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Layer 2 Is Not A Magic Incantation

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A common chant from many in this space these days in response to any discussion of changes to the Bitcoin protocol is “Don’t mess with Layer 1! You can just build it on Layer 2!” This seems like a very logical thing to do, right? Why risk the security and stability of L1 when you can just build on top of it? The problem is this fundamentally fails to understand the relationship between Layer 1 and Layer 2.

An L2 protocol is an extension of the L1. Everything that an L2 is designed to do must ultimately reduce down to what the L1 is capable of. The blanket statement of “just do it on L2!” obfuscates numerous implicit realities of what can or can’t be done on an L2 given the current state of the base layer. For instance, imagine trying to build the Lightning Network without the existence of multisignature scripts. You couldn’t. It wouldn’t be possible to share control between more than one person, and the whole concept of a payment channel wouldn’t be possible.

The Evolution of Payment Channels

The entire reason that payment channels can exist in the first place is because of the fact that L1 of Bitcoin supports the ability for multiple people to share control of a UTXO with a multisig script. What is possible on a L2 is inherently constrained by what is possible on L1; yes, of course it is possible to do things on L2 that aren’t possible on L1, but the ultimately limiting factor of what you can do off-chain is what is possible on-chain. Faster payment confirmation in a payment channel is only possible because on-chain custody can be shared between multiple people.

Even that isn’t enough for a safe payment channel though. The original payment channel had a pre-signed transaction using an nLocktime timelock that gives the funder their money back after so many blocks, and only supported payment channels in one direction. Transaction malleability made these original payment channels unsafe to use. If the funding transaction was malleated by someone before confirming, then the refund transaction would become invalidated and the funder would have no way to claim their money back. The other party in the channel could effectively hold their money hostage.

CHECKLOCKTIMEVERIFY, the absolute timelock opcode, was the solution. CLTV allows you to make a coin unspendable until a certain blockheight or time in the future. This, in combination with the ability to make scripts that can be spent in multiple ways, allowed the multisig UTXO to have a script path where the funder could spend all of the funds themselves after a timelock. This guaranteed the funder would be able to claim the money back in a worst case scenario even if the funding transaction was malleated. The channel could still only facilitate one-way payments though.

In order to facilitate two-way payments, a proper solution to transaction malleability was necessary. This was a huge motivator for Segregated Witness. A timelock is all that was necessary for a one way channel because the money only increased in one direction. The only risk to the sender was that the other party would never claim what they have already been sent on-chain, leaving the rest of the sender’s money trapped. The timelock refund both gave the receiver the incentive to claim funds on-chain before the timelock, when they would lose all the funds they had already been sent, and the sender a worst-case recourse in case something happened to permanently knock the receiver offline. Script does not support enforcing certain amounts to certain future scripts, so a pre-signed transaction is the only viable initial refund mechanism if payments are to flow in both directions. This reopened the risk of funds being held hostage.

With the upgrade to Segwit, this problem was solved. In place of the timelock refund incentivizing honest behavior, the penalty key was introduced. Because the funds in a two-way channel can flow back and forth in each direction there will inevitably be a case where both sides had more money in a prior state of the channel than the current one. By establishing a branch in each channel state’s pre-signed transaction using a penalty key, users can exchange these after signing the new state and know if the other party tries to use an old transaction they can claim 100% of the funds in the channel. Timelocks are used to guarantee the normal spending path where users take their respective balances isn’t valid for a time to give channel parties the chance to use the penalty key if necessary. There’s a problem with this though, using CLTV means that at some point in the future the channel has to close or else the timelock will expire and you no longer have that safety period to penalize the dishonest party.

Bi-directional payment channels also needed CHECKSEQUENCEVERIFY, or relative timelocks, in order to solve this issue. Unlike CLTV, which specifies a specific time or blockheight in the future, CSV specifies a relative length of time or number of blocks from the time or block that the UTXO using CSV in the script is confirmed in the blockchain. This allowed the safety period to function for penalty key use without requiring channels having to close on-chain at a pre-decided time.

Even this does not give us the Lightning Network though. There is still no way to actually route a payment across multiple payment channels. They can conduct payments in both directions, but only between the two people involved in the channel. In order to route payments across multiple channels you need, you guessed it, other functionality from the L1. Hash Time Locked Contracts are how this is accomplished, and they require both CLTV as well as hashlocks. Hashlocks require providing the preimage to a hash in order to spend the coins. It’s like a signature, except you actually just reveal the “private key” instead of signing with it. This allows the receiver in a Lightning payment to provide a hashlock, and every intermediate channel between sender and receiver create a script that allows spending immediately with the hash preimage, or refunding the money backwards after a timelock. If the receiver reveals the hashlock, everyone can claim the money for forwarding the payment, if not, then the money can be claimed backwards and reversed without finalizing it.

