How will Bitcoin halving drive Layer 2 development?

By Daniel Kuhn, CoinDesk; Translated by Tao Zhu, Golden Finance

On April 20, Bitcoin successfully completed its fourth halving, a planned, drastic reduction in the number of new Bitcoins (BTC) entering circulation through mining. While the event itself is somewhat exciting — people around the world were able to celebrate the moment virtually — many were focused on what was about to happen.

Runes is a new protocol that enables the creation of meme coins on top of Bitcoin, and its launch coincided with the halving. Hundreds of tokens have been launched, contributing more than $80 million in fees to Bitcoin miners. According to TokenTerminal, the increase in trading activity has also pushed up the costs associated with sending transactions with Bitcoin, which now average over $70, up 1,395.8% from the average price over the past 30 days.

While it’s hard to say whether this activity will level off, some believe that “Epoch V,” the period before the next halving in 2028, will be when Bitcoin Layer 2 technologies like the Lightning Network finally become popular.

“Anything that causes fees to spike is likely to drive people to look for other solutions,” Bitcoin Core developer Ava Chow told CoinDesk. “Lightning is one option. There are also sidechains like Fedimint, Ark, and a bunch of Layer 2s. High transaction fees will drive people to look into them.”

This was echoed by a recent report from Messari, which argued that with rising levels of on-chain activity, “Layer 2 solutions for Bitcoin are not just a luxury, but a necessity,” analyst Nikhil Chaturvedi wrote. Bitcoin is no longer just “digital gold,” but a platform to build on.

This shift in mindset was sparked last year by the launch of the Ordinals protocol, which enabled a new way to store data on BTC’s smallest unit, called a “satoshi.” Ordinal’s NFT-like “inscriptions” have seen sales of over $3 billion, with trading activity trending upward, with an average of nearly 2 million transactions.

But Ordinals aren’t the only thing driving up Bitcoin fees. BitVM is a way to move computation off-chain, enabling people to build Ethereum-like smart contracts on Bitcoin. Babylon is building a way to stake and earn a yield on BTC. Layer 2s like Stacks and Merlin are becoming home to many decentralized applications and meme coins.

Interestingly, tokens associated with Bitcoin L2 have outperformed BTC since the halving. For example, Elastos’ ELA token is up 11%, and SatoshiVM’s SAVM is up 5%. Stack’s STX token is up nearly 20%, to $2.87.

While market forces may drive action on Bitcoin Layer 2, that may not always be a good thing. On the one hand, those with lower Bitcoin balances who want to use the Lightning Network non-custodially and set up their own channels may be priced out of using platforms like the Lightning Network, Chow suggested.

“The problem is, all of this Layer 2 stuff requires on-chain transactions,” said Chow, referring to the “inbound capacity” needed to fund lightning accounts. Lightning users must also pay for on-chain closing transactions. “In a high-fee environment, that means it’s going to be a little bit harder to actually start using this stuff.”

There are workarounds, of course: custodial lightning companies are subsidizing these surprisingly expensive transactions.

“I’m concerned that higher transaction fees will drive users to custodial lightning services…leaving BTC users with no sovereignty or anonymity over their BTC holdings,” noted anonymous bitcoiner and lightning critic Sovereign Matt. “A custodial lightning service will become a new bank/middleman that people will have to trust because it’s too expensive to self-custody and transact using mainchain Bitcoin.”

In a way, all of this is a ripple effect of the so-called “block size war” over how to scale Bitcoin years ago, when it was decided not to increase the size of Bitcoin blocks, but to scale the blockchain through Layer 2. That set Bitcoin on its current path.

“There are basically two schools of thought about increasing the number of transactions per block. You can make blocks bigger or you can make transactions smaller,” Chow said, adding that increasing block size is like a “brute force” solution.

There are multiple ways to make Bitcoin transactions smaller, but until then, it looks like Layer 2 will grow.