Understanding The “Bitcoin L2 Trilemma”


As a venture capitalist, I maintain a “token agnostic” stance. Because we invest at the early stages of a new technology’s development, we invest in equity rather than tokens, only receiving tokens on a pro-rata basis. We firmly believe that for a token to be valid, it should serve a crucial role; in essence, removing the token should disrupt the core value proposition and underlying architecture. Merely having tokens for their sake, or avoiding them without reason, raises immediate red flags. In much of Web3, there’s an overflow of tokens made just to have a token. Projects which may have otherwise succeeded but fail due to their token’s economic unsustainability and lead to significant financial losses for investors. Contrastingly, within the Bitcoin community, you’ll find developers wasting uncountable hours on unsolvable technology problems in what amounts to solutions I call “tokenless tokens” – an approach I liken to “attempting sex without intercourse.” Both approaches seem irrational.

Now, let’s delve into the three facets of this trilemma:

1. Off-Chain Networks

e.g., Lightning & RGB

These aren’t blockchains but networks that save data off-chain (stored by users). There isn’t a universal public ledger here, making data and smart contracts less accessible and interactive. Thus, you miss out on the comprehensive functionalities offered by smart contract blockchains like Ethereum or Solana. It also requires users to run their own nodes or infrastructure in order to be fully decentralized, resulting in a significant user experience barrier for adoption. That said, this approach affords scalability and privacy benefits far beyond what blockchain technology will ever be capable of, making it optimal for application-specific use cases, notably scaling payments.

2. Decentralized Sidechains

e.g., Stacks, Interlay, Layer-0 solutions, etc.

Decentralized Sidechains enable anyone to participate in consensus (i.e. mining blocks), as they supplement their security budget with a new token issued by the protocol. This results in a competitive marketplace of miners spending resources vying to earn the blockchain’s native token, subsequently utilized by users to cover gas fees when executing smart contracts. The anticipation is that increased usage and network effect will bolster the token’s demand and make it economically sustainable. However, introducing an extra token could complicate the user experience. Moreover, the “Laser-Eye” Bitcoin maximalists will attack these efforts and call them a scam for their perceived competition with BTC as an asset; making a developer’s life more stressful. On the upside, possessing a token can foster community building and facilitate capital raising to fund substantial research and development efforts.

3. Federated Sidechains

e.g., Liquid, RSK, Botanix

In this scenario, absent a token, miners (or validators) are compensated solely by the company behind the development effort, or by blockchain user fees, which often amounts to negligible sums for years until significant uptake occurs. This compensation is needed because in Proof-of-Work-style consensus models, mining costs money; in Proof-of-Stake, there’s the risk of capital being slashed. Even Bitcoin and Ethereum, with over 100M users each, predominantly fund their security budget through a token reward subsidy. To address this, a federated sidechain doesn’t open mining to everyone. Take Liquid, for example; it has formed a group of 15 crypto businesses, including exchanges, trading desks, and infrastructure providers. While this approach can work well, it requires trust in the selected entities. To become more decentralized over time, the age-old dilemma arises: how to draw in ample users and fees while functioning within a trusted group? Efforts are underway to devise hardware solutions to automate and potentially democratize membership, but trust now shifts to the hardware being utilized. So what are the advantages of federated sidechains? A more streamlined user experience, as these sidechains utilize a form of pegged BTC for network fees. Avoiding a new token also reduces the likelihood of facing opposition from the “Laser-Eye” Bitcoiner camp. Although it’s yet to be seen whether this group of Bitcoiners will actually participate in the Web3 use cases these sidechains enable.

Additional Insights: Mining vs. Bridging

It’s pivotal to recognize the distinction between RSK and Liquid. The former employs Merged Mining and has impressively garnered 64% of BTC’s hashrate as of February 2022. However, RSK has a federation and hardware-centric approach for their bridge. In contrast to this, token-based sidechains are building decentralized bridges which use their native token as collateral. Examples of this include sBTC, which Stacks is advancing, and alternatives by Interlay and several Layer-0 sidechains. By leveraging the native token as collateral, this design uses the chain’s native token as collateral, providing an incentive model to sustain an open-membership bridging protocol for the BTC asset. BitVM, newly introduced this month through a white paper, could present a solution to make federated bridges more trust-minimized and eliminate the need for hardware-based solutions. I’m closely watching its progress over the coming months.

Three Potential Solutions to Solve the Trilemma

Numerous prospective solutions necessitate a Bitcoin soft fork, which could take a considerable time to gain traction. Drivechains serve as a recent controversial example. Initially proposed in 2017, it’s now having its moment. Validity Rollups (or zk Rollups) hold promise and have garnered more positive feedback from several Bitcoin Core developers. Yet, effective implementation remains a challenge and could be a distant reality. Merged Mining is intriguing, especially with RSK demonstrating significant adoption from Bitcoin Miners, even without compelling incentives. However, the absence of a token still means reliance on a trusted bridge or advanced hardware configurations that await market validation. BitVM might revolutionize federated bridges in tandem with merged mining in the coming years, potentially resolving the decentralization dilemma.

