Building on Bitcoin, part two: Sidechains, Wrapped Bitcoin

In the previous article, we’ve covered the layered approach to scaling Bitcoin: a conservative base layer, the dynamically growing Lightning Network on top of it, and a third application layer tapping into the Lightning graph. To complete our analysis of various approaches to scaling Bitcoin, we’ll cover sidechains and wrapped bitcoin in today’s post.
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The Sidechain approach

Sidechains are separate blockchains attached to Bitcoin’s main chain through various mechanisms. Sidechains have a protocol of their own and run on different nodes than the parent chain, but they do not issue a native token. Instead, sidechains work with a “pegged” asset, essentially a stablecoin to the parent chain’s native asset. Such stablecoin holds its value because of its redeemability for the parent chain asset.

There are currently two Bitcoin sidechains: Liquid, under development by Blockstream, and RSK, under development by RSK Labs.

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Bitcoin sidechains. Source: author.

Liquid

“Liquid is primarily a tool for traders and exchanges looking to transfer large amounts of bitcoin (or other tokens) quickly and privately.”

Blockstream

The Liquid Network was launched in October 2018, and its main goals are to “provide fast, secure, and confidential transactions to address the needs of exchanges, brokers, market makers, and financial institutions around the world.” As we can see, the target users of the sidechain are mostly institutions, not retail. Liquid is thus a scaling solution aimed at business needs rather than the needs of an average bitcoiner.

Liquid network uses a Liquid bitcoin (L-BTC) as its main asset and a unit of account. L-BTC can be obtained in two ways. First is through a peg-in process, where the user sends bitcoin to a Liquid federation multisig and waits for 102 confirmations, after which L-BTC is minted on the Liquid sidechain. The second way is to trade BTC for L-BTC on an exchange (e.g. Bitfinex or Sideshift).

peg-in.png
The peg-in process. Source: Blockstream.

The reverse of the peg-in is the peg-out: exchange of L-BTC back to BTC. This feature is only available to federation members – other users need to sell L-BTC for BTC on an exchange.

The sidechain consensus is based on a federation of 57 members, each running a Hardware Security Module (HSM) that fulfills the role of a Liquid node and maintains the 2-way peg. The federation members are geographically dispersed around the world – a list of current members is maintained on the Blockstream website. At least two-thirds of the federation members need to be honest for the Liquid network and the peg to remain reliable. In any case, the federation members are legal entities and could be held liable in case of any wrongdoing. Since Liquid is mainly aimed at institutions, this kind of setup with an element of trust may be reassuring.

Liquid is based on the Elements codebase – a modified Bitcoin script with several opcodes that are not available on Bitcoin’s main chain. The most interesting of those are confidential transactions, where the amount sent and asset type are visible only to the sender and the receiver. This can be useful to traders who move around large amounts in between exchanges, as well as other cases requiring an increased level of privacy.

Since its launch in late 2018, Liquid has attracted moderate usage. The current key metrics are as follows:

  • 3209 Liquid Bitcoin in circulation (source) ~ $155M
  • 51,000 total transactions (source)

Liquid provides users with the ability to issue assets in the form of tokens, for example, stablecoins or security tokens. There are currently 36 million tethers (dollar stablecoins) issued on Liquid, and Blockstream itself issued a security token representing a mining hashrate in Blockstream’s mining facility. Moreover, several NFT projects are experimenting with Liquid integration: Light Nite for gaming NFTs, NFTglee for its auction platform, Raretoshi for its NFT marketplace.

Pros:

+confidential transactions, other advanced opcodes not yet available on Bitcoin
+faster block time (1-minute average), low fees
+keys can be held offline (in contrast to Lightning Network)
+wide exchange adoption

Cons:

-federated peg: partially trust-based
-cumbersome peg-in/peg-out process; BTC / L-BTC trading includes spreads and fees

Useful for:

1) asset issuance (NFTs, security tokens, stablecoins)
2) fast and private transactions of any size among exchanges, market makers, and similar institutions

Resources:

Liquid website
Documentation
Github
Block explorer
Network statistics
Sideswap – L-BTC exchange
Sideshift – L-BTC exchange
Aqua – Liquid assets wallet
Green – Hybrid Bitcoin/Liquid wallet

RSK

RSK (previously called Rootstock) is a merge-mined Bitcoin sidechain that brings Ethereum-style smart contracts to Bitcoin users. The development on RSK started in 2015 and the mainnet was finally launched in January 2018. Similar to Liquid, the RSK sidechain is mostly developed by one company: Argentina-based RSK Labs.

The blockchain consensus on RSK is achieved via merged mining with Bitcoin. Since merged mining is easy for miners to set up and provides them with extra revenue, around half of all miners mine RSK at any time, making it very secure and practically immune to attacks. The pegged bitcoin on RSK is called Smart Bitcoin (R-BTC), and its peg is maintained via the Powpeg protocol. Powpeg is a new pegging technology introduced in December 2020, where the members of the RSK federation operate their Hardware Security Modules (HSM) with encrypted private keys; these HSMs sign the peg-related transactions, after which the network has to wait for a sufficient number of confirmations for the transaction to be valid. The peg-in transaction (BTC to R-BTC) requires 100 Bitcoin confirmations, the peg-out transactions (R-BTC to BTC) require 4000 RSK confirmations (RSK blocks have 30s block time, so 4000 RSK blocks correspond to 200 Bitcoin blocks).

