Layer 2 Networks: Solving the Blockchain Trilemma? | 12/28/22

publicity

Blockchains have been slow and expensive since the beginning of their existence. For years it seemed like this scalability trilemma would be a permanent problem, but thanks to recent innovations we have found a way out through Layers 2. Layer 2 solutions are set to become the next big step forward in the blockchain development. They offer cheap and fast transactions while maintaining security and decentralization. Layer 2 solutions are blockchains built on top of the main (layer 1) blockchain. This is the approach Ethereum (ETH) is taking to scale its congested network. Scaling Issues in Layer 1 Networks Traditionally, a user enters their commands on a Layer 1 and waits for their transaction(s) to be executed. However, there is a limited space (also called blockspace or blocks) to enter these transactions and this is how delays are created. As these blocks get bigger, more transactions can fit into them, which speeds up the network. Unfortunately, larger blocks require faster and more expensive computers. If we want a distributed network, we can’t create these financial barriers, otherwise only the elite would be able to make the system work – a problem most are already all too familiar with. The solution to avoid larger blocks is to rely on another blockchain. On this blockchain, users enter thousands of transactions, which are then aggregated into one. This transaction (representing thousands) is then published on the layer 1 blockchain, verifying the veracity of these transactions. Layer 2 blockchain can have “larger blocks” managed by few. Because they are controlled and verified by the layer 1 blockchain, which is decentralized and operated by many people. But if the transaction still needs to be verified by the slow and expensive Layer 1, don’t we have the same problem? Layer 2s and their scaling solution First, expensive Layer 1 transaction fees are spread over thousands of transactions, making each transaction much cheaper. In fact, this solution reverses the problem – previously, more transactions meant more demand for block space, and therefore higher transaction fees. Now more transactions means more users to share costs with, so more users means lower fees. This is why, as shown below, 2 nappies can be so cheap. Layer 2 transactions are “bundled” into a Layer 1 transaction. This is also the reason why some Layer 2s are called rollups. Cost of Layer 2 transactions compared to Layer 1 (ETH) / Source: CoinShares Second, Layer 2 rollups can work much faster despite relying on the Layer 1 blockchain to verify transactions. There are two explanations for this, depending on the type of rollup we are talking about: optimistic rollups or validity rollups. Optimistic cumulations, as their name suggests, are optimistic. They don’t wait for Layer 1 to verify the transaction, but optimistically assume the transaction is correct and move on to the next batch. However, it is understood that other players monitor the transactions displayed to ensure their accuracy. If a transaction is found to be incorrect, whoever entered the transaction will be penalized. In return, the whistleblower is rewarded. The whistleblower provides Layer 1 with proof that fraudulent activity has taken place, and this “proof of fraud” (which involves replaying transactions) is used to determine the outcome of the dispute. As long as there is at least one person in the world monitoring these transactions (financial or otherwise), bullish rollups can do their job. Validity rollups (also known as zero-knowledge rollups or ZK rollups) also bundle transactions into one and submit it to Layer 1. However, they also submit a proof of validity with that transaction. Using sophisticated cryptographic calculations, this proof immediately proves to Layer 1 that all transactions are indeed valid, without the need to re-execute them. Layer 1 verifies the proof in a very short time and then moves on to the next transaction. However, ZK summaries are more computationally intensive, because the generation of proofs requires significant computation time. The Layer 2 landscape in charts Of all the Layer 2s under development, ZK rollups are the most popular because they can quickly determine the validity of a set of transactions. However, the calculations underlying these validity rollups are relatively new, so progress is slower than optimistic rollups. The following shows the percentage of Layer 2 based on the type of evidence used, with optimistic rollups using fraud proofs while validity rollups use validity proofs. Type of evidence used / Source: CoinShares Although still in its infancy, the Layer 2 landscape is rapidly advancing as the number of daily active addresses continues to grow. Although a user may have multiple addresses, this is a useful indicator of network usage, as shown below. Layer 2 daily active addresses as a percentage of ETH / Source: CoinShares Since Layer 2s pay a fee to post to Layer 1, their growing popularity means they have a larger share of Ethereum’s revenue ( as shown below). In fact, Layer 2s Arbitrum and Optimism are already the fifth and seventh largest chains in Total Value Locked (TVL), respectively, with the DeFi ecosystem being larger than Solana. Layer 2 as a percentage of ETH fees / Source: CoinShares While TVL measures the value that is in all dApps in a chain, Total Scammed Value (TVE) measures the value that is in both dApps and dApps. user wallets. Among Layers-2, Arbitrum and Optimism are the clear leaders in TVE ($3.7 billion combined), underscoring the maturity of optimistic rollups in this space. Below we show the main 2 layers according to TVE. TVE (in millions USD) / Source: CoinShares Conclusion Layer 2 appears to be the solution that Ethereum has needed for many years. They offer users cheaper and faster transactions while inheriting the decentralization and security strengths of the Ethereum network. In fact, an upcoming Ethereum upgrade, EIP-4844, will make transactions on Ethereum Layer 2 an order of magnitude cheaper. At current levels of demand, this would reduce transaction fees on chains like Arbitrum, Optimism, and zkSync to fractions of a penny. The Layer 2 design space is largely unexplored, with many different variations emerging in different parts of the world. This free market approach to scaling Ethereum could actually give the system an edge over competing Layer 1s. All in all, the technological fundamentals are improving and the future of Layer 2 looks bright.