So the Lightning Network as it exists today depends entirely on five functionalities being possible on the base layer of Bitcoin. Multisignature scripts, absolute timelocks, relative timelocks, Segregated Witness, and hashlocks. Without any one of these features existing on L1, Lightning as we know it today would not be a possible L2 we could construct. Its existence as an L2 is entirely dependent on L1’s capability to do certain things. So if one were to, in a world with a Bitcoin that did not support hashlocks, timelocks in script, and no malleability fix, simply go “Just build a bidirectional multi-hop payment channel system on Layer 2! We shouldn’t be messing around with Layer 1” it would be a completely incoherent statement.

The Catch

That said, strictly technically speaking, it still would have been possible to build that bidirectional multi-hop payment channel system in that world without those three features on L1. At a massive cost in terms of introducing trust in other people to not steal your money when they are capable of doing so. A federated sidechain. Everyone could have just set up a federated chain like Liquid or Rootstock and added those features to the sidechain, building the Lightning Network there instead of on the mainchain. The problem with that is, it’s not the same thing. On a technical level the network would function exactly the same, but no one using it would actually have the same degree of control over their coins.

When they closed out a Lightning channel it would settle on a sidechain backed by a federation, i.e. it would just be an accounting entry on top of someone else’s multisig wallet where you have no ability to control those coins on L1. You just have to trust the distributed group operating the federation to not rug everyone. Even drivechains (which ironically itself requires new L1 functionality to be done) is just another form of federation at the end of the day, with some extra restrictions added to the withdrawal process. The federation is just miners instead of people holding private keys.

This is the implicit reality, whether they understand it or not, underlying the reaction “just build it on L2!” whenever someone is discussing improvements to L1. There is the scope of what is already possible to build on L2, which is rather limited and restricted by its own scaling limitations, and then there is the scope of what is not already possible. Everything falling into the latter category is impossible to build without interjecting some trusted entity or group of entities that ultimately is in control of users’ funds for them.

What’s the Point?

“Layer 2” is not a magic incantation. You can’t just wave a magic wand and chant the words, and anything and everything becomes magically possible. There are strict inescapable limitations of what an L2 can accomplish, and those limitations are what the L1 can accomplish. This is just an inherent fact of engineering reality when looking at a system like Bitcoin. You can’t escape it in any way except by degrading the trust assumptions more and more the more flexible of an L2 you build beyond the capabilities of L1.

So when discussions around these issues occur, such as what improvements can be made to L1, two things are of utmost importance. First, those improvements to L1 are almost entirely centered around enabling the construction of more flexible and scalable L2s. Secondly, L2s cannot magically enable everything. L2s have their own limitations based on those of the L1, and to have a discussion regarding changes to L1 without acknowledging the only way around those limitations is to introduce trusted entities is not an honest conversation.

It’s time to start acknowledging reality if we are going to discuss what to do with Bitcoin going forward, otherwise nothing is happening but denial of reality and gaslighting. And that is not productive. 

​ Layer 2s are inherently limited in what they can accomplish, and importantly under what trust model they can accomplish things, by what the Layer 1 they are built on is capable of. 

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Proton Wallet — Now Available To Everyone — Is A Great Starter Self-Custodial Bitcoin Wallet

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Follow Frank on X.

In July of last year, Swiss privacy tech company Proton (makers of Proton Mail) announced it would be launching its own bitcoin wallet — Proton Wallet.

I (along with about 100,000 other users) was given early access to the wallet to test it out and was impressed with the wallet’s user interface. I particularly liked that it allows you to link a user’s email address to their bitcoin address so that you only need to input the email address when sending bitcoin.

You can read my review of the wallet here.

Now that the wallet is available to the general public, I will recommend it to anyone I know who’s finally ready to move their bitcoin out of the hands of an exchange and into their own custody. I’ll also recommend it to anyone looking to make semi-regular bitcoin payments on-chain with a relatively small amount of bitcoin.

