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Bitcoin: The Rise of a Multi-layered Financial System

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What is Bitcoin? To the uninitiated, this question sounds rather unexciting. They understand Bitcoin to be a cryptocurrency as it is repeatedly portrayed by the mainstream media. While this is true on a very superficial level, the common Bitcoiner would stress the fact that Bitcoin is more than just a cryptocurrency, financially speaking. There is Bitcoin the network or protocol as well as bitcoin/BTC the currency or asset. 

In making this differentiation they follow the footsteps of popular Bitcoiners like Jack MallersElizabeth Starkand Nic Carter that have each emphasized this important distinction between bitcoin (BTC) the asset, and Bitcoin the network. By pointing this out, they have contributed to an enhanced understanding of Bitcoin as a new sort of economic institution with its own institutionalized money. 

A more nuanced way to see Bitcoin

I’d love to propose an even more nuanced differentiation: I consider Bitcoin to be a multi-layered financial ecosystem with its own monetary system. Because of this monetary system, Bitcoin can be wholly independent of today’s existing financial and monetary system.

I regard Bitcoin’s native monetary system as its chief achievement and a true novelty. Over the last two decades, people have tried rebuilding finance using fintech. While many interesting financial applications have come out of this, they all remained bound to the traditional monetary base layer of the fiat system. True innovation in the field of money and finance has only started with Bitcoin.

So, when it comes to a new and alternative monetary system, Bitcoin is unmatched. Its native monetary policy is elegantly simple, and its immutable supply is free from human discretion, something no other money has had since gold. In contrast to the yellow precious metal though, Bitcoin's monetary policy is algorithmically determined and thus perfectly predictable, rule-based, and neither event- nor emotion-driven. By depoliticizing monetary policy and grounding it in rule-based parameters, Bitcoin’s monetary asset is structured as neutrally as possible. One can consider Bitcoin to be truly sound money since it provides the highest degree of stability, reliability, and security as a monetary system.

Money forms the base layer 

This unprecedented code-erected monetary arrangement builds the foundational layer of Bitcoin. At its core sits the bitcoin asset, which can be considered a new global, digital money. Because this money resides on a base layer, it’s more apt to speak of Bitcoin as being base money. This base money is being settled in a distributed fashion on Bitcoin’s blockchain, which acts as the final settlement network within Bitcoin’s native, global monetary system. 

Today, most people talking about Bitcoin see it as a currency for everyday use. Visions of being a fast and cheap means of payment are projected into Bitcoin without understanding that Bitcoin’s base money is not directly suited for such endeavors. Bitcoin the base money – also known as on-chain bitcoin or BTC that is settled on Bitcoin’s blockchain with finality – is really “just” the first or base layer for a rapidly evolving multi-layered financial order.

This all-important nuance was already clear to Bitcoin's anonymous founder, which is why he chose his terms carefully in the Bitcoin whitepaper. Satoshi Nakamoto described Bitcoin as an electronic cash system - a subtlety that has unfortunately been missed by many to this day. Judging from retrospective, Nakamoto probably should have emphasized the term cash, as it carries a very distinct meaning within monetary theory: Coming from the old French word casse, which means money box or money in hand, cash is defined as a bearer asset that is typically used to settle money transactions, therefore being a base money asset. So, I believe that it was Nakamoto’s intention to introduce the Bitcoin blockchain as a base settlement infrastructure for a blockchain-native base money.

A layer for financial logic 

So, most people are familiar with Bitcoin’s monetary layer, particularly its on-chain asset BTC, while nevertheless misunderstanding its true nature. What goes unnoticed by many is Bitcoin’s rapidly developing financial system. The reason is that this new system is not directly built in Bitcoin’s protocol code itself.

This stands in stark contrast to so-called smart contract platforms like Ethereum, Solana, Avalanche, Terra, or Binance Smart Chain. While these fully programmable blockchains – technically called Turing-complete systems – allow for native smart contract compatibility, Bitcoin’s programming languages script has been intentionally limited. By not going for full programmability on its base layer, Bitcoin has been optimized for stability, reliability as well as security.

With Bitcoin, the implementation of financial logic of any kind has been offloaded to a second layer within its multi-layered financial system. As of now, this layer is populated by sidechains like RSK or Mintlayer, second-layer protocols like the Lightning Network, or alternative layer 1 blockchains like Stacks that run in parallel to Bitcoin and settle its state thereon. 

