its base layer or high-performance L2 peaked during the 'block size debate,' and much of this war was resolved with the activation of SegWit on Bitcoin in August 2017 and the separate launch of Bitcoin Cash. SegWit enabled the payment-centric Lightning Network, which has been the most famous L2 for years. Two notable sidechains were launched in 2018—Blockstream's Liquid (focused on asset issuance and payment confidentiality) and Rootstock (an EVM-compatible sidechain).
The rise of Ordinals has brought tokenization activities back to Bitcoin's base layer in 2023 and helped rekindle interest in building applications on Bitcoin. This rekindled interest, combined with advancements in Rollup development within the Ethereum developer community, has sparked a new wave of Bitcoin Layer 2, primarily leveraging Rollup technology (optimistic and zero-knowledge). Although the Lightning Network has achieved some success in enabling fast, cheap payments, developers have struggled to create yield-generating applications for BTC on the blockchain itself. A significant portion of the difficulty stems from Bitcoin's inability to support general-purpose smart contract applications. The base layer of Bitcoin is not Turing complete, which prevents it from executing the smart contract logic required by most DeFi applications. However, future upgrades may enable improved multi-party escrow capabilities, leading to more robust bridging and Layer 2 architecture. While Turing-complete upgrades for Bitcoin have yet to be realized and are unlikely to occur, some Bitcoin holders are already operating in DeFi with their BTC, or earning yields by bridging assets to other Turing-complete chains, rather than high-performance and trust-minimized Layer 2s—like Ethereum's fully featured blockchain. Packaged Bitcoin (WBTC) on Ethereum accounts for the largest share (62%) of all packaged versions of BTC. The packaged versions of BTC used in Ethereum DeFi represent a significant group of BTC holders seeking more efficient use cases.
The over $9 billion in packaged BTC (WBTC, tBTC, cbBTC) on Ethereum may indicate user demand for using BTC within 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, as they are familiar with operating packaged BTC assets on other chains. Bitcoin L2 may prioritize developing attractive yield-generating applications priced in BTC to entice existing packaged BTC users on Ethereum to move their funds to the new Bitcoin L2. Packaged BTC holders may also use Bitcoin L2 since they have already shown a preference for utility over decentralization. All launched Bitcoin L2s will be more centralized systems than Bitcoin L1, although some will exhibit decentralization features comparable to existing Ethereum L2s.
The ability to use BTC in DeFi applications without exiting the Bitcoin ecosystem is a significant selling point for Bitcoin L2. It may reduce friction in the user experience of bridging BTC and provide a more secure alternative for using BTC in DeFi beyond existing solutions. One major advantage of Bitcoin DeFi on Bitcoin L2 is that BTC serves as both the native Gas asset and the focal point for DeFi development. Historically, native assets have demonstrated greater utility on their local blockchain compared to external networks. For example, the substantial lending demand for ETH within Ethereum DeFi applications arises from its indispensable role as Ethereum's native Gas token and its widespread adoption as the primary unit of account for NFT and fungible token transactions. The evolution of DeFi ecosystems on platforms like Ethereum and Solana illustrates an important principle: robust DeFi economies are built around the native assets of the blockchain.
This report defines the key features of Bitcoin L2 and provides a high-level overview of different types of Bitcoin scaling solutions. The report also details the $447 million in cryptocurrency venture capital invested in Bitcoin L2 since 2018 and provides a TAM analysis for emerging Bitcoin L2s. Finally, the report shares important insights regarding the future prospects of Bitcoin modularity.
What is Bitcoin Layer 2?
Bitcoin L2 provides higher transaction throughput than Bitcoin L1 by implementing larger and faster blocks. Bitcoin L2 acts as its own execution environment, allowing it to circumvent the technical limitations present on Bitcoin L1, such as the lack of Turing completeness. By serving as an independent execution environment, Bitcoin L2 can utilize 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, please refer to Christine Kim's report on Ethereum ZK-Rollups).
Another key determinant for Bitcoin L2 is their bridging mechanism, specifically how users transfer BTC from the base layer to L2. Bitcoin L2 employs a wide range of bridging frameworks, including multi-signature and multi-party custodial (MPC) wallet schemes, as well as third-party bridges. Some Bitcoin L2s use multi-signature/MPC wallet schemes with BitVM, which is an off-chain Turing-complete virtual machine compatible with Bitcoin. At a higher level, the BitVM bridge involves a 1-of-n trust assumption, where only one honest bridge operator needs to be online for users to exit the bridge. MPC and multi-signature bridges typically require more than 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 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 there are no unilateral exits for Bitcoin L2 bridges using sidechains and Rollups, meaning users cannot exit L2 without trusting an intermediary. Ethereum Rollups may include a feature called enforced withdrawal, which allows anyone to submit their transactions directly to L1 to extract funds from Rollup if the sequencer is offline or unable to include user transactions. State channels are the only Bitcoin L2 that have untrusted unilateral exits. The construction of Lightning Network bridges is designed so that users can seamlessly withdraw funds back to L1 as long as they hold the latest balance state.
