Cryptocurrencies have come a long way since the introduction of Bitcoin in 2008. But, as ten-minute Bitcoin transactions or exorbitant Ethereum gas fees can attest, they can’t quite match the transaction speeds of Visa or completely replace fiat currencies. At the core, these problems stem from a lack of scalability – a problem that Layer 2 solutions could solve.
This article examines why blockchain architecture inherently introduces scalability issues and three ways Layer 2 solutions could address them.
Why Scalability Is Hard
Blockchain architectures face several scalability challenges. Unlike traditional payment systems, they don’t rely on a centralized intermediary that can unilaterally approve transactions while only maintaining a single database. Instead, they rely on a network of nodes and a complicated consensus system to operate without any authority figure – and those add overhead.
Some of the biggest challenges include:
- Consensus: Many blockchains use consensus mechanisms that intentionally slow down the transaction process to prevent fraud. For example, proof-of-work algorithms require a difficult computation to add a block. These complex computations discourage bad actors from trying to brute-force a transaction.
- Nodes: Many blockchains require each node to store a complete replica of the blockchain, which can become resource-intensive over time as transactions are added. Moreover, blockchains must propagate transactions and blocks to every node in their network, introducing network latency.
- Blocks: Bitcoin and other blockchains have a fixed block size, limiting the number of transactions per second. For example, Bitcoin can process around seven transactions per second, significantly less than traditional payment systems.
These challenges create several scalability issues:
Limitations: Blockchains have limited transaction throughput and processing speeds thanks to their consensus mechanism and block sizes. Moreover, as the number of network participants increases, blockchains may struggle to meet demand.
Transaction Fees: High transaction fees due to difficult consensus mechanisms and other factors make it costly for users to complete transactions and impede a blockchain’s ability to scale.
- Response Times: Scalability issues can lead to longer response times. For instance, Bitcoin can only process seven transactions per second, which means that users may have to wait a long time before a transaction is officially complete. And congested networks with an insufficient number of nodes can compound these problems.
These challenges create the so-called blockchain trilemma – or the belief that decentralized networks can only provide two of three benefits concerning decentralization, security, and scalability. For example, improving scalability would be simple if you centralized the consensus mechanism or didn’t worry about fraudulent transactions.
What Are Layer 2 Solutions?
Most software is built in layers, whereas applications are generally built on a single foundation. So, it shouldn’t be surprising that blockchains are also made in layers. Layer 1 blockchains, like Bitcoin and Ethereum, provide a foundation for Layer 2 solutions and other ecosystems. And it turns out that these additional layers could be critical to address scalability issues.
Layer 2 solutions operate atop an underlying blockchain protocol to improve scalability and efficiency. For instance, the Lightning Network is a second layer for Bitcoin that uses micropayment channels to scale the blockchain’s capability to handle transactions more efficiently (and cost-effectively), improving Bitcoin’s notoriously slow transactions.
That said, the rise of Layer 2 solutions doesn’t mean there haven’t been efforts to improve Layer 1 networks. For example, Ethereum 2.0 moved to a more efficient proof-of-stake (PoS) consensus mechanism, while the migration from EVM to eWASM will dramatically cut transaction times by compiling code rather than interpreting it in real time.
Layer 2 solutions also come with their own trade-offs. While they may improve scalability, many solutions trade-off decentralization or security. But the good news is that these solutions have steadily improved. New approaches tend to improve scalability more than hurt the other components of the blockchain trilemma.
Layer 2 Scalability Approaches
Layer 2 solutions use several different strategies to improve the scalability of their underlying Level 1 blockchain. But generally, these strategies fall under three categories.
Nested blockchains have a parent-child relationship to a Layer 1 blockchain