These different approaches make up the building blocks of what I call the infrastructure layer within Bitcoin’s financial system. Its purpose is to enhance Bitcoin’s expressive power in some form or another. At the same time, this layer is a layer of its own. This way the monetary layer can provide the essential assurances for a sound monetary base asset, while the expressive financial logic in the form of smart contracts is moved off of Bitcoin’s blockchain onto the infrastructure layer higher up the stack.

The difference between second layer protocols and sidechains 

People are trying to bring financial logic to Bitcoin in a variety of ways. I refer to these as infrastructure projects and all of them have chosen unique approaches. Some are built on top of the Bitcoin blockchain, others exist as separate blockchains that run parallel to Bitcoin: The common link among them is that they ultimately depend on Bitcoin for finality and security.

Probably the most popular so far is the Lightning Network. This is a second-layer protocol implemented on top Bitcoin. As such, Lightning is a mechanism for transmitting payments off-chain, using Bitcoin as its underlying blockchain for security. Notably, it does not give rise to an alternative blockchain.

With the Lightning Network, Bitcoin is sent to off-chain payment channels that are periodically settled on Bitcoin’s main layer blockchain. While Lightning is commonly associated with lightning-fast, cheap, and cryptographically secured payments, other financial logic can be implemented on the Lightning Network.  There’s the possibility to build Lightning-based networks for decentralized virtual private networks (VPNs), messaging platforms, or even streaming videos or podcasts. Projects building applications in this regard are Imprevious (secure p2p data transmissions) or Breez Technology (podcasting 2.0).

In contrast with the Lightning Network protocol, a sidechain is its own blockchain; as such, technically speaking, sidechains are not second-layer solutions but new blockchains that run alongside Bitcoin. In the grand scheme of things though, I look at sidechains as being part of the infrastructure layer of Bitcoin, which again is considered the second layer in Bitcoin’s multi-layered financial system.

When dealing with sidechains, there are two basic questions that need to be asked: First, who runs, maintains, keeps, and is incentivized for the security regarding the sidechain? And second, how is a sidechain linked to Bitcoin and how is it guaranteed that bitcoin transacted on the sidechain is really bitcoin? 

The answer to the first question is this: Sidechains are run by their own full nodes. They enforce the consensus rules that are specific to the sidechain. This is the same for all sidechains. The answer to the second question is more nuanced: The security of the sidechain’s blockchain, and with it also the warranty that the sidechain’s native asset adequately represents Bitcoin, is established differently depending on the sidechain. 

Creating Bitcoin-surrogates 

One of the first sidechains to be created was the Liquid Network, which launched in October 2018. This sidechain’s consensus mechanism is operated by what is called Strong Federations. A set of geographically dispersed functionaries make up this federation and act as the ultimate maintainer and securer of the Liquid sidechain. Their role is two-fold: Functionaries are block signers that make sure transactions on the Liquid Network are processed. In this setup, block signers take turns proposing a new block every minute in a round-robin fashion and other functionaries sign that block after validating its content. Also, functionaries act as watchmen that validate all the transactions according to Liquid’s consensus rules. By doing this, they secure the network.

The native asset of the Liquid sidechain is L-BTC which is created through what is called a 2-way pegging mechanism. When creating L-BTC, on-chain BTC is locked on Bitcoin’s base layer blockchain through a multi-signature setup established by Liquid’s functionaries. This essentially creates L-BTC, which can be considered a Bitcoin surrogate, economically speaking. Important to note: all Liquid Bitcoin (L-BTC) are verifiably backed one to one by on-chain BTC.

A similar approach is pursued by another sidechain called RSK. With its launch in January of 2018, this project started a little earlier than the Liquid Network. This sidechain is merged-mined, meaning that RSK borrows the security from the Bitcoin base layer. Bitcoin miners merge-mine RSK blocks, thereby providing security to the sidechain as well.

RSK’s native asset is rBTC. It is fully backed by on-chain BTC and established by a 2-way peg called pow-peg. BTC from the Bitcoin blockchain can be moved to the RSK sidechain and vice-versa. Once BTC is “transferred” from the base layer, they become temporarily locked on the Bitcoin blockchain, while the same amount of rBTC is unlocked on RSK. Since RSK’s native asset rBTC aims to fully imitate on-chain BTC on a sidechain, rBTC can also be considered a Bitcoin surrogate.