Users can either peg-in their bitcoin for R-BTC or trade for it on various exchanges, in a similar fashion to Liquid Bitcoin.

Since RSK is a clone of Ethereum, everything that is done on Ethereum is also theoretically possible on this sidechain – issuance of ERC-20 tokens as well as other token types, Turing-complete smart contracts, and so on. But the fact is that RSK has a low network effect when compared to Ethereum, and there are not many reasons why developers should prefer RSK over Ethereum. The main activity on RSK is now centered around Decentralized Finance projects, namely Sovryn and Money on Chain projects.

Money on Chain doesn’t have much traction with only 536 R-BTC deposited by users, even though the project has been live since December 2019.

Sovryn, launched in December 2020, attracts much more attention and is the only RSK project that gained some user traction. Sovryn is a typical DeFi project, with features such as automated market making (AMM) with users able to provide liquidity and earn yield, lend and borrow, as well as stake SOV, the Sovryn governance token. At the time of writing, there is $69 million worth of assets locked in the Sovryn liquidity contracts and a further $500 million in the governance staking contract.

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Sovryn AMM liquidity pools growth. Source: Sovryn Metrics.

There are currently 1969 R-BTC outstanding, putting the total capitalization of the RSK sidechain’s main asset at ~$90 million. That is not much for a chain that has been live for almost three years.

Pros:

+EVM compatibility
+merge-mined with Bitcoin with large miner participation

Cons:

-slow-paced adoption
-small network effect when compared with Ethereum

Useful for:

1) theoretically everything that works on Ethereum, but practically no reason to do so

Resources:

RSK website
Documentation
Github
Block Explorer
Network Statistics
Testnet Faucet
Liquality – wallet supporting RSK assets
Nifty – wallet supporting RSK assets
Sovryn Metrics

The Wrapped bitcoin approach

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Wrapped bitcoin. Source: author.

While RSK attempts to bring Ethereum to Bitcoin, the Wrapped Bitcoin project does the opposite and brings a tokenized version of bitcoin to Ethereum. There are multiple attempts at tokenizing bitcoin and issuing the bitcoin stablecoin on other chains, but the Wrapped Bitcoin (WBTC) launched on Ethereum in January 2019 is by far the largest one.

Wrapped Bitcoin is a centralized custodial solution, where all the issued WBTC tokens are backed by bitcoin held by BitGo – a regulated custodial services company. While BitGo is probably the best choice as a custodian, it still is the single point of failure, and any user or developer working with WBTC should realize that they are essentially working with a credit instrument of one company.

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WBTC minting process. Source: WBTC website.

At the time of writing, there are over 200,000 WBTC outstanding, making it the most capitalized of the Bitcoin scaling solutions that we’ve covered. WBTC is the ERC-20 token, making it fully compatible with Ethereum smart contracts. As such, it is naturally mostly used within the Ethereum DeFi ecosystem:

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Top ten DeFi services that integrated WBTC. Source: DeFi Pulse.

WBTC makes it possible for bitcoin holders to earn yield, take bitcoin-backed loans, or enter leveraged positions – all with the double caveat of holding a credit instrument on a platform with consensus mechanisms very different from that of Bitcoin. Wrapped Bitcoin is essentially a bitcoin derivative not much different from those found on exchanges, although there are two advantages: users can verify the proof of reserves, and the token is usable across a wide variety of services, not just those provided by a particular exchange.

Developers can work with WBTC in the same manner as they would with any other ERC-20 token, making its integration easy and supported by a wide range of wallets.

Other notable projects aiming to bring Bitcoin to Ethereum and other chains are RenBTC with over 15,000 bitcoin tokenized, and sBTC with more than 4,000. 

Pros:

+strong support and network effect among various Ethereum apps
+simple integration due to ERC-20 token standard
+transparent bitcoin price derivative

Cons:

-fully centralized solution with a single point of failure (BitGo)
-holders forego Bitcoin settlement assurances and rely on those of Ethereum

Useful for:

1) DeFi integrations of all kinds
2) DEX trading pairs

Resources:

WBTC website
Proof of Reserves

Summary: Bitcoin scaling options

In this two-part series, we have covered all the major Bitcoin scaling options of today: Bitcoin’s native layers secured by its limited smart contract capability, two sidechains developed by private companies and maintained by federations, and a tokenized bitcoin on Ethereum.

It’s important to keep in mind that whenever bitcoin leaves the base layer, there is some risk involved. On Lightning, users may experience forced channel closure or lose their bitcoin in case of wallet crash and insufficient backups; sidechains may be subject to exploits yet to be discovered as their capacity grows; Wrapped Bitcoin relies on the single point of failure of one company.

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