Stacks Bitcoin Layer 2 Explained

Introduction

Bitcoin, the king of digital assets, is ready to unlock its earning potential. Bitcoin was and continues to be the unrivalled titan in the realm of digital assets. With the highest market capitalisation, the first mover advantage and unparalleled decentralisation, Bitcoin has not only been a major player in the cryptocurrency market but it is a currency marked with historical significance.

Bitcoin continues to have a cemented first place in the industry. And this is true for multiple reasons:

• Absolute Market Dominance: The preeminent blockchain with a towering market cap of $1,232.41 billion, showcasing its financial prowess.

• Decentralisation and Security: Boasts unparalleled decentralisation with over 15,000 nodes, consumes 165 TWh annually, renowned for its fortified security against hacks.

• Network Effects and Brand Strength: Commands a vast user base with over 200 million wallets, benefiting from significant network effects and a strong, recognizable brand in the crypto space.

• Regulatory Clarity and Institutional Acceptance: Achieves the highest regulatory clarity in the U.S., esteemed as a commodity by the CFTC, and enjoys widespread institutional acceptance with major investments.

• Establishment and Future Potential: As the pioneering blockchain, its sustained operation and reliability are projected by the Lindy effect, laying a robust foundation for DeFi innovations.

In spite of these significant advantages, daily innovation and momentum on the public front for Bitcoin are overshadowed by networks of much smaller size. Like gold, Bitcoin has become a valuable asset in itself, but it is losing the lustre associated with novelty.

Most newer chains, with their "Proof of Stake" consensus mechanism, offer the ability to "stake" coins and earn passive income yield. This feature attracts widespread attention and fosters innovation. Bitcoin, with its tried-and-tested "Proof of Work" consensus, misses out on this opportunity. Despite being a vast, untapped mine of opportunities, questions arise about how Bitcoin can create rewards. How will this system work, and what are its risks?

Bitcoin’s Staking Dilemma

Outside of Proof of Work, the Proof of Stake consensus mechanism reigns supreme. Staking forms the backbone of this mechanism; participants lock up cryptocurrency to secure the network, while earning rewards for the same.

Validators (or stakers) are chosen to create new blocks and validate transactions based on the amount of cryptocurrency they have staked as collateral. The more you stake, the higher your chances of being chosen as a validator. This process secures the network and helps to achieve consensus without the need for intensive computational work.

Staking thus provides a way for holders to earn passive income by delegating the tokens they hold to validators. These rewards are usually proportional to the amount staked and the duration of the stake.

Bitcoin does not support staking because it operates on a Proof of Work (PoW) mechanism, where miners expend computational effort to solve complex mathematical problems for validating transactions and creating new blocks. The architectural foundations of Bitcoin are distinctively different, to the extent that smart contracts, which are crucial for the staking process, are not supported on its platform.

• Bitcoin's Scripting Language Limitations: Uses the Unspent Transaction Output (UTXO) model, complicating smart contract implementation by design, unlike systems with an account model conducive to smart contracts.

• Bitcoin Script Constraints: The platform's programming language has notable restrictions and lacks the capabilities needed to effectively support on-chain smart contracts. This inherent limitation emphasises Bitcoin's prioritisation of simplicity and security over flexibility and extended functionalities.

• Impact of Lacking Smart Contracts: Constrains the development capabilities on Bitcoin, limiting the platform's ability to host self-executing contracts which are essential for decentralised applications (DApps). This results in Bitcoin being perceived as slower, more expensive, and generally a more cumbersome development experience.

While we have highlighted enough of Bitcoin’s structural limitations, we must recognize that its simplicity and stability continue to gravitate everyone towards it, with innovators being no exception. Therefore many have tried their hand at some workarounds. One of the popular methods has been building Bitcoin Layers and “wrapping” Bitcoin.

What's a Bitcoin Layer?

A layer is basically a concept which bring extra usability to BTC, and is defined by these characteristics -

1. Bitcoin Dependence: They rely on Bitcoin to operate and cannot function independently.

2. Bitcoin Settlement: Information in Bitcoin Layers is recorded back to the Bitcoin blockchain, leveraging its robust Proof of Work security protocol.

3. Extended Functionality: They offer additional capabilities like scaling and smart contracts, without changing Bitcoin's core protocol.

For brevity, we will discuss the chain example, since that is a very relevant method used to bring BTC to DeFi, by building a bridge.

Moving bitcoin to another blockchain is not an easy task — it requires a bridge. When BTC is moved to another chain via a bridge, it’s turned into a tokenized, synthetic, or wrapped asset. It’s a representation of the “real” bitcoin asset on the Bitcoin main chain. A major example would be wBTC.

