Among today's 75 Bitcoin L2s, only 3-5 participants are likely to capture the largest share of the market.
Written by: Gabe Parker, Galaxy
Compiled by: Wu Zhu, Golden Finance
Summary
Since 2021, the number of Bitcoin Layer 2 (L2) projects has more than quadrupled, increasing from 10 to 75. Over 36% of all venture capital in Bitcoin L2 was allocated in 2024, and since 2018, cryptocurrency venture capital firms have collectively invested $447 million in Bitcoin L2 projects. Bitcoin L2 will leverage the raised funds to develop robust applications and new use cases for BTC, aiming to attract significant liquidity from local BTC holders and the existing packaged BTC market. The report estimates that by 2030, over $47 billion of BTC may be connected to Bitcoin L2. Our Total Addressable Market (TAM) analysis for Bitcoin L2 considers the current market share of all BTC packaged versions used in DeFi, as well as the native BTC locked in Bitcoin L2 and BTC locked in staking protocols. As of November 20, 2024, these components account for 0.8% of the circulating BTC supply. 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, and more.
Introduction
Since the inception of Bitcoin, discussions about its future have included the concept of layered 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, a move described as 'Bitcoin 2.0'. The debate over whether Bitcoin should expand its base layer rather than high-performance L2 reached its peak 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 made payment-centric Lightning Network possible, which has been the most well-known L2 for years. Two notable sidechains were launched in 2018 – Blockstream's Liquid (focusing on asset issuance and payment confidentiality) and Rootstock (an EVM-compatible sidechain).
The rise of Ordinals has brought tokenization activities back to the base layer of Bitcoin in 2023, reigniting interest in building applications on Bitcoin. This renewed interest, coupled with advancements in Rollup development within the Ethereum developer community, has sparked a new wave of Bitcoin Layer 2 projects, primarily utilizing Rollup technology (both optimistic and zero-knowledge). While the Lightning Network has achieved some success in facilitating fast and cheap payments, developers have struggled to build yield-generating applications for BTC directly on the blockchain itself. A significant part of the challenge stems from Bitcoin's inability to support general smart contract applications. The base layer of Bitcoin is not Turing-complete, thus unable to execute the smart contract logic required by most DeFi applications. However, future upgrades may enable improved multi-party computation capabilities, allowing for stronger bridging and Layer 2 architectures. Although upgrades to achieve Turing completeness in Bitcoin are not yet realized and are unlikely to be, some Bitcoin holders are already operating with their BTC in DeFi or earning yield by bridging assets to other Turing-complete chains instead of high-performance and trust-minimized Layer 2s like full blockchains such as Ethereum. The packaged Bitcoin (WBTC) on Ethereum commands the largest share of all packaged BTC versions (62%). The BTC packaged versions used in Ethereum DeFi represent a large cohort of BTC holders seeking more efficient BTC use cases.
The over $9 billion worth of packaged BTC (WBTC, tBTC, cbBTC) on Ethereum may indicate the demand for using BTC in DeFi applications. Holders of WBTC, tBTC, and other bridged BTC are more likely to transfer and utilize BTC on the new Bitcoin L2, as they are familiar with operating packaged BTC assets on other chains. Bitcoin L2 may prioritize developing attractive BTC-denominated yield-generating applications to entice existing packaged BTC users from Ethereum to move their funds to new Bitcoin L2. Packaged BTC holders may also use Bitcoin L2 because they have shown a preference for utility over decentralization. All launched Bitcoin L2s will be more centralized systems than Bitcoin L1, although some systems will possess 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. A major benefit 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 shown greater utility on their local blockchain compared to external networks. For example, the high borrowing demand for ETH in Ethereum DeFi applications stems from its indispensable role as Ethereum's native Gas token and its widespread adoption as the primary unit of account for NFTs and fungible token transactions. The evolution of the DeFi ecosystem 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 characteristics of Bitcoin L2 and provides a high-level overview of different types of Bitcoin scaling solutions. It also offers a breakdown of the $447 million in cryptocurrency venture capital invested in Bitcoin L2 since 2018 and presents an analysis of the TAM for emerging Bitcoin L2. 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 bypass the technological limitations present on Bitcoin L1, such as the lack of Turing completeness. By serving as an independent execution environment, Bitcoin L2 can use 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, refer to Christine Kim's report on Ethereum ZK-Rollups).