Bitcoin Rollup and Sidechain
There are two categories 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 this technology is primarily used for enabling faster and cheaper peer-to-peer transactions on Bitcoin and currently does not support Turing-complete smart contracts.
Sidechains: A sidechain is essentially an independent blockchain that runs in parallel with the base layer through embedded connections to its own node operators and security mechanisms. Sidechains extend the base layer by creating independent compatible blockchains with larger blocks and faster block times. As a result, more transactions can be processed in a shorter period. Since sidechains use their own consensus model, they do not rely on a data availability layer but act as a closed and independent execution environment. Some critics argue that because sidechains use their own consensus model, they are technically not 'Layer 2' solutions but rather separate scaling of Layer 1. However, sidechains can be designed in various ways, making it important to distinguish between those that are aligned with the base layer and those that are not. Sidechains can publish the hash of block headers or other data to L1 as a way of checkpointing their own state to L1.
Rollup: A Rollup is a blockchain that offloads transactions from the base layer and executes them on an auxiliary layer. Therefore, Rollups offer users 10 to 100 times cheaper and faster transactions. By using transaction data compression algorithms that batch multiple transactions together, Rollups can achieve higher transaction throughput than sidechains.
Rollup also uses the parent blockchain to achieve data availability. The parent blockchain stores the state root, transaction data, or state differences of the Rollup. Data stored on the parent blockchain allows any full node to reconstruct the latest state of the Rollup. Rollups can be designed to support a single application or provide general functionalities and host multiple applications.
Rollups update the state root in two ways. Validity Rollups (also known as zk-Rollups) create concise cryptographic proofs that L1 immediately verifies upon receipt of the updates, proving that the updates are consistent with the correct execution of those transactions. Optimistic Rollups push the optimistic correct state root updates to L1 and provide a defined time window for validators to challenge the state root updates.
The classification of the market map above follows these primary features:
Bitcoin Rollup: The execution layer that publishes proofs and state difference data or transaction data to the Bitcoin blockchain.
Non-Bitcoin Rollup: The execution layer that publishes proofs and state difference data or transaction data to Ethereum or an alternative DA layer.
Sidechain: An independent execution layer that is compatible with the Bitcoin base layer and does not require DA from the parent chain.
Infrastructure: Data availability protocols and any packaged BTC providers.
State Channel: An off-chain execution environment without global state, only submitting the initial and final states of account balances.
ECASH: A custodial state channel solution based on David Chaumian's Ecash proposal.
Virtual UTXO and CSV: New iterations of client-validated state channels and execution layers.
Effective Chain: An execution layer that is compatible with BTC and uses off-chain or alternative DA.
The market map does not include every project in each category and serves as a reference for the construction of different types of projects within the Bitcoin L2 ecosystem. As of November 20, 2024, the Bitcoin L2 market consists of 40 Rollups and 25 sidechains. This report does not cover state channels, CSV, Drivechain, or ECash protocols, which collectively represent 10 projects.
Bitcoin L2 Venture Capital
As of September 2024, Bitcoin L2 raised $174 million from cryptocurrency venture capital firms. Among them, sidechains received the largest allocation of $105 million, followed by Rollups at $63 million. Notably, in 2024 alone, 39% of the historical venture capital for Bitcoin L2 occurred. A significant shift occurred in Q2 2024, where Bitcoin L2 accounted for 44% of all venture capital deployed in L2 solutions across the entire industry, a staggering 159% increase quarter-over-quarter. In 2024, cryptocurrency venture capital investment in Bitcoin L2 surged, highlighting that traditional cryptocurrency venture capital (excluding Bitcoin-focused funds) had nearly no exposure to the Bitcoin ecosystem prior to the fundraising and development phase in early 2024. As of November 2024, Bitcoin L2 has undergone 2 rounds of Series A financing involving 30 disclosed transactions.
Since 2018, Bitcoin Layer 2 has attracted significant investment, with sidechains leading the way. Of the total investment amount of $447 million in Bitcoin L2, sidechains accounted for the largest share at 64%. State Channels followed closely, accounting for 22%, while Rollups accounted for 14%. Notably, ECASH-based protocols like Cashu and Fedimint are not included in the above figures but have collectively secured $27.2 million in venture capital. Electronic cash projects do not meet our definition of Bitcoin L2 but are worth considering as potential infrastructure in the Bitcoin L2 space.
The potential market for Bitcoin L2
We believe that the directly available market for Bitcoin L2 consists of packaged versions of BTC in DeFi contracts, native BTC bridged to L2, and the total supply of BTC staking protocols. The demographics of the 'active' BTC supply are the focus of our TAM analysis. We believe this group of holders is most likely to connect BTC with new L2s in search of yield opportunities.
As of November 20, approximately 0.8% of the BTC circulating supply (164,992 BTC) is actively in use. For the packaged BTC market, $1 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 used for DeFi, L2, and staking increases by 0.25% annually over 6 years, we estimate that by the end of 2030, the 'active BTC supply' could grow to 471,806 BTC (approximately a threefold increase).
In contrast, 2.3% of Ethereum's circulating supply (ETH, WETH, stETH, wstETH) is locked in DeFi smart contracts (excluding staking protocols). Based on current prices as of November 20, 2024, this model estimates that Bitcoin L2's TAM will reach $44 billion by 2030.