Wrapped Bitcoin (wBTC) is a novel solution that tries to bridge the gap between Bitcoin and DeFi protocols by essentially locking up Bitcoin, and issuing an equivalent amount of wBTC. Being an Ethereum based “​​ERC-20 token” wBTC could be used in the greater Ethereum ecosystem, and open more avenues.

Though wBTC looks like a plausible solution, it has a major caveat. From an objective standpoint, wBTC is no longer BTC; it is an Ethereum token. It does not retain the properties of the Bitcoin ecosystem. Its primary function is to enable BTC holders to engage with Proof of Stake (PoS) platforms. This reliance on a different blockchain entirely removes Bitcoin’s inherent security and trust mechanisms.

Stacks and Stacking

As is apparent from its popularity, staking offers a great financial incentive to its users. While Bitcoin is structurally not designed for staking, ETH layered solutions like wBTC aren’t the best way to go about things.

However, we need not abandon this lucrative market just yet. Since there is another layered solution which offers a very similar prospect, and a similar name - Stacking.

Without departing from the Bitcoin ecosystem, this initiative unveils a brand-new chapter for the time-honoured Bitcoin economy. Enter Stacks—an intriguing project set to redefine the landscape.

Stacks does not inherently change the Bitcoin architecture; it simply builds on top of it, embracing Bitcoin's idiosyncrasies. By preserving the solid, secure foundation of Bitcoin and adding modern features, Stacks aims to show that Bitcoin can be the foundation of a better internet. The project is dedicated to enabling smart contracts, NFTs, and bringing Bitcoin into the world of Decentralised Finance, thus expanding the functionality and utility of the Bitcoin ecosystem.

Consensus at the Core

To explain how Stacks works, right off the bat - let’s get into the details of the consensus. Consensus mechanisms remain at the core of the ecosystem, and their design defines the features and functioning of a blockchain throughout its lifetime. The unique approach of Stacks is defined by its Proof of Transfer (PoX) mechanism which binds the whole thing together.

Let's draw an analogy with two cities. Picture one as an older, well-established city, revered for its unique culture and charm. However, due to its age, there's a cap on expansion or new construction. City planners address this by developing another city nearby, which, while independent, also benefits from the older city's economy. Residents migrate to this new city, confident in its enduring significance, given its support from and proximity to the more established city.

Similarly, Stacks and Bitcoin share a symbiotic relationship. Stacks operates with its STX token, and Bitcoin with its BTC, distinct chains yet interconnected by the Proof of Transfer (PoX) consensus. This unique consensus mechanism fosters a novel localised economy that engages with both STX and BTC. Stacks facilitates the modern foray into Decentralised Finance (DeFi), while Bitcoin ensures the preservation of a traditional, secure store of value.

The bridge connecting these cities is the Proof of Transfer(PoX) consensus mechanism.

Proof of Transfer (PoX)

Traditional consensus methods include proof of work (PoW), where computational power is the key, with participants solving complex mathematical problems to validate transactions and create new blocks. The other method, proof of stake (PoS), relies on financial stakes to safeguard the network, where the probability of validating transactions and minting new blocks is proportional to the amount of cryptocurrency a participant holds and is willing to "stake" as a form of security deposit.

The Stacks blockchain introduces a unique consensus mechanism known as Proof of Transfer (PoX). PoX draws inspiration from Bitcoin's Proof of Work (PoW) system, where, analogous to Bitcoin miners who expend electricity and receive BTC as a reward, Stacks PoX miners use previously mined BTC to bid for the chance to write new blocks and, in turn, earn rewards in STX tokens.

PoX operates on a Nakamoto-style consensus, where miners' chances of being elected as leaders to write the next block are proportional to their BTC bids. This leader election is conducted on the Bitcoin blockchain, with the winning blocks recorded on the Stacks layer. Importantly, this system capitalises on the work already done by Bitcoin miners, requiring no significant additional energy beyond the operation of standard computing devices for participating in the Stacks network.

Moreover, PoX maintains a permissionless nature, allowing anyone to become a Stacks miner provided they're willing to invest BTC. Additionally, STX holders can engage in "stacking," where they lock up their STX to support the network's consensus and, in return, earn Bitcoin rewards. This process not only incentivizes positive contributions to the network but also incorporates economic disincentives to prevent misbehaviour, without the harsh penalties found in some Proof of Stake systems.

Another interesting feature of the Proof of Transfer (PoX) mechanism is its on-chain Bitcoin price oracle, which constantly updates the price ratio between BTC and STX. This functionality is vital for providing accurate, decentralised price information directly on the blockchain, thereby eliminating the need for external price data sources.

