During the last crypto cycle, smart contract networks and applications built on top of them generated significant momentum, causing Bitcoin’s developer mindshare to gradually fade due to its lack of programmability. Most developers and crypto natives flocked to Ethereum and other smart contract protocols such as Solana, Avalanche or BNB Chain.

In the original whitepaper authored by Satoshi, Bitcoin is termed an “electronic peer-to-peer cash”, indicating for it to serve as a globally accessible, censorship resistant medium of payment, that is not susceptible to the risks of the global financial system or central bank driven monetary policy. However, challenges such as long settlement times and increasing transaction fees made Bitcoin an infeasible mode of payment. The Bitcoin narrative eventually evolved into it being a hedge against inflation, by virtue of its decelerating issuance curve, and a store of value. Bitcoin became digital gold.

In 2017 and 2021, two key upgrades to the Bitcoin network – Segregated Witness (SegWit) and Taproot, expanded the use cases Bitcoin could cover by 1) increasing blockspace beyond the original limit of 1MB, 2) adding a “witness data” section in which certain information could be appended and 3) updating Bitcoin’s scripting language such that information could be encoded into any of the smallest quantum of Bitcoin – a satoshi. This has made programmability on the Bitcoin blockchain possible with the help of certain protocols built on top of it. These protocols are the Ordinals protocol and other Bitcoin Layer 2s. They form what is now a budding Bitcoin smart contract ecosystem. Bitcoin Layer 2s have the potential of pushing the boundaries of capital efficiency for $1.3 trillion worth of dormant BTC. BTC can be used to generate yield instead of just being an idle asset in a digital wallet.

To understand how assets such as NFTs and fungible tokens within the Bitcoin ecosystem exist, we first need to understand the underlying protocol that started it all – Ordinals. Ordinals are a means of creating Bitcoin based fungible tokens or NFTs by etching or “inscribing” data such as images or text to an individual satoshi on the Bitcoin blockchain. Unlike Ethereum NFTs or ERC-20s, ordinals don’t exist in smart contracts. Rather, they use an arbitrary but logical ordering system called ordinal theory to give each individual satoshi a unique number. In this regard, ordinal tokens are completely Bitcoin-native. They work without changes to the Bitcoin protocol and are backward compatible with the network. Ordinals were made possible by SegWit and Taproot. It is important to understand that ordinals exist within satoshis, which is a fraction of a Bitcoin. This can be likened to a banknote embellished with artwork from an artist. If a Bitcoin user does not recognize or care about an ordinal or the data attached to it, it can simply be used like any other Bitcoin. In contrast, tokens on the Ethereum network are separate from a unit of Ethereum token. The fungible token ordinals standard is called BRC-20.

The total market capitalization of BRC-20 tokens has crossed $3.5 billion while the market capitalization of ordinals NFTs is over $1.5 billion. The top BRC-20s by market capitalization currently are $ORDI ($1.57 billion), $SATS ($1.16 billion), and $MUBI ($142 million). The top NFT collections are NodeMonkes and Bitcoin Puppets, which have a floor price of 0.38 BTC and 0.15 BTC respectively. The ordinals hype over the past year attracted a lot of developers and speculators to the Bitcoin ecosystem, but the protocol still has its limitations. The full extent of smart contract capabilities can only be realized with the advent of Bitcoin Layer 2s. Layer 2s address scalability and transaction cost concerns of the Bitcoin blockchain and allow developers to write complex smart contracts necessary for a rich, composable dapp ecosystem. Although the Bitcoin Layer 2s don’t yet draw security directly from the Bitcoin blockchain, some of them are on track to rollout upgrades which would allow them to, effectively transforming them into Layer 2s similar to the Ethereum network.

The most used Bitcoin Layer 2s currently are

Lightning Network: The Lightning Network is a payment protocol enhancing Bitcoin's scalability. It operates off-chain, utilizing payment channels for micropayments, facilitating near-instant transactions with lower fees compared to the main blockchain. Through direct channels between transacting parties, it bypasses the need for global consensus, offering high-volume transaction processing. There are currently 15,000 Lightning Network nodes.