If Bitcoin reaches $100,000 in 2030, the TAM for Bitcoin L2 could reach $47 billion, assuming that 2.3% of the total Bitcoin supply is locked in Bitcoin L2 by then.
Please note that this analysis can roughly estimate how much BTC supply could flow into Bitcoin L2 for yield; it does not account for the potential growth of the Bitcoin L2 ecosystem, which 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 assume that the percentage of BTC supply locked in Bitcoin L2 may grow by 0.25% per year from now until 2030; second, we assume that the price of BTC could reach $100,000 by 2030. Our view is that these are conservative estimates regarding the demand for Bitcoin L2 users and the price of Bitcoin over the next six years.
It is also important to note that our projections depend on the progress of Bitcoin's DeFi and L2 staking ecosystem, while building legitimacy over the next 6 years. Crucially, if the DeFi yield rates on new Bitcoin L2s are not sufficiently attractive, the supply of BTC packaged on Ethereum may remain within the Ethereum ecosystem. The following sections will focus on the minimum yield levels required for DeFi applications on Bitcoin L2 to compete with DeFi applications on Ethereum that accept BTC packaged versions.
Gaining market share from BTC DeFi on Ethereum
Although new packaged versions of BTC are being used in DeFi, this section focuses solely on WBTC, as this token accounts for 62% of the packaged BTC market.
To capture significant market share from WBTC, lending protocols on Bitcoin L2 must 1) provide higher supply yields by increasing BTC utilization (users borrowing BTC), and 2) ensure sufficient stablecoin liquidity for lending. Approximately 72% of all WBTC locked in DeFi contracts are deposited into lending protocols. The large proportion of WBTC in lending protocols indicates that this group of BTC holders is only interested in lending applications. Additionally, for every $100 of WBTC deposited on the two major lending protocols on Ethereum (Aave and MakerDAO), approximately $50 of stablecoins are borrowed.
By observing the average utilization rates of these deposit pools, it is evident that there is a significant amount of stablecoin borrowing against WBTC on AAVE and Maker. On AAVE, the average utilization rate for WBTC 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 for WBTC deposits on AAVE is only 0.04%. For reference, the utilization rate for WETH on AAVE is 89%, and WETH deposits yield 2.3% annualized returns.
The utilization of ETH/WETH far exceeds that of WBTC. Use cases for WETH include DeFi, perp trading, staking, and NFTs. Lending applications on Bitcoin L2 aim to enhance the utility of BTC by building a dedicated ecosystem for the asset, thereby providing higher yields. Some examples include ordinal and alternative token protocols built on Bitcoin L2.
The table below highlights the yields of depositing packaged BTC into lending protocols and DEX pools on Ethereum.
While depositing WBTC in DEX pools may offer higher yields than loan pools, the risks of impermanent loss and yield volatility make DEX pools unreliable yield sources. As a result, 72% of WBTC's DeFi contracts are allocated to lending protocols. When borrowing BTC on Bitcoin L2 exceeds lending activities of WBTC 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 to capture market share from the packaged BTC market. Bitcoin L2 can only succeed if it can capture market share from DeFi applications that accept BTC tokenized versions such as WBTC, tBTC, and cbBTC. A vibrant DeFi ecosystem on Bitcoin L2 is the most important development for the long-term adoption of L2. This is evident when looking at the top applications by TVL on Ethereum L2 (Arbitrum, Optimism, and Base), which include lending, DEX, and derivatives platforms.
The trust assumptions of the new Bitcoin L2 bridge designs are not weaker than those of 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 bridging operators. Although no unilateral exits exist for any Bitcoin Rollup or sidechain, once this feature is developed, bridging on the new Bitcoin L2 will be less trustworthy than WBTC, cBTC, and tBTC.
In 2024, Bitcoin L2 raised $174 million in venture capital, providing a platform for these projects to execute market strategies. Bitcoin L2s that have raised significant funds will establish ecosystem funds and use this capital to install existing EVM applications. Ongoing investment in the Bitcoin L2 ecosystem will play a crucial role in the growth of the industry over the next 6 years. Once Bitcoin L2 goes live on the mainnet, cryptocurrency venture capital firms may shift to investing in early native applications.
The emergence of Ordinals and BRC-20 in 2023 signaled to cryptocurrency venture capital firms that Bitcoin might have another investment avenue beyond digital gold. As Bitcoin L2 matures and its user base expands, cryptocurrency venture capital firms will continue to deploy funds into the Bitcoin ecosystem.
Among the 75 Bitcoin L2s today, only 3-5 participants may ultimately capture the largest market share. There will not be enough users, liquidity, and attention to be distributed across 75 Bitcoin L2s. We highlighted this point regarding Bitcoin Rollups for using Bitcoin for DA in previous reports. The L2 with the most liquidity and yield-generating applications may be the only projects that survive over the next 6 years. Therefore, partnerships for business development in infrastructure, liquidity provision, and market-making will be crucial in determining which Bitcoin L2s will lead others.