This elaborate system enables Stacks to forge an entirely new ecosystem, simply by harnessing the existence of Bitcoin. Looking deeper into this ingenious idea, we can see that Stacks ecosystem is not just interlinked, but in fact anchored to the Bitcoin blockchain. Being based on Bitcoin, Stacks also mints blocks with the same blocktime of 10 minutes. However, there is no hindrance in scalability or speed because of an interesting workaround -

Scalability Through Microblocks

• Mechanism: Stacks employs a unique scalability solution known as microblocks to enhance transaction throughput. This is designed to work in conjunction with anchor blocks, which are the primary method of confirming transactions on the Stacks blockchain.

• Anchor Blocks: These are the main blocks on the Stacks blockchain that are confirmed simultaneously with Bitcoin blocks, adhering to Bitcoin's average block time of 10 minutes. The anchor block system ensures that Stacks remains anchored to the security and consistency of the Bitcoin network.

• Microblocks: In between the anchor blocks, Stacks generates microblocks. These are smaller blocks that allow for rapid settlement of transactions on the Stacks network. Transactions included in microblocks are confirmed once the next anchor block is approved.

• Benefits: This dual system of anchor blocks and microblocks allows Stacks to significantly increase its transaction throughput beyond the limitations of the Bitcoin blockchain. It ensures scalability by facilitating quicker transaction confirmations, improving the overall efficiency and user experience on the Stacks blockchain.

STX in the Details

The anchoring with BTC does not just end there. Many of Bitcoin’s qualities are mirrored in the STX coin as well. Here’s a quick rundown on the STX token.

• Usage: The native token of the Stacks blockchain, STX, is used for a variety of purposes. Primarily, it is used to pay for transaction fees on the network. Additionally, STX can be stacked by users to participate in the network's consensus mechanism, earning Bitcoin rewards in return.

• Capped Supply: The total supply of STX tokens is capped at 1.82 billion. This finite supply is similar to Bitcoin's capped supply model, which aims to prevent inflation and contribute to the token's value over time.

• Halving Schedule: The issuance of STX follows a halving schedule reminiscent of Bitcoin's. This means that the rewards for mining STX are halved at predetermined intervals. Initially, miners received 1000 STX per block mined, which has since halved to 500 STX, and will continue to halve to 250 STX, and then to 125 STX. Once the reward reaches 125 STX per block, it will remain at this level indefinitely.

• Long-Term Supply Dynamics: The halving schedule ensures that the total supply of STX will reach its cap by the year 2050. This gradual release of new tokens into circulation is designed to balance new supply with the increasing demand, potentially stabilising the token's value over time.

sBTC

Let's take a moment to navigate through the acronyms we've encountered today: STX, BTC, PoX, and now sBTC. You might wonder, wasn't STX the currency for Stacks? And how does sBTC fit into the picture? Is it similar to wBTC? Don't worry, all your questions will be addressed. Indeed, sBTC serves a similar purpose to wBTC but within the Bitcoin-Stacks ecosystem, offering a decentralised and trustless approach.

Recall our examination of wBTC, an ERC-20 token on Ethereum pegged to Bitcoin, facilitating Bitcoin's integration into the DeFi ecosystem. sBTC offers a parallel solution within the Stacks framework, aiming to democratise and decentralise the process. This approach brings DeFi capabilities directly to Bitcoin, rather than integrating Bitcoin into an existing DeFi framework.

Just like wBTC is an ERC-20 Token, sBTC is a SIP-010 Token. Ethereum has Ethereum Request for Comments (ERC) for proposing improvements and standards, Stacks has Stacks Improvement Proposals (SIP) for a similar purpose.

sBTC is created via a novel decentralised peg mechanism that enables 1:1 pegging to BTC without depending on centralised authorities. Its goal is to overcome the significant challenge of establishing a decentralised two-way peg with Bitcoin, allowing for trustless transactions on the Bitcoin blockchain. This groundbreaking development opens the door to BTC-based lending, BTC-backed stablecoins, and a variety of decentralised applications, boosting Bitcoin's utility while adhering to its core principles of decentralisation.

On the other hand, STX functions as the backbone of the Stacks ecosystem. As the native utility token, STX is crucial for executing smart contracts, processing transactions, and maintaining network security. It facilitates the extension of Bitcoin's capabilities through smart contracts and decentralised applications (DApps). Importantly, unlike sBTC, STX is not pegged to Bitcoin and possesses its unique value.

Benefits for the Holders

Our in-depth look at Stacks should have provided you with a clear understanding of the technology and its emerging potential. Now, let's explore what's in it for you—the user. Whether you're an investor seeking security, services, or hodling for profits, the Stacks ecosystem offers benefits similar to those found in other DeFi economies.

Stacks simplifies the process of earning Bitcoin rewards. The steps are straightforward:

1. Purchase some STX tokens.

2. Stack them.

3. Earn Bitcoin rewards monthly.

Yes, it's that simple. Despite the complexity of the technology discussed earlier, the user experience remains straightforward, with all complexities hidden behind the scenes.

The Stacks ecosystem, having opened doors to DeFi, offers all the benefits offered by “traditional” PoS Liquid Stacking.

• Passive Income: Offers the ability to earn dual rewards through stacking rewards in Bitcoin and potential appreciation in the value of STX, leading to a compounding effect on investments.

• Increased Capital Efficiency: Liquid stacking reduces the opportunity cost associated with locking up STX, allowing holders to participate in various DeFi activities without immobilising their assets.

• Enhanced Access to DeFi: Enables STX holders to engage with previously inaccessible DeFi opportunities, such as lending and borrowing, within the Stacks ecosystem, leveraging Bitcoin's security and liquidity.

Risks and Considerations

As a novel technological concept, Stacks continues to undergo refinement. Users have identified areas needing improvement or causing concern, yet with each new Stacks Improvement Proposal (SIP), there's evident maturity and enhancement. Supported by a thriving community and visionary founders, Stacks is adeptly navigating its challenges. However, for investors, risk assessment remains crucial.

Smart Contract Risks: Smart contracts attract attention, including from malicious actors. Incidents like the 2017 Parity Hack underscore the need for robust security. The Stacks ecosystem is evolving to enhance security, but it's equally important for users to select stacking providers with strong security measures. Providers such as Luganodes commit to security through audits and insurance, setting a standard for the industry.

Regulatory Uncertainty: The DeFi regulatory landscape is in flux, potentially affecting the accessibility and operation of liquid staking protocols on Stacks. Notably, STX distinguishes itself as the first token offering to be qualified by the U.S. Securities and Exchange Commission (SEC), bolstering trust in the project.

Community and Developer Support: The vibrancy and engagement of the Stacks community, coupled with developer support, are vital for sustained growth and resilience. Potential users and developers should evaluate the ecosystem's energy and resource availability.

Interoperability with Other Chains: As DeFi grows, Stacks' ability to seamlessly connect with other blockchains emerges as a key success factor, addressing the blockchain trilemma's challenge of interoperability.

Market Adoption and Network Effects: The value of Stacks and its DeFi protocols is highly dependent on market adoption and network effects. Broad acceptance among users and developers fosters a stronger, more secure ecosystem.

Conclusion, and the Vision Ahead

We've embarked on an extensive journey, beginning with a renewed appreciation for Bitcoin's significance and exploring the innovative strides made in the DeFi Proof of Stake (PoS) arena through liquid staking and decentralised applications (dApps). This exploration led us to Stacks' ambitious efforts to replicate such successes using Bitcoin, the most established cryptocurrency, and highlighted the far-reaching developments and novel approaches that are attracting widespread attention.

With an increasing Total Value Locked (TVL) and a vibrant community, the future of Stacks holds much promise. The platform's current objective revolves around continual refinement and enhancement, along with rallying enthusiasts to its cause.

By fostering the development of valuable applications on Bitcoin, Stacks aims to amplify the network's value, thereby attracting more capital to its smart contracts and applications – perpetuating a virtuous cycle of growth and innovation. Achieving a self-sustaining flywheel economy remains the ultimate ambition.

If there's one takeaway from Stacks' vision, it's the abundance of opportunity that lies ahead.

Bitcoin is the seed that has spawned all of the innovation we are seeing today. And there is so much more it can offer, so much more opportunity - an untapped mine lies beneath us. The roots of this ecosystem are strong, and there is much reason to not veer too far from it.

About Luganodes

Luganodes is a world-class, Swiss-operated, non-custodial blockchain infrastructure provider that has rapidly gained recognition in the industry for offering institutional-grade services. It was born out of the Lugano Plan B Program, an initiative driven by Tether and the City of Lugano. Luganodes maintains an exceptional 99.9% uptime with round-the-clock monitoring by SRE experts. With support for 45+ PoS networks, it ranks among the top validators on Polygon, Polkadot, Sui, and Tron. Luganodes prioritizes security and compliance, holding the distinction of being one of the first staking providers to adhere to all SOC 2 Type II, GDPR, and ISO 27001 standards as well as offering Chainproof insurance to institutional clients.