Layered Money – Bitcoin Ecosystem Innovation on Layer 1

Sep 29, 2021

You know what Bitcoin is, right? After more than a decade, this question is still far from being answered. Most say Bitcoin settled for being gold 2.0. Yet a growing group claims it is becoming a payment network. Finally, there is a group who claims it will become a smart contract platform in the future. So, what is Bitcoin, really? As this colorful chart of July 2018 shows (Figure 1), the visions of what Bitcoin is at any given point in time is not clear cut and continues to be in flux until today. How people see Bitcoin mainly hinges on what they can and cannot do with it.

Illustration 1: Visions of Bitcoin over time
Source: Medium (courtesy of @hasufl and @nic__carter)

Most people today would agree that base-layer Bitcoin is not a particularly good payment network: transactions are too slow and too expensive for daily business. Some even complain that Bitcoin failed in its mission because, after all, the famous white paper by Satoshi Nakamoto was called “Bitcoin: A Peer-to-Peer Electronic Cash System.” Many people today rather agree that Bitcoin is akin to digital gold, or gold 2.0, mostly for the same reasons: It is expensive to create, expensive to transfer, and in general quite … expensive. Again, some complain that Bitcoin is not as good as gold because its value fluctuates too much and is erratic. Others, however, value it as it is because they can invest in a volatile asset that is uncorrelated to most other financial assets, and so on.

Writing a description for this thing for general audiences is bloody hard. There’s nothing to relate it to.

Satoshi Nakamoto

This Decrypt edition will shed some light on recent developments in Bitcoin’s multi-layered ecosystem. Some developments you may have heard of and some are still under-the-radar outside small groups. The one thing they all have in common is the aim to make the Bitcoin base layer more useful by adding new functionality on top, creating new layers with new properties. This overview makes no claim to completeness. Rather, it aims to show that the Bitcoin ecosystem has a great deal of innovation, even though it is considered old-fashioned and boring by many when compared to the exciting DeFi and NFT worlds around us.

On-chain Bitcoin innovations

Layer 1 (L1) is the Bitcoin base layer. Here, the settlement of base transactions takes place and, as we may see, it serves as an arbitrage layer for conflict resolution on higher layers. For example, when authors claim Bitcoin is on its way to becoming a new global money standard or reserve-like currency due to its immutable monetary policy and specific stock-to-flow dynamics, they are referring to this base layer (cf. The Bitcoin Standard).

On this layer, two on-chain innovations are noteworthy. The reader may have heard of Segregated Witness or SegWit (BIP-141). SegWit was activated on 01.08.2017 after emanating from the Blocksize Wars 2015-2017. It solves a few problems and enables new functionality.

Technically, to make a payment, a user needs to provide a “witness”, a solution to a cryptographic puzzle placed on spendable bitcoin (unspent transaction outputs, UTXO). Usually, the witness data is a digital signature proving ownership. While witness and UTXO were part of the transaction previously, SegWit separates both. What sounds like a technical detail has profound implications. (1) The separation prevents so-called transaction malleability attacks and paves the way for more complex protocols like the Lightning network (see below). (2) Having separate unlocking scripts allows for versioning, which in turn makes it possible to upgrade scripting capabilities in a nonobtrusive way thus making extensibility and innovation in the future much easier. In addition, SegWit reduces the average size of transactions which improves Bitcoin’s scalability and reduces transaction fees. Most noticeable for users, SegWit addresses start with bc1 (Bech52 format, BIP-173) instead of 1 or 3. As of September 2021, around 80% of daily transactions are SegWit transactions.

A second on-chain innovation, Taproot, will introduce a major, complex upgrade with profound long-term impacts. Taproot will enable a much more complex sets of locking scripts, moving Bitcoin closer towards “smart contracts”. Plus, while doing this, Taproot will offer a higher degree of privacy as even the most complex multi-sig contracts will be indistinguishable from normal payment transactions on-chain. To give more room for a deep dive into Merkelized Abstract Syntax Trees (MAST), Schnorr signatures, Tapscript, and other aspects of the upgrade, we will dedicate a future Decrypt edition to Taproot when we are closer to activation (November 2021).

Bitcoin Sidechains

Innovations on L1 are not confined to on-chain upgrades. The Bitcoin ecosystem also features innovative solutions based on sidechains. Sidechains are separate L1 blockchains that are two-way pegged to Bitcoin. By locking coins on Bitcoin, you get newly created coins/tokens on the sidechain. Being separate, sidechains can create new and innovative cryptoeconomies that have different functionalities compared to Bitcoin while the way back home is always guaranteed: you just need to burn the sidechain tokens to release your bitcoin again.

Figure 2 shows three Bitcoin sidechain projects. The two on the left are based on Elements, an open source, federated two-way pegged blockchain platform that provides additional features to Bitcoin users. One can send “confidential transactions” that keep the amount and type of assets transferred visible only to the participants of the transaction and those they decide to reveal them to as well as “confidential assets” that can represent any fungible asset (share, bond, token, etc.) while keeping amount and type of the asset confidential. This level of financial privacy is quite different to Bitcoin’s reliance on address pseudonymity. Also, Elements uses a consensus model proposed by Blockstream called Strong Federations. Instead of Proof-of-Work, a federation of mutually-distrusting “Functionaries” validate and sign blocks (Blocksigners) and pegs (Watchmen).