As a Bitcoin surrogate, rBTC is used to pay for the execution of transactions within the RSK ecosystem. For example, rBTC is used to pay the transaction fee when RSK-based tokens are traded. This way, rBTC is supposed to be a version of Bitcoin that allows for the full smart contract functionality enabling open finance.

DeFi secured by Bitcoin 

Yet another approach is pursued by a sidechain named Stacks. In contrast to Liquid or RSK, Stacks operates its own layer-1 blockchain with its own native asset called STX. So, I would consider Stacks a sidechain blockchain - although they themselves reject being called a sidechain - that runs in parallel to the Bitcoin blockchain, while its coin STX is not pegged to on-chain BTC. Nevertheless, the Stacks chain uses the Bitcoin blockchain as an anchor for its transaction state. In other words: Stacks’ entire state periodically settles on Bitcoin. For any Stacks block to be created, a Bitcoin transaction must be initiated on the Bitcoin blockchain itself. This transaction incorporates the hash of the respective Stacks block thereby unambiguously anchoring it within a block on the Bitcoin blockchain.

Consequently, Stacks’ entire transaction and state history are unequivocally represented on the Bitcoin base layer. The latter is used by the Stacks chain as reliable storage and broadcast medium, meaning that everything that happens on Stacks (the relevant transaction history compiled in Stacks blocks) is recorded on Bitcoin itself.

As a consequence, different sorts of decentralized finance applications can be used through Stacks, secured by Bitcoin. There is a decentralized exchange (DEX) called Stackswap that has a launchpad and more. Various financial applications like lending and borrowing can be accessed through Arkadiko or AlexGo. Also, NFTs have seen traction on Stacks. Heylayer, Byzantion, or STX NFT are marketplaces for trading as well as minting NFTs. 

A protocol of many options

An innovative approach that is launching soon is called Mintlayer. This is another Bitcoin sidechain that relies on a new consensus mechanism by the name of dynamic slot allotment (DSA). It uses Bitcoin hashes for anchoring Mintlayer blocks to the Bitcoin base layer. Thereby, Mintlayer blocks reference Bitcoin blocks and use their hashes to determine the order of Mintlayer blocks. If Bitcoin were to be reorganized, then so would Mintlayer. Ultimately, the status of the Mintlayer chain is consolidated within the Bitcoin blockchain as snapshots through a sophisticated system that is built-in the Mintlayer protocol.

For long-term security, the Mintlayer chain makes use of a checkpointing system. Checkpoints are relied upon as an integral way to prevent long-range attacks on the Mintlayer blockchain. By having such periodic checkpoints that anchor Mintlayer transactions and blocks to the Bitcoin base layer, Mintlayer separates itself from Proof-of-Stake blockchains that may suffer such attacks.

Interestingly enough, Mintlayer is one of the first sidechains that is specifically designed to integrate with Bitcoins’ second-layer protocol Lightning. By doing this, so-called Lightning swaps are enabled. Because Mintlayer uses Bitcoin’s programming language script as well as the same UTXO structure, real non-surrogate BTC can be used through Mintlayer’s wallet. This way, decentralized exchanges (DEX) swaps for Bitcoin can be provided in a fast and scalable way. At the same Mintlayer supports different token standards for fungible as well as non-fungible tokens of any kind. For example, they allow for the creation of privacy-enabled Bitcoin surrogates within the Mintlayer network. Also, developers building on Mintlayer will be able to choose between Turing-complete as well as Turing-incomplete programming areas, depending on their needs.

Similar to Stacks, Mintlayer will have its own coin and it will be usable within Lightning to allow for trustless atomic swaps. Since Mintlayer supports integration with the Lightning Network, its functionality may finally be extended. After all, Mintlayer introduces the possibility to use Lightning for the popular case of trading, which may lead to further growth of Lightning Network. 

Free-market for innovation on Bitcoin

Bitcoin’s infrastructure layer is giving rise to a free-market competition for building a financial system on top of Bitcoin. This is beneficial to the users as more; qualitatively different options mean more freedom of choice. So, the bigger and more diverse the DeFi ecosystem on Bitcoin, the better.

As a user, one thing needs to be kept in mind:  Regarding consensus and security, all of the projects obviously necessitate accepting some trade-offs. Because the different protocols do things differently, these trade-offs will differ from project to project. This again is to the benefit of the users, who can opt for the options they feel most comfortable with. If one doesn’t buy the selling story of some coin or token that associates itself with Bitcoin and positions itself to be a DeFi project on Bitcoin, one does not have to hold any of them but can just keep on holding Bitcoin. After all, Bitcoin’s base layer is also not technically affected by any project purporting to be Bitcoin-related. 