Another key determinant for Bitcoin L2 is their bridging mechanism, which refers to how users transfer BTC from the base layer to L2. Bitcoin L2 uses a wide range of bridging frameworks, including multi-signature and multi-party computation (MPC) wallet schemes, as well as third-party bridge operators. Some Bitcoin L2s employ multi-signature/MPC wallet schemes with BitVM, which is a Turing-complete off-chain virtual machine compatible with Bitcoin. At a higher level, the BitVM bridge involves 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 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, Ethereum's smart contract accounts and Bitcoin public key addresses are typically controlled by a set of private keys. Another key difference is that Bitcoin L2 bridges for sidechains and Rollups do not have unilateral exits, meaning users cannot exit L2 without trusting an intermediary. Ethereum Rollups may include a feature known as forced withdrawal, which allows anyone to submit their transactions directly to L1 to withdraw funds from the Rollup in case the sequencer goes offline or is unable to include user transactions. State channels are the only Bitcoin L2 that possesses trustless unilateral exits. The construction of Lightning Network bridges is designed to allow users to seamlessly withdraw funds back to L1 as long as they have the latest balance state.
Bitcoin Rollup and Sidechains
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, the most well-known being the Lightning Network, but this technology is mainly used to achieve 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 to the base layer through embedded connections with its own node operators and security mechanisms. Sidechains extend the base layer by creating independent compatible blockchains with larger blocks and faster block times. Therefore, more transactions can be processed in a shorter time. Because sidechains use their own consensus model, they do not rely on a data availability layer but operate as a closed and independent execution environment. Some critics argue that, since sidechains use their own consensus model, they are technically not 'Layer 2' solutions but rather separate Layer 1 extensions. 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 to 'checkpoint' their own state to L1.
Rollup: A Rollup is a blockchain that offloads transactions from the base layer and executes them on a secondary layer. Therefore, Rollup provides users with transactions that are 10 to 100 times cheaper and faster. By using transaction data compression algorithms that batch multiple transactions together, Rollup can achieve higher transaction throughput than sidechains.
Rollup also utilizes the parent blockchain for data availability. The parent blockchain stores the Rollup's state root, transaction data, or state differences. Data stored on the parent blockchain allows any full node to reconstruct the latest state of the Rollup. Rollup can be designed to support a single application or provide general functionality and host multiple applications.
Rollup updates the state root in two ways. Validity Rollup (also known as zk-Rollups) creates succinct cryptographic proofs that L1 immediately verifies upon receiving updates, proving that the updates are consistent with the correct execution of those transactions. Optimistic Rollup pushes the Optimistic correct state root updates to L1 and provides a defined time window for validators to challenge the state root updates.
The classification of the market map above follows the following key characteristics:
Bitcoin Rollup: Executes the layer that publishes proofs and state difference data or transaction data to the Bitcoin block.
Not on Bitcoin Rollup: Executes the layer that publishes proofs and state difference data or transaction data on Ethereum or alternative DA layers.
Sidechain: An independent execution layer compatible with the Bitcoin base layer without requiring 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 Chaum's Ecash proposal.
Virtual UTXO and CSV: New iterations of state channels and execution layers using client-validated.
Valid chain: An execution layer compatible with BTC, using off-chain or alternative DA.
The market map does not include all projects 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 has raised $174 million from cryptocurrency venture capital firms. Of this, sidechains received the largest allocation at $105 million, followed by Rollups at $63 million. Notably, 39% of the historical venture capital for Bitcoin L2 occurred in 2024 alone. A significant shift took place in Q2 2024, where Bitcoin L2 accounted for 44% of all cryptocurrency venture capital allocated to L2 solutions across the industry, representing a shocking 159% increase quarter-over-quarter. In 2024, venture capital investment in Bitcoin L2 surged, highlighting that traditional cryptocurrency venture capital (excluding funds focused on Bitcoin) had almost no exposure to the Bitcoin ecosystem before the early stages of fundraising and development in 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 substantial investments, with sidechains leading the way. Of the total investment of $447 million in Bitcoin L2, sidechains account for the largest share at 64%. State Channels follow closely with 22%, while Rollups account for 14%. Notably, protocols based on ECASH, such as Cashu and Fedimint, are not included in the above table and have collectively received $27.2 million in venture capital. E-cash projects do not fit our definition of Bitcoin L2 but are worth noting as potential infrastructure in the Bitcoin L2 space.
Potential Market for Bitcoin L2
We believe that the directly addressable market for Bitcoin L2 is the total supply of packaged BTC in DeFi contracts, native BTC bridged to L2, and BTC locked in 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 their BTC with the new L2 in search of yield opportunities.
As of November 20, approximately 0.8% of the circulating BTC supply (164,992 BTC) is actively in use. For the packaged BTC market, $10 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 using 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 tripling).
In contrast, 2.3% of the circulating supply of Ethereum (ETH, WETH, stETH, wstETH) is locked in DeFi smart contracts (excluding staking protocols). Based on the current prices as of November 20, 2024, this model projects that by 2030, the TAM for Bitcoin L2 will reach $44 billion.