Rootstock: Rootstock is a solution augmenting Bitcoin's efficiency by processing transactions off the main blockchain. Operating as an EVM compatible smart contract platform, it's linked to Bitcoin via a sidechain. Utilizing Proof of Work (PoW) consensus and merged mining with Bitcoin, Rootstock achieves ~30-second block confirmations and network throughput of 10-20 transactions per second. Rootstock leverages the RSK Infrastructure Framework (RIF) for decentralized infrastructure services, fostering development of decentralized applications (dapps). Rootstock’s total value locked (TVL) is $180 million.

Stacks: Stacks introduces smart contracts and dapps to Bitcoin via an open-source Layer-2 blockchain. It utilizes microblocks for faster transaction processing, reducing latency compared to Bitcoin's 10-minute block time. Stacks is integrated with Bitcoin through Proof of Transfer (PoX), settling every transaction on Bitcoin's base layer, ensuring security without altering Bitcoin's network. This innovative approach allows Stacks blocks to be inherently tied to Bitcoin blocks. By combining smart contract functionality with Bitcoin's security, Stacks expands the utility of the Bitcoin blockchain, offering faster transactions and increased throughput while maintaining robust security measures. Stacks’ current TVL is $148 million.

Liquid Network: Liquid Network is a Layer-2 sidechain that aims to improve the Bitcoin network’s performance and functionality. Originally intended to be a scaling solution and an asset issuance platform, Liquid operates independently of Bitcoin, working on its own global ledger and consensus mechanism. Liquid is capable of confirming transactions in two minutes with a 60-second block time and two-block finality.

In addition to the above Layer 2s, there several other upcoming projects in the rapidly expanding Bitcoin ecosystem. Some other emerging innovations include Ark – an off-chain privacy focused payment layer, Babylon - Babylon is a Proof-of-Stake (PoS) network comprising two security-sharing protocols between Bitcoin and other PoS networks, Multibit – a dual sided bridge for cross-chain transfers between BRC-20 and ERC-20 tokens, Merlin – a zkEVM built using Polygon CDK operating as a Bitcoin Layer 2, and many more. With the uptick in projects building in the Bitcoin ecosystem, the level of fundraising activity has substantially increased as well.

Bitcoin's growing ecosystem

Source: Spartan Bitcoin Layers report. Full report: https://bitcoinlayersreport.com/

Bitcoin ecosystem market opportunity

Source: Spartan Bitcoin Layers report. Full report: https://bitcoinlayersreport.com/

Bitcoin ecosystem projects not only provide an avenue for dormant holders to make their BTC more productive, but also address a major issue in Bitcoin’s security budget. The Bitcoin halving reduces miner incentives by half every four years. Bitcoin price needs to at least double in the same period to sustain miner rewards. This is because until now, the transaction fee share of miner rewards was a negligible proportion of the total rewards, and the block subsidy of 6.25 BTC per block, contributed the major share. As Bitcoin based dapps, Ordinals, and Layer 2s gain increasing traction, the overall transaction fees would increase, addressing the declining security budget to incentivize miners to sustain or even increase their hashrate to mine BTC. As of February, transaction fees contributed 5% to total miner incentives worth $71.5 million. An order of magnitude increase in on-chain Bitcoin activity would make transaction fees a major share of miner rewards. It is in miners’ interest to support the Bitcoin smart contract ecosystem in any way they can, and multiple miners have already made investments into the ecosystem.

The next Bitcoin halving is in mid of April and is expected to be a major catalyst for BTC as an asset and for activity in the Bitcoin ecosystem. Bitcoin ETF approvals in January fostered new demand that has led to inflows worth over $9 billion. There is significant institutional interest in the asset class, particularly in Bitcoin. The potential of Bitcoin's smart contract ecosystem will likely draw increased interest and capital.