A layer to enact financial primitives

All the presented approaches enable smart contract functionality for Bitcoin in one way or another. To make this functionality useful for as many users as possible, slowly but surely, financial operating systems operating on Bitcoin and representing the third layer in Bitcoin’s multi-layered financial order will emerge. It will be the components of the infrastructure layers – second layers and sidechains – that act as middlemen between Bitcoin’s base layer blockchain and the financial operating systems.

The most prominent Bitcoin-powered financial operating system (OS) to date is built by Sovryn. As an operating system, Sovryn’s goal can be compared to what Microsoft or Apple provide with Windows OS or Mac OS respectively. Both these companies make sure that computers are usable for end-users. Were it not for Windows or for Mac OS, operating a computer would be much harder. 

Sovryn wants to mimic exactly this and provide the entire world with transparent, permissionless, and incorruptible financial solutions that are connected to a transparent, permissionless, and incorruptible monetary base asset. 

As a full-stack financial operating system, Sovryn makes use of fully backed Bitcoin surrogates that are provided by the infrastructure layer. As their name suggests, Bitcoin surrogates are not real on-chain Bitcoin but either cryptographically or game-theoretically secured Bitcoin equivalents that are fully backed by on-chain Bitcoin. In the case of Sovryn, this is rBTC which is provided by the sidechain RSK, a smart contract blockchain, which is secured by Bitcoin miners. As a sidechain-agnostic operating system, Sovryn could integrate with other sidechains such as Mintlayer, as they have indicated

The usability of these fully backed Bitcoin surrogates is magnitudes greater than that of the Bitcoin base money. Because of their inherent smart contract functionality, they can be traded, lent, borrowed, or conditionally committed directly on Bitcoin’s infrastructure layer themselves. As such they give rise to new decentralized marketplaces that are built around financial primitives like liquidity, leverage, risk-taking, and arbitrage. The more pronounced these primitives are, the more efficient and functional Bitcoin’s evolving financial order becomes.

Bitcoin’s native application layer 

While a financial operating system like Sovryn can provide various decentralized applications (dApps) in one place, these financial applications can also exist as standalone applications. This is the beauty of Bitcoin’s open and permissionless setup. Everyone can provide useful software to interact with Bitcoin’s emerging financial order.

The myriad of these decentralized applications will make up the fourth layer within Bitcoin’s multi-layered financial order. Token swaps, leveraged trading, collateralized lending, uncollateralized lending, and more – it is all emerging as a feature on top of Bitcoin. Depending on what sort of infrastructure setup users prefer – be it RSK, Liquid, Mintlayer, or any other that has yet to emerge – they can choose freely.

A decisive part in all of this is played by wallets. Digital wallets that allow interaction with Bitcoin-powered services like MuunHiroLiquality or with Ethereum-based MetaMask are to blockchains what browsers are to the internet. They allow users to easily access the underlying technology.  As the fifth and highest layer, they come most naturally to users and complete Bitcoin’s multi-layered financial order. The higher up the stack we move, the more room for innovation and development there is. 

As we have seen throughout this exploration, DeFi on Bitcoin is alive and progressing well. While it is still underdeveloped in comparison to the rest of DeFi, chances are that DeFi based on Bitcoin will grow – after all, many more Bitcoiners might look for a place to use some of their Bitcoin to do Bitcoin-powered finances. 

To summarise, this is how Bitcoin’s multi-layered financial system structurally looks in its entirety:


C:\Users\huegl\Downloads\Bitcoin multi-layered system.png

DISCLAIMER:

At the BTC Times, we decided to responsibly cover news about altcoins from time to time, provided that we consider them relevant for Bitcoin or interesting for our readers. The goal of these articles will always be to inform, explain, clarify, debunk, and expose, sticking to the objective facts and qualified technical opinions, and never to promote, advertise, or legitimize "coins", "tokens", or other investment propositions.

Pascal Hügli is the chief researcher at Insight DeFi, an upcoming Swiss research boutique. They publish a bi-monthly newsletter in German here. At the same time, he is an accredited lecturer at HWZ and CCFE, and author of the book “Ignore at Your Own Risk: The New Decentralized World of Bitcoin and Blockchain.”

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