My reasons for recommending the wallet are as follows:

  • It’s free to use (users can create up to three wallets and have up to three accounts in each wallet, which is sufficient for most users — more on that here; to create more wallets or accounts, Proton charges a fee)
  • It’s easy to set up (you aren’t required to write down the 12-word seed phrase when you set up the wallet; however, it’s good practice to do so!)
  • Like Proton Mail, Proton has no access to Proton Wallet user data, nor does it have access to its users’ private bitcoin keys
  • Using an email address (which doesn’t have to be a Proton Mail address) to send bitcoin reduces the likelihood of inputting the wrong bitcoin address into the recipient field of a transaction
  • You can select the priority speed of a transaction when sending bitcoin
  • You can purchase bitcoin via Ramp or Banxa using Proton Wallet, enabling the bitcoin you purchase to be transferred directly into your custody

The only downsides to the wallet is that it doesn’t support Lightning transactions (consider the Breez SDK, Proton team!), and it doesn’t let you manage your UTXOs (loose change from bitcoin transactions, in layperson’s terms).

The latter isn’t super important, though, as, again, I’d recommend this wallet to those new to bitcoin self custody. UTXO management is more of a practice for moderate to advanced Bitcoin users.

All in all, Proton has created yet another fine product here for its 100 million users and counting, and it’s one that I’ll be recommending to Bitcoin newbies moving forward.

This article is a Take. Opinions expressed are entirely the author’s and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

 Proton Wallet is well-suited for anyone looking to begin their bitcoin self custody journey and/or anyone looking to make semi-frequent payments on-chain while managing a relatively small bitcoin stack. 

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El Salvador Is Still Bitcoin Country

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Follow Frank on X.

El Salvador is still Bitcoin country, despite the fact that bitcoin is no longer legal tender in the country — at least from where I’m sitting.

Let’s start with some background on the matter.

On January 29, 2025, the Legislative Assembly in El Salvador voted to remove bitcoin’s status as legal tender.

This means that businesses in the country no longer have to accept bitcoin (not that this rule was ever strictly enforced while bitcoin was classified as legal currency, as far as I know; however, I have been told that big businesses that operate in the country (e.g., McDonalds, Walmart) may stop accepting bitcoin as payment now, which could have a detrimental effect on adoption).

This change occurred approximately one month after the International Monetary Fund (IMF) struck a deal with authorities in El Salvador that stipulated the following:

  • El Salvador would receive a $1.4 billion loan to support the government’s “reform agenda”
  • Bitcoin-related risks be mitigated; bitcoin acceptance in the private sector must be voluntary, while the public sector’s participation in Bitcoin-related activities would be “confined” (bitcoin can no longer be used to settle government debts or pay taxes)
  • Operations for the government-created Bitcoin wallet, Chivo, would be “unwound”

While the news of the Salvadoran government’s reversing its policy on bitcoin as legal tender as a result of influence from the IMF feels like a gut punch even to me, someone who isn’t Salvadoran and doesn’t live in the country, I can’t help but believe that El Salvador is still Bitcoin country.

And this feeling has only grown stronger based on what I’ve seen Bitcoiners in El Salvador posting on X.

Evelyn Lemus, co-founder and Director of Education at Bitcoin Berlin, a Bitcoin circular economy within the country, doesn’t plan to stop teaching everyday Salvadorans about Bitcoin.

The team at Bit Driver don’t plan to change their business model — accepting bitcoin as taxi fare — any time soon.

While John Dennehy, founder of Mi Primer Bitcoin, expressed concern about the government of El Salvador’s rolling back its policy on bitcoin as legal currency, he and the ever-growing team at Mi Primer Bitcoin plan to double down on the work they’re doing.

The legendary Max and Stacy haven’t publicly voiced any plans to give up on El Salvador anytime soon.

And El Salvador’s Bitcoin Office, run by Stacy, is still stacking bitcoin and helping to run Bitcoin education programs in the country.

The lesson here is that while the law around Bitcoin may have changed in El Salvador, the Bitcoiners on the ground in the country have hardly flinched.

Because we are Bitcoin, what matters most is that everyday Salvadorans and everyone else involved in the Bitcoin movement in El Salvador continues to push forward with the Bitcoin mission.

The IMF may have landed a blow, but Bitcoiners in El Salvador remain steadfast in their efforts to foster broader Bitcoin adoption.

El Salvador is still Bitcoin country.

This article is a Take. Opinions expressed are entirely the author’s and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

 Bitcoin may no longer be legal tender in El Salvador, but Bitcoiners in the country haven’t given up on the mission. 

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Introducing the Bitcoin Everything Indicator

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Wouldn’t it be great if we had one all-encompassing metric to guide our Bitcoin investing decisions? That’s precisely what has been created, the Bitcoin Everything Indicator. Recently added to Bitcoin Magazine Pro, this indicator aims to consolidate multiple metrics into a single framework, making Bitcoin analysis and investment decision-making more streamlined.