Illustration 2: Overview of innovations in Bitcoin’s ecosystem, by layers
Source: Bitcoin Suisse Research

The first example of an Elements based sidechain is Liquid. It is a settlement network for traders and exchanges, offering faster, more confidential Bitcoin transactions and the issuance of confidential digital assets. Blockstream is the company backing the Liquid network, which launched in September 2018.

The two-way peg guarantees that any L-BTC is backed 1:1 on the Bitcoin chain. Transaction fees are paid in L-BTC and tend to be lower than on Bitcoin. The minimum fee is 0.1 satoshi/vbyte compared to 1 satoshi on Bitcoin. Transfers on Liquid are fully settled within two minutes, allowing traders to move funds rapidly between exchanges and wallets. Anyone can issue new assets on Liquid, including stablecoins and security tokens. Currently Liquid Bitcoin (L-BTC) and Liquid Tether (L-USDT) are supported. Having types and amounts of assets hidden by default keeps transaction data confidential and may prevent front-running of large orders.

A Liquid wallet user can send and receive Liquid assets, while a Liquid node enables a user to peg-in bitcoin, issue new native assets, and fully verify blocks on the sidechain. However, peg-outs must be conducted through one of the 50+ Liquid Federation members – which is also a point of critique in terms of centralization. Over 20 platforms support the Liquid Network as of writing and let users exchange BTC for Liquid assets and vice versa, among them Bisq, Bitfinex, and Hodlhodl.

Finally, non-fungible tokens (NFTs) can also be created on Liquid. Two examples are LightNite and Raretoshi. LightNite is a game in which users can trade character skins as NFTs. On Raretoshi, users can offer and trade rare digital art as NFTs .

The second example of an Elements based sidechain is Stacks 2.0 (formerly Blockstack). It is a platform designed to bring smart contracts and decentralized apps to Bitcoin users. The platform is powered by a native token, Stacks (STX), which is akin to ‘gas’ in Ethereum and used to pay for contract execution, transaction processing and registering new assets on-chain. Hiro is the company backing the Stacks network whose mainnet launched in January 2021 (explorer).

Stacks uses the proof-of-transfer (PoX) consensus mechanism. PoX requires miners to spend BTC to win the block reward for a Stacks block. The winning miner is selected randomly, with their chance of winning the block being proportional to the amount of BTC they have spent, compared to the other miners. “Stacking”, akin to staking elsewhere, means locking STX to support the security and consensus mechanism. As a reward, users earn bitcoin from miners. Stackers are holders of the STX token who lock their tokens up for several “cycles”. Each cycle lasts for 2100 blocks, which is equivalent to 2100 Bitcoin blocks (ca. 14 days). If users own less than 1m STX, they can only stack collectively via stacking pools (eg PlanBetter). Above 1m STX, users can stack individually using the Stack Wallet.

Smart contracts on Stacks are written in Clarity. Clarity is a LISP-like decidable language (ie not Turing-complete), meaning one can predict what a program will do. Clarity is interpreted and smart contracts are published in human-readable source code, not bytecode, on-chain. The language has simple-payment-verification (SPV) proofs built in and has visibility into Bitcoin chain state and can include Bitcoin-based logic. Specifications for contract templates have been ratified using the Stacks Improvement Proposal (SIPs) process for fungible tokens (SIP-10) and non-fungible tokens (SIP-09).

The third example of a sidechain, Rootstock (RSK), is not based on Elements. RSK is an EVM-compatible smart contract platform that is secured through the Powpeg protocol. Powpeg is a two-way peg secured by proof-of-work. That means two things: one, RSK is two-way pegged to the Bitcoin chain resulting in RSK Bitcoin (RBTC) on the RSK chain that are also used to pay for gas. Bitcoin are sent to a special address and locked there, while on the same address on the RSK chain the same amount of RBTC is released (peg-in). Two, Bitcoin’s proof-of-work consensus mechanism is used through merged mining. Merged mining (also called ‘Auxiliary Proof of Work’) is the process of mining two chains that use the same hashing algorithm, in one go. RSK is backed by “more than 50% of Bitcoin hashrate”. This approach has a few advantages: (1) the security assurances of Bitcoin are inherited, (2) gas fees are lower than e.g., on Ethereum, (3) transaction fees can be paid in bitcoin.

While speaking of “locking” is not entirely correct as users can always move their sidechain coins, the following figure shows an equivalent of the “Total Value Locked (TVL)” of the three sidechains and Lightning, a layer-2 innovation we discuss in part 2 of our miniseries. The collective TVL is ca. 810m USD as of 28.09.2021.

Illustration 3: Total Value Locked (TVL) on different Bitcoin sidechains and Lightning, total 810m USD, as of 28.09.2021
Source:,,, DeFi Pulse for Lightning


In part one of our miniseries on innovations in the Bitcoin ecosystem, we looked at innovations on layer 1. While on-chain innovations like SegWit and Taproot aim to improve the performance and functionality of Bitcoin itself, sidechains – separate chains connected to Bitcoin through a two-way peg – open the innovation space much wider by introducing different transaction models and optimizations while relying on Bitcoin as the secure settlement layer. Sidechains create their own ecosystems next to Bitcoin.

Stay tuned for part two of the miniseries, in which we will discuss projects that further extend the scope of the Bitcoin ecosystem beyond layer 1.

Marcus Dapp

Head of Research