Bitcoin Blocks Are Going Out Half Full as Layer 2s Take Off

Bitcoin’s mempools are seeing fewer transactions in the past few months, with a few days so low that blocks went out unfilled.

Beginning in January, the mempool’s average transactions per block dropped to its lowest level in 10 months. Throughout January and February the average number of transactions dropped to 2,700 and then below 2,500. Compare that to 3,500 to 4,500 from May through November.

But those are averages. On Feb. 1, the mempool emptied out completely, leaving a chain of blocks going out half empty or worse. And the transactions fees were minuscule, around one satoshi, or one one-hundred-millionth of a bitcoin.

Typically, there are tens if not hundreds of thousands of transactions waiting for a place on the oldest blockchain.

Bitcoin Drying Up

It’s not hard to figure out what’s happening. As the emerging Bitcoin Layer 2 ecosystem expands and gains users, more and more transactions are moving off the base layer, so that many transactions return to Bitcoin bundled into a single transaction.

It’s the same problem Ethereum is having with its larger and more robust Layer 2s, to say nothing of competing Layer 1s. And it’s having the same effect on transaction fees.

But that’s not all that’s happening to Bitcoin. A growing amount of it is wrapped and shipped off to the Ethereum ecosystem for use in decentralized finance (DeFi). And then there are the exchange-traded funds, gobbling up more and more Bitcoins and putting them into what is effectively cold storage.

“Everything in the ecosystem is basically predicated on taking bitcoin somewhere else,” said Matt Mudano, CEO of Arch Labs, which is building a Solana-style virtual machine that would bring smart contracts to the Bitcoin network.

“As a reserve asset people are taking it to Ethereum where it can participate in the likes of [DeFi lending protocol] Aave or [liquid staking platform] Ether.fi,” he said “It’s being taken to cold storage and qualified custodians so it can be invested in ETFs. We need to figure out ways where we can turn Bitcoin from this reserve asset that can be leveraged in other ecosystems, and make it be able to be utilized in other types of ways on Bitcoin.”

Where It’s Going

Layer 2s like Lightning Network, Rootstock, Merlin Chain and Stacks send large bundles of transactions to Bitcoin in a single transaction. Lightning Network has a total of $480 million in total value locked (TVL), Rootstock has a TVL of $216 million, Merlin Chain has $153 million, Stacks has $101 million.

Wrapped Bitcoins are going off to Ethereum or Ethereum Virtual Machine (EVM) capable blockchains to be used in decentralized finance (DeFi). Wrapped Bitcoin has a market capitalization of $12.5 billion

The fast-growing exchange-traded funds are essentially putting bitcoins in cold storage. They currently have $113.3 billion in assets under management

Miners Need Fees

When node operators mine bitcoins, they typically choose transactions with the highest fees first, leaving low-fee transactions for slack times.

The problem is that miners rely on those fees to help make their business profitable, even more so after April’s halving cut Bitcoin mining rewards to 3.125 bitcoins mined per block. While that still leaves more than $300,000 per block mined at current prices, low to nonexistent fees make the profitability of mining trickier. That is especially true for smaller miners in the capital-intensive mining business.

“The problem with that is for Bitcoin to be this very decentralized thing, if smaller and medium size miners drop off and we just rely on this group of large miners, that means Bitcoin is becoming more centralized,” Mudano said. Over time, that could become a security problem.

Off the Market

It’s notable that a lot of new activities in the Bitcoin ecosystem are actually taking Bitcoins effectively off the market.

Not that these are bad things. Wrapped bitcoin opens up DeFi to people who don’t want to sell their bitcoins, Layer 2s make it far faster and cheaper to transact on Bitcoin, bringing more DApps into the fold, and ETFs are encouraging people who might not want to deal with exchanges or custody solutions to invest in BTC.

And Bitcoin transaction numbers dropping to nothing is very rare at this point.

The solution for increased activity on the Bitcoin main chain might be to make it programmable. That is Mudano’s goal.

He’s not the only one with this goal. There’s BitVM, another way of making Ethereum-style smart contracts available on the Bitcoin network. It would work like Ethereum’s Optimistic Rollups, which allow off-chain computations to be verified on-chain. There’s also OP_CAT, a major upgrade that could go live sometime this year. It will enable layer 2 networks, covenants and ZK-rollups.

Mudano asked, “Why are we starting with scalability before fixing the programmability issue — which doesn’t exist on the base layer of Bitcoin.”