If Bitcoin reaches $100,000 by 2030, the TAM for Bitcoin L2 may reach $47 billion, assuming that 2.3% of the total Bitcoin supply is locked in Bitcoin L2 by 2030.
Please note that this analysis can roughly estimate how much BTC supply could flow into Bitcoin L2 for yield; it does not consider the potential growth of the Bitcoin L2 ecosystem, which includes other crypto assets that will be issued on 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 from now until 2030 may grow by 0.25% annually; second, we assume that the price of BTC may reach $100,000 by 2030. Our view is that these are conservative estimates of future demand for Bitcoin L2 users and the price of Bitcoin over the next six years.
It is also important to note that our predictions depend on the progress of Bitcoin's DeFi and staking ecosystem on L2, while establishing legitimacy in the next six years. Crucially, if the DeFi yields on the new Bitcoin L2 are not attractive enough, the packaged BTC supply on Ethereum may remain within the Ethereum ecosystem. The following section 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 a new BTC packaged version is used in DeFi, this section focuses only 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) provide ample liquidity in stablecoins for lending. About 72% of all WBTC locked in DeFi contracts is deposited in lending protocols. The substantial proportion of WBTC in lending protocols indicates that this group of BTC holders is primarily interested in lending applications. Furthermore, for every $100 of WBTC deposited in the two major lending protocols on Ethereum, Aave and MakerDAO, about $50 of stablecoins are borrowed.
By observing the average utilization rates of these deposit pools, it is clear to see the substantial stablecoin borrowing against WBTC on AAVE and Maker. On AAVE, the average utilization rate of WBTC is 7.7%, meaning that 92.3% of the 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%, with WETH deposits yielding 2.3% annually.
The utilization of ETH/WETH is significantly higher than that of WBTC. The use cases for WETH include DeFi, perpetual trading, staking, and NFTs. Lending applications on Bitcoin L2 aim to enhance the utility of BTC by building a dedicated ecosystem around the asset to provide higher yields. Some examples include ordinal and alternative token protocols built on Bitcoin L2.
The table below highlights the yield rates of depositing packaged BTC into lending protocols and DEX pools on Ethereum.
While depositing WBTC in DEX pools can provide higher yields compared to lending pools, the risks of impermanent loss and yield volatility render DEX pools unreliable sources of yield. Therefore, 72% of WBTC in DeFi contracts is allocated to lending protocols. Lending protocols on Bitcoin L2 that borrow BTC more than the WBTC borrowing activities on Ethereum will provide higher yields due to improved utilization of the underlying asset.
Conclusion
DeFi applications on Bitcoin L2 need to offer higher yields than Bitcoin DeFi on Ethereum to capture market share from the packaged BTC market. Only by taking market share from DeFi applications that utilize tokenized versions of BTC, such as WBTC, tBTC, and cBTC, can Bitcoin L2 potentially succeed. A vibrant DeFi ecosystem on Bitcoin L2 is the most crucial 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 in the design of the new Bitcoin L2 bridges are not weaker than those of WBTC, cBTC, and tBTC bridges. WBTC holders need to trust BitGo's consortium, a centralized entity, while BTC holders on Bitcoin L2 need to trust a relatively more decentralized group of bridging operators. Although there is no unilateral exit for any Bitcoin Rollup or sidechain, once this feature is developed, bridging on the new Bitcoin L2 will be more untrustworthy than WBTC, cBTC, and tBTC.
In 2024, Bitcoin L2 raised $174 million in venture capital, providing a platform for executing market strategies for these projects. Bitcoin L2s that have raised significant funds will establish ecosystem funds and use this funding to install existing EVM applications. Ongoing investment in the Bitcoin L2 ecosystem will play a critical role in the industry's growth over the next six years. Once Bitcoin L2 is operational on the mainnet, cryptocurrency venture capital firms may shift towards investing in early native applications.
The emergence of Ordinals and BRC-20 in 2023 signals to cryptocurrency venture capital firms that Bitcoin may offer another investment avenue beyond digital gold. As Bitcoin L2 matures and its user base grows, cryptocurrency venture capital firms will continue to deploy funds into the Bitcoin ecosystem.
Among today's 75 Bitcoin L2s, only 3-5 participants are likely to capture the largest share of the market. There will not be enough users, liquidity, and attention to distribute among 75 Bitcoin L2s. We emphasized this point in previous reports regarding the use of Bitcoin for DA in Bitcoin Rollups. The L2 with the most liquidity and yield-generating applications may be the only ones able to survive over the next six years. Thus, business development partnerships focusing on infrastructure, liquidity provisioning, and market-making will be crucial in determining which Bitcoin L2s will lead over others.
