Bitcoin Layer 2s – The CoreDAO Model

Abstract: We make a brief comparison between some of Bitcoin’s supposed “layer 2” systems, such as Lightning, Ethereum (WBTC), Blackrock’s $IBIT and a sidechain called CoreDAO. We argue that a critical factor to consider is whether the system is non-custodial or not. CoreDAO has non-custodial Bitcoin staking, however, we conclude by claiming that it was only able to obtain this non-custodial status because one can consider it as “fake staking”. This non-custodial risk free staking, with no slashing, actually has some merits and from a financial perspective, it can be even more attractive than “real” staking. However, our “fake staking” claim is somewhat controversial.

Bitcoin Layer 2’s

Bitcoin commentator and podcaster Vlad Costea recently commented on X, about the state of Bitcoin’s layer 2 networks. Vlad mentioned that Ethereum is Bitcoin’s “biggest, most popular & most liquid layer 2”, since the WBTC balance of 154,707 BTC is larger than any of the other well known layer 2s.

We responded with a tongue and cheek reply, claiming that he was wrong and Blackrock’s Bitcoin ETF $IBIT is a larger layer 2. This was similar in tone to our 2019 post comparing Facebook’s Libra coin to other Blackrock ETF products. Since WBTC is custodial, from the perspective of evaluating layer 2s, why is it fundamentally any different to a $IBIT or Coinbase? Interestingly the WBTC custodian appears to be currently in the process of changing from Bitgo, to an entity controlled by the former Permanent Representative of Grenada to the World Trade Organization, Mr Justin Sun.

Summary table – Example Bitcoin Layer 2’s

Sources: Vlad Costea’s post, CoreDAO website, Blackrock website, bitcoinlayers.org and Coinbase Quarterly filings

Note: In this case, perhaps the best way to think about whether the Bitcoin is usable, is if you can exchange it for something else, while the underlying Bitcoin is still locked inside the respective system.

In our summary table above, one can see how Lightning is somewhat unique, in that it’s a non-custodial Bitcoin layer 2, where you can make and receive Bitcoin payments. In our view, whether or not there is a custodian is the key distinction to make when evaluating layers 2s. Directly comparing Lightning to Ethereum, Rootstock, Liquid and $IBIT may therefore be inappropriate. On the other hand, another key consideration one may have is whether there is a blockchain or not, Ethereum, Liquid and Rootstock have a blockchain and therefore some may consider it inappropriate to compare this to systems like $IBIT, which is not blockchain based. Our point is, that in our view, whether the system is custodial or not, is perhaps more important than whether or not there is a blockchain. Therefore, if you are going to compare Lightning to Ethereum (WBTC) as a Bitcoin layer 2, you might as well compare $IBIT to Ethereum.

There is another so-called layer 2 project in the above table, with over 5,000 BTC locked in it, CoreDAO. This is non-custodial like lightning, however, the key disadvantage is that you cannot actually use the non-custodial locked Bitcoin on the CoreDAO blockchain. Therefore, it is a bit odd to call it a Bitcoin layer 2, but some people do refer to it as such. Indeed, there is no precise definition of a layer 2 and just as with sidechains, almost anything can be considered a layer 2. There is justification for making the staked CoreDAO Bitcoin unusable, there is no known robust solution for having non-custodial Bitcoin being usable on a blockchain based sidechain.

CoreDAO

CoreDAO is an Ethereum virtual machine (EVM) compatible Bitcoin sidechain. The chain has its own native token, $CORE, which at the time of writing, according to Coin Market Cap, has a market capitalisation of just under US$1 billion. Of interest to us is the claim of non-custodial Bitcoin staking, which yields around 3.4%. The staking pays the yield in the form of newly issued $CORE tokens. Of course the price of the $CORE tokens are volatile and the current yields are not guaranteed to last, however these returns at least seem possible in the short or medium run.

CoreDAO has some potentially impressive DAPPs, such as CMS Holdings backed DEX Glyph and DeFi lending platform Colend. It is possible that these DAPPs gain traction, in part due to CoreDAO’s association with Bitcoin and that the $CORE token is able to retain some kind of value in the medium term. If the token crashes, one can always stop staking the Bitcoin anyway.

CoreDAO Consensus Algorithm

The CoreDAO blockchain has three interrelated components to its consensus system:

1. Merge mining with Bitcoin – In the form of an OP_Return commitment in the coinbase transactions
2. Staking of the CoreDAO token itself
3. Staking of Bitcoin, in a non-custodial way

We are not going to evaluate the entire consensus system, because this can be challenging and time consuming. Instead, we are going to comment on one component, the non-custodial Bitcoin staking. Consensus systems are complicated, and the risk of only looking at one of three components is that we do not have a holistic view. This could lead to incomplete or incorrect conclusions. It should also be noted that if you stake the CoreDAO token itself, there is slashing risk.

OP_CLTV and OP_Return

Firstly, we want to establish that the staking is indeed non-custodial. Rather than using the CoreDAO tools, we were able to stake Bitcoin into the CoreDAO system, without running any CoreDAO related clients, software or wallets. All we needed to do was construct a Bitcoin transaction in the CoreDAO staking format, a transaction which sent Bitcoin from ourselves to ourselves, involving just one private key.

