(Bloomberg) -- Billions of dollars worth of Bitcoin are pouring into the type of blockchain projects that historically have been vulnerable to hackers and other security risks. 

The allure of the new projects is simple: They allow owners of the original cryptocurrency to earn a passive yield on their holdings, a common attraction for more elaborately designed tokens that came after Bitcoin. 

Yet the excitement for these projects, many of which promote themselves as safe, has obfuscated risks associated with them. That’s because the Bitcoin blockchain was not set up as a “proof of stake” network, which allows crypto owners to earn rewards by locking up their tokens as part of the system that validates transactions. Instead, these projects rely on what are known as side chains and bridges, or pieces of software that allow tokens to be transferred between blockchains. 

“When you are depositing money into a sidechain, you are trusting the sidechain bridge,” said Haseeb Qureshi, managing partner at digital-asset venture-capital fund Dragonfly. “At the end of the day, you have some counterparty risk with the people who are part of that bridge.”

Losses related to sidechains and bridges count among some of the biggest exploits in the history of crypto. Ronin, a sidechain for the blockchain-based game Axie Infinity, lost about $625 million to thieves in March 2022. That same year, hackers also stole about $325 million from Wormhole, a bridge for Solana and other blockchains. That doesn’t mean that all sidechains and bridges will get exploited. Yet with billions of dollars worth of the biggest cryptocurrency at stake, the projects make for attractive targets for thieves.

‘Layer 2’

Complicating matters, the developers of these projects have marketed them as what are known as layer 2 blockchains, implying they are built on top of the Bitcoin network and are leveraging the security of the largest cryptocurrency while allowing for faster transactions and the type of applications that are popular in decentralized finance. 

However, current technology does not allow Bitcoin’s network to verify transactions on other blockchains. As a result, what are billed as layer 2 blockchains are actually sidechains. While sidechains allow Bitcoin to be transferred to and from the main Bitcoin blockchain, their setup introduces risks such as the potential vulnerabilities in bridges. Bridges usually have a group of entities, a so-called multisig, to secure and monitor the transactions, making them more centralized — and as a result, more vulnerable to being exploited. 

The hottest project in the category is Merlin Chain, which saw more than 11,642 Bitcoin worth about $800 million sent to its platform as of Monday, according to data compiled by Dune Analytics user eat_apple. Other popular projects include BSquared and Bitlayer. None of the Bitcoin layer 2 projects have had any security breaches so far. 

Advocates argue that Merlin and similar projects offer a number of benefits to the sector such as bringing more liquidity to the market and earning yield for Bitcoin holders.

“There should be a channel to turn native Bitcoin, which is like gold, into a wrapped Bitcoin” on other blockchains, said Jeff Yin, founder of Merlin Chain.  

Yin acknowledged that Merlin Chain isn’t a layer 2 blockchain, chalking it up to a “branding language” problem. 

“From day one, we’ve said this is a sidechain, we don’t need to ride the hype of layer 2,” Yin said. Still, Merlin Chain’s website and its technical page continue to show that it’s promoted as a layer 2 blockchain that’s “native” to Bitcoin. Yin argued that much of the criticism has come from the rival Ethereum community, and added that the fight over the term ‘layer 2’ has become more political than technical.

“Saying ‘oh this is not a layer 2’ is pointless,” Yin said, “Then it really just becomes a political fight.”

As for security, Yin said Merlin Chain and some of the other major Bitcoin projects have been working with several institutional custodian firms. Merlin Chain alone has paid “millions of dollars” to these service providers to help with security, he added.

Inscriptions inspiration

This type of effort is not new in crypto. Wrapped Bitcoin, for example, was launched by digital-asset firm BitGo in January 2019 and can be used on a number of blockchains such as Ethereum. Wrapped Bitcoin is backed 1-to-1 by Bitcoin held in custody by BitGo. 

These days, however, Bitcoin is facing competition not only from more crypto projects that pay holders rewards, but also higher rates offered by relatively safe, real-world assets such as US Treasuries. 

Merlin Chain’s growth is also owed partly to the launch of a so-called points system, similar to the rewards programs offered by airlines and credit-card companies. Among the Bitcoin sent to Merlin Chain, a majority is staked on a project called Solv Finance, which allows users to earn loyalty points for potential tokens in the future.

To many, the growth of projects like Merlin Chain owe much of their success to inscriptions, a type of nonfungible token based on Bitcoin, which showed there is demand for projects built around the oldest cryptocurrency.

“Inscriptions are the catalyst,” said Forest Bai, co-founder and general partner of crypto venture fund Foresight Ventures, which has invested in a number of Bitcoin projects. “The success of inscriptions led to more interest from users on the Bitcoin ecosystem.”  

‘Theme park’

Like inscriptions, the new Bitcoin projects first took off among the Chinese crypto community, according to investors. Historically speaking, the early crypto community in China was formed around the Bitcoin mining industry, said Qureshi at Dragonfly. As a result, most of the Chinese crypto investors, especially Bitcoin miners, have favored Bitcoin for years.

“Miners own huge swaths of Bitcoin and they see what’s happening with all the money that’s being made on Ethereum and the Ethereum ecosystem,” Qureshi said. “Everyone else is having fun over here in this theme park, and you’re sitting over there.”

Since Bitcoin’s market capitalization dwarfs that of other cryptocurrencies, it also doesn’t take much to draw impressive amounts of funds to these projects, Qureshi pointed out. Therefore, he argues that the Bitcoin layer 2 narrative has been a supply-focused story rather than demand. The current top depositor on Merlin Chain, for example, sent more than 500 Bitcoin to the chain, according to Dune Analytics. After an initial rush earlier this year, Merlin saw much fewer Bitcoin inflows.

“A bunch of Bitcoin miners thinking I can get yield on my Bitcoin by putting it into these Bitcoin layer 2s does not create users,” he added. “It does not create demand, it does not create volume. And that’s the actual thing we care about.”

©2024 Bloomberg L.P.