The Question of EVM (A Topic for Another Day)

It’s worth highlighting that many sidechains opt for EVM (the Ethereum Virtual Machine), with RSK, Botanix, and numerous Layer-Zero solutions taking this approach. This decision fast-tracks market entry and ensures compatibility with exchanges and EVM-centric blockchain infrastructure. Conversely, Stacks and Starkware (zk Rollup) have devised their own virtual machines, aiming to be an improvement over EVM in specific areas, such as decidability and zk compatibility. This dual-edged sword means they might lose the network effect but may provide developers a platform to craft superior applications and distinguish themselves from market-leading applications on Ethereum.

Abolish All Tokens

For most builders, the decision about a token should be rooted in practical concerns. Even on Ethereum, where Layer-2 Validity Rollup solutions don’t require a token because of their smart contract support on Layer 1, leading projects like Optimism and Arbitrum have tokens. They leverage these tokens to strengthen community ties and finance development. This market-based evidence further complicates navigating the token vs. no token question. BASE, a Layer-2 Ethereum initiative by Coinbase, has recently garnered significant traction without having its own token. However, the company has indicated that introducing a token in the future remains an option.

Drawing from my past experience as a corporate innovation executive and an entrepreneur, I liken the token vs. no token debate to the startup equity vs. corporate equity conundrum. In my book, “The Lean Enterprise” (2014), I highlighted numerous instances where internal innovation attempts failed due to lack of incentives proportional to the high risks and extensive R&D these projects demanded. Even Google, known for its innovation-focused corporate culture, witnessed its employees forgo hefty stock options to venture out on their own, leading to the birth of giants like Twitter, Instagram, Niantic (of Pokemon Go fame), Pinterest, and more. This resulted in a potential market cap loss worth over a hundred billion dollars.

Layer 2 projects carry immense risks, with a majority bound to fail. The funds required for their development are significant. New Bitcoin cannot be created to fund a new blockchain’s security budget or developer community. Despite offering fewer security benefits than Validity Rollup solutions like Optimism, Arbitrum, and BASE; Polygon, an Ethereum sidechain, still dominates in terms of market cap and developer engagement among all Ethereum scaling solutions. It’s now shifting towards a zk-based strategy. Hence, even if a zk-rollup method doesn’t inherently demand a token, possessing a native token for a blockchain (as opposed to an application) might offer a competitive edge. As with all things related to business, there are no clear cut answers.

Final Thoughts

The Bitcoin L2 space is captivating, with the race intensifying as protocols like Ordinals, BRC-20, and Runes attract more Web3 developers to build on Bitcoin. As Web3 investors, our focus remains on applications and infrastructure, steering clear of token trading. Presently, our interests lie in Off-Chain Networks with distinctive application-specific advantages and Decentralized Sidechains, primarily due to their open membership consensus model, community building, and capital acquisition benefits. We’re also bullish on Merged Mining, if BitVM succeeds at introducing a more trust-minimized approach for federated bridging. Importantly, both the collateral-driven bridges like sBTC and the BitVM method are still in developmental phases. BitVM was just announced via white paper this month and has garnered significant developer interest, while sBTC has been under development for over a year with substantial resources invested in the effort. Ultimately, alongside investing in Bitcoin L1 applications and infrastructure, the Bitcoin Frontier Fund aims to strategically venture into all three trilemma corners, investing in the most promising efforts by outstanding teams.

This is a guest post by Trevor Owens. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

Rodarmor Returns: Announces “Runes Protocol” To Compete With BRC-20


Casey Rodarmor, the mad genius creator behind Bitcoin Ordinals, has largely avoided the spotlight since March. A month and a half after launch, the Ordinals protocol exceeded any developer’s wildest dreams of adoption, long before it reached the current statistics of 32M inscriptions, 180k unique users, and $550M in trading volume, nine months down the line. In September, Casey started getting his feet wet in the Ordinals community again, attending the Ordinals Summit in Singapore and resuming his acclaimed podcast, Hell Money Pod.

But on Tuesday of this week, Casey’s warm up was over. He unveiled a blog post introducing the idea for “Runes,” an alternative fungible token protocol on Bitcoin. In his words, Runes serves to mitigate UTXO proliferation and provide significant user experience benefits compared to other fungible token protocols on Bitcoin.

“Runes are harmis harm reduction. BRC-20s create a lot of unused UTXOs. In order to spend Runes, you have to destroy UTXOs, which is good for the system as a whole. It’s also beneficial for users, enabling simpler PSBT-based swaps. Since a UTXO can only be spent once, you can create a set of transactions and then out of those transactions, you can guarantee only one of those can be mined. BRC-20 transactions can’t do this.” – Casey Rodarmor on Twitter Spaces

What Are Runes?