The Bitcoin staking transaction contains three outputs and is constructed as follows:

1. Pay to witness script hash output (P2WSH)
   • Contains CLTV in the redeem script – The funds have to be locked up for several weeks in order to be counted as staking Bitcoin
   • A single public key hash in the redeem script, with the same private key as the transaction input
2. OP_Return, with three key pieces of data:
   • The address of the chosen CoreDAO chain validator, there are numerous validators to choose from
   • Your address on the CoreDAO chain, to receive your $CORE rewards
   • The redeem script for the above P2WSH output
3. Change output – back to the same address which was used in the transaction input

As the above shows, this is indeed genuinely non-custodial and essentially kind of risk free. There is of course some execution and security risk in the setup, as well as the costs of degrading your privacy, you also need to lock up your coins for a short amount of time, but from an economic point of view, this is largely risk free. No matter what goes wrong with CoreDAO, your Bitcoin should be safe, this is what we mean by essentially risk free. It is not even necessary to validate anything on the CoreDAO chain. All you are doing is tagging your Bitcoin, using OP_Return, to indicate that it is staking on the CoreDAO chain. For this, you get paid rewards.

Usage of OP_Return like this is pretty neat in our view. By putting the redeem script in the OP_Return string, it means you cannot lose access to the redeem script. Therefore, it can be considered as making Bitcoin wallets more user friendly and makes wallet backups far easier. With usage of OP_Retrun like this, your wallet can do complex scripting, and yet all you need is the recovery phrase and you can back up all your funds. Of course the downside is that this increases the data usage onchain, which can be expensive, but for large value transactions it seems potentially worth it and perhaps this is something some wallets could implement.

Apparent Fake Staking

To some of our regular readers and to the Bitcoin maximalists, it may seem like this kind of “staking” is not staking at all. Why would merely tagging some of your Bitcoin and locking it up with CLTV count as staking? You are not running any validation software. The entity doing the validation does not own the Bitcoin. Also, it’s risk free, without any real costs. How can a staking system be genuine without any slashing? Indeed, we argued way back in 2018, that staking cannot fundamentally work without slashing, a view we still hold today, although it has become a more controversial view of late. Therefore, in this case, in our view this staking could be considered “fake staking”.

This is not to say that the CoreDAO staking protocol is broken. We have not done the work to determine that. Perhaps the way to express this is that we consider that the Bitcoin staking does not contribute to CoreDAO’s security. Or that we consider that the Bitcoin staking does not help the CoreDAO chain converge in the event of a split.

Some proponents of the CoreDAO system, would push back and claim the staking is real. Afterall, Solana is a proof of stake chain without slashing, is that also fake staking? Our response here is that, perhaps the Solana staking process is composed largely of smokes and mirrors and the real Solana security comes from centralisation. However, in Solana’s defence, when you stake Solana, if the stakers behave nefariously, the value of Solana may decline. This is a form of punishment. This does not seem to apply to Bitcoin staking in CoreDAO, if the stakers behave nefariously, the value of Bitcoin should be unaffected. No punishment at all. It is of course possible we are living in the past and still have a luddite 2014 to 2017 view of blockchain technology and that staking without any costs can now actually contribute to security.

The Merits Of “Fake Staking“

While some may be disappointed by “fake staking”, hoping for something more real, the financial mind in us consider it as potentially something positive, something to embrace. If the staking is truly fake, then that explains how it’s genuinely totally custodial risk free. If the staking was “real”, there would be more risk, in our view. The lack of risk is a positive. This makes staking Bitcoin into the CoreDAO system potentially quite attractive, you can get exposure to the growth of the CoreDAO ecosystem, without taking much risk. One can just lock up one’s coins using CLTV, for a short period, and stake away. Crypto funds could even build this process into their wallets. Justin Sun could even consider doing this with the WBTC balance and he could honestly communicate to WBTC users that the coins were not leant out or rehypothecated in risky activity.

On the other hand, if too many people start staking Bitcoin in CoreDAO, this may create $CORE selling pressure and the yields will decline. Staking would then become less attractive.

Bitcoin ETP With A Yield

Bitcoin ETP provider Valour has even issued a Bitcoin ETP, that stakes the Bitcoin into CoreDAO and then pays back the yield to ETP unit holders. Now that we know there is no significant extra risk from this staking, it makes this ETP even more attractive. In contrast, when staking Ethereum in the Ethereum staking ETPs, there may be extra risks that ETP unit holders are not sufficiently aware of.

It should be noted that this ETP has a high 1.9% management fee, it has the ticker $2452364D in Germany and it is not available in most brokerage accounts. It is therefore unlikely to challenge Blackrock’s $IBIT any time soon.

Conclusion

We have started to stake some of our personal Bitcoin into the CoreDAO staking system. Precisely because, rightly or wrongly, we consider the staking process as possibly fake, is why we think it’s a potentially attractive investment. If the staking was custodial or had slashing, with significant extra risks, this would not be something that would interest us. As for whether the staking really is fake, we have provided our opinion, but it is a controversial topic and readers can make up their own mind.

This piece should not be considered as investment advice. 

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