For a more in-depth look into this topic, check out a recent YouTube video here: The Official Bitcoin EVERYTHING Indicator

Why We Need a Comprehensive Indicator

Investors and analysts typically rely on various metrics, such as on-chain data, technical analysis, and derivative charts. However, focusing too much on one aspect can lead to an incomplete understanding of Bitcoin’s price movements. The Bitcoin Everything Indicator attempts to solve this by integrating key components into one clear metric.

Figure 1: The new Bitcoin Everything Indicator.

View Live Chart 🔍

The Core Components of the Bitcoin Everything Indicator

Bitcoin’s price action is deeply influenced by global liquidity cycles, making macroeconomic conditions a fundamental pillar of this indicator. The correlation between Bitcoin and broader financial markets, especially in terms of Global M2 money supply, is clear. When liquidity expands, Bitcoin typically appreciates.

Figure 2: Global Liquidity cycles have had a major influence on BTC price action.

View Live Chart 🔍

Fundamental factors like Bitcoin’s halving cycles and miner strength play an essential role in its valuation. While halvings decrease new Bitcoin supply, their impact on price appreciation has diminished as over 94% of Bitcoin’s total supply is already in circulation. However, miner profitability remains crucial. The Puell Multiple, which measures miner revenue relative to historical averages, provides insights into market cycles. Historically, when miner profitability is strong, Bitcoin tends to be in a favorable position.

Figure 3: BTC miner profitability has been an accurate gauge of network health.

View Live Chart 🔍

On-chain indicators help assess Bitcoin’s supply and demand dynamics. The MVRV Z-Score, for example, compares Bitcoin’s market cap to its realized cap (average purchase price of all coins). This metric identifies accumulation and distribution zones, highlighting when Bitcoin is overvalued or undervalued.

Figure 4: The MVRV Z-Score has historically been one of the most accurate cycle metrics.

View Live Chart 🔍

Another critical on-chain metric is the Spent Output Profit Ratio (SOPR), which examines the profitability of coins being spent. When Bitcoin holders realize massive profits, it often signals a market peak, whereas high losses indicate a market bottom.

Figure 5: SOPR gives insight into real-time realized investor profits and losses.

View Live Chart 🔍

The Bitcoin Crosby Ratio is a technical metric that assesses Bitcoin’s overextended or discounted conditions purely based on price action. This ensures that market sentiment and momentum are also accounted for in the Bitcoin Everything Indicator.

Figure 6: The Crosby Ratio has technically identified peaks and bottoms for BTC.

View Live Chart 🔍

Network usage can offer vital clues about Bitcoin’s strength. The Active Address Sentiment Indicator measures the percentage change in active addresses over 28 days. A rise in active addresses generally confirms a bullish trend, while stagnation or decline may signal price weakness.

Figure 7: AASI monitors underlying network utilization.

View Live Chart 🔍

How the Bitcoin Everything Indicator Works

By blending these various metrics, the Bitcoin Everything Indicator ensures that no single factor is given undue weight. Unlike models that rely too heavily on specific signals, such as the MVRV Z-Score or the Pi Cycle Top, this indicator distributes influence equally across multiple categories. This prevents overfitting and allows the model to adapt to changing market conditions.

Figure 8: The most influential factors impacting the price of bitcoin.

Historical Performance vs. Buy-and-Hold Strategy

One of the most striking findings is that the Bitcoin Everything Indicator has outperformed a simple buy-and-hold strategy since Bitcoin was valued at under $6. Using a strategy of accumulating Bitcoin during oversold conditions and gradually selling in overbought zones, investors using this model would have significantly increased their portfolio’s performance with lower drawdowns.

Figure 9: Investing using this metric has outperformed buy & hold since 2011.

For instance, this model maintains a 20% drawdown compared to the 60-90% declines typically seen in Bitcoin’s history. This suggests that a well-balanced, data-driven approach can help investors make more informed decisions with reduced downside risk.

Conclusion

The Bitcoin Everything Indicator simplifies investing by merging the most critical aspects influencing Bitcoin’s price action into a single metric. It has historically outperformed buy-and-hold strategies while mitigating risk, making it a valuable tool for both retail and institutional investors.

For more detailed Bitcoin analysis and to access advanced features like live charts, personalized indicator alerts, and in-depth industry reports, check out Bitcoin Magazine Pro.

Disclaimer: This article is for informational purposes only and should not be considered financial advice. Always do your own research before making any investment decisions.

 A Single Metric to Rule Them All – The Bitcoin Everything Indicator combines multiple key metrics into one comprehensive tool for better investment decisions. 

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