Runes is a fungible token protocol for Bitcoin, designed to be an alternative to BRC-20, Taproot Assets, RGB, Counterparty, and Omni Layer. In Casey’s blog post he details the differences with Runes and these protocols. Basically, it comes down to the fact that all of the others either work off-chain or are address (account) based.

According to Casey, the off-chain fungible token protocols require you to reconcile the off-chain data with the blockchain, creating an awkward user experience. The ones that are address based don’t work well with Bitcoin’s UTXO-based approach, leading to similar complications for end users.

UTXO-Based Fungible Token Tracking

Herein lies the magic of the Runes protocol. Instead of linking the record of balances to wallet addresses, it puts the records in the UTXOs themselves. A new Rune starts with an issuance transaction, specifying the supply, symbol, and number of decimals, assigning that supply to a specific UTXO. Any amount of Rune tokens can be in a UTXO, no matter its size. The UTXOs are just used to keep track of balances. Then, a transfer function uses that UTXO, splitting it into multiple new UTXOs of arbitrary size, containing different amounts of Runes, to send records to other people.

For example, if I use a UTXO with ten thousand satoshis (arbitrary), it can have a million (any number) Runes in it. If I want to send two friends 100k Runes each, I put the tuple assigning where those Runes go into the OP_RETURN of the Bitcoin transaction. I put in one UTXO, three UTXOs come out; two with 100k Runes each to my friends and the other with 800k Runes to myself.

The Return of OP_RETURN

Casey decided to use OP_RETURN, instead of the Witness part of the transaction, as he did with the Ordinals protocol, because using the Witness can make swaps and PSBTs tricky. For instance, if you have a transaction with two inputs, each of those inputs have a signature, and extra data can be added in the Witness by each. So, if you sign a transaction, another person signing the same transaction can add their own Witness data. This means you could sign it with one set of transfer instructions and so could the other user. This can’t happen with OP_RETURN.

This also means that Runes are separate from the Ordinals protocol. In some ways, this is beneficial; the separation between Ordinals and Runes makes development simpler without each depending on the other. The downside is that Runes can’t take advantage of the already existing user base and decentralization of Ordinals, making it more challenging to start a base of nodes. Conversely, if Runes become more well-liked than Ordinals—since BRC-20s currently form the majority of inscriptions—it could lead the current BRC-20 Ord node runners to switch to Runes.

Standardness Rules Are For B*tches

An interesting problem with Runes is that some transactions will break Bitcoin Core’s “standardness” rules by having OP_RETURNs that are larger than 80 bytes or by using two data pushes. In response to this, Casey mentioned that these standard rules don’t decide what makes it into a block and what’s valid within a block. If a non-standard transaction makes it into a block, it still gets processed. These rules merely decide what the vanilla Bitcoin Core will relay once your transaction is broadcasted. If miners can earn money from fees produced by Runes, nothing will stop them from accepting OP_RETURN transactions that are larger than 80 bytes. In essence, if Bitcoin Core was The Matrix, Casey is like the little bald kid telling you, the Rune user, that the key to bending the spoon is understanding that it doesn’t really exist to begin with.

Benefits to Bitcoin

In unveiling Runes, Casey points out his belief that 99.9% of fungible tokens are nothing more than scams and memes, expressing his disdain for their existence. However, he also acknowledges that he doesn’t foresee their disappearance—much like casinos are here to stay. Rather, he suggests, it would be beneficial if the “shitcoin casino” contributed fees to fortify Bitcoin while also drawing in more users and developers who are taking an interest in other blockchains. He architected Runes to possess a minimal on-chain footprint and to promote conscientious UTXO management. True to his crass style, he likened Runes to offering clean needles to street drug addicts.

Compatibility with Lightning and DLCs

It’s important to highlight a significant advantage of Runes: the fungible tokens would be compatible with both Lightning and DLCs. This is a distinctive edge over BRC-20s, attributed to Runes’s UTXO-based approach. Essentially, this means you could incorporate Runes into various multisig wallet configurations and settle their balances to a diverse set of parties. Competition invariably benefits users, and Runes might vie with Taproot Assets on its own territory, all while introducing new use cases, developers, and users to the Lightning Network.

The Ordinals Community Goes Wild

Casey revealed Runes in a blog post at 6:39pm ET, dubbing it, “a terrible idea” and a “worse-is-better fungible token protocol for Bitcoin.” Within the hour, addressing over 400 people on X Spaces, he described it as “not even a partially formed idea.” Still, the excitement within the Ordinals community was unmistakable. I personally extended an open investment offer of $100k into our next accelerator program to the first team to launch an indexer, issuance or transfer app. And by 1:12am, the first Rune token $RUNE was issued and confirmed in a Bitcoin block. The journey from a nascent blog post to implementation by an independent developer unfolded in less than 7 hours—a pace rarely witnessed on any blockchain, and certainly exceptional for Bitcoin.

A screenshot from the video game Diablo II. 

This is a guest post by Trevor Owens. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.