How Bitcoin is Tackling Scalability: On-Chain vs. Layer 2 Solutions

Bitcoin was designed with decentralization, security, and immutability as its core values. However, in maintaining these values, Bitcoin also intentionally limits the number of transactions it can process per second (TPS). As Bitcoin aims to become a global digital payment system, scalability has become a pressing issue. The Bitcoin community has taken two major approaches to address this: on-chain scalability and off-chain (Layer 2) scalability.

1. On-Chain Scalability

On-chain scalability involves making protocol-level changes to the Bitcoin blockchain itself. Rather than drastically altering its consensus mechanism, Bitcoin has taken a more conservative approach, focusing on optimizing data efficiency.

1.1 Segregated Witness (SegWit)

Background: In 2017, the Bitcoin community was divided over whether to increase the block size limit to process more transactions. SegWit was proposed as a compromise that improved capacity without directly increasing block size.

How it Works:

Bitcoin blocks contain both transaction data and witness (signature) data.
SegWit separates the signature data into a distinct structure outside the main 1MB block.
This effectively increases block capacity by about 2–4x, as more transaction data can now fit into a block.

Benefits:

Improves scalability without sacrificing decentralization.
Fixes transaction malleability, enabling the development of Layer 2 solutions like the Lightning Network.
Backward-compatible as a soft fork.

Limitations:

Does not fundamentally remove block size limits.

1.2 Taproot

Background: Activated in November 2021, Taproot is one of Bitcoin’s most significant upgrades post-SegWit, focusing on privacy, efficiency, and flexible smart contract support.

How it Works:

Schnorr Signatures: Allows multiple signatures to appear as one, increasing efficiency and privacy for multi-signature transactions.
MAST (Merkelized Abstract Syntax Tree): Enables complex smart contracts where only the executed condition is revealed, preserving privacy.

Benefits:

Enhances privacy, especially for multi-signature and script-based transactions.
Reduces transaction data size, saving on fees.
Expands the flexibility of Bitcoin scripting.

Limitations:

Only modest impact on TPS; primarily improves privacy and efficiency.

2. Off-Chain Scalability (Layer 2 Solutions)

Layer 2 solutions process transactions off the main Bitcoin chain and record only final outcomes or critical data on-chain. This significantly reduces the burden on the main network.

2.1 Lightning Network

Overview: Bitcoin's flagship Layer 2 solution designed for fast, low-fee micropayments. It enables nearly instant off-chain transactions between users.

How it Works:

Channel Opening: Two users lock a certain amount of BTC in a multi-signature wallet via an on-chain transaction.
Off-Chain Transactions: All future exchanges between the users are recorded off-chain by updating their shared balance.
Channel Closing: When finished, the users close the channel and broadcast the final balance to the Bitcoin blockchain.
Routing: Users can send payments across a network of channels (e.g., A to C via B), not just through direct connections.

Benefits:

Instant payments: Transactions within a channel are almost instantaneous.
Low fees: Fees are significantly lower compared to on-chain.
Scalability: Theoretically supports millions of transactions per second.
Micropayment-friendly: Enables everyday usage of Bitcoin.

Drawbacks:

Complex for end users: Managing liquidity, channels, and routes can be technical.
Initial collateral required: Users must lock funds to open a channel.
Offline risks: One party being offline can hinder closing channels.
Centralization concerns: Liquidity may concentrate around large hubs.

Current Usage:

Integrated into Twitter's tipping feature.
Adopted for everyday payments in El Salvador.

Conclusion

Unlike Ethereum, which embraces complex smart contracts to expand scalability and utility, Bitcoin maintains its role as "digital gold" by focusing on security and simplicity. Through upgrades like SegWit and Taproot, and the development of the Lightning Network, Bitcoin is incrementally improving its efficiency without compromising its foundational values.

Layer 2 solutions like the Lightning Network hold great promise for turning Bitcoin into a viable payment method for daily use, while on-chain upgrades ensure long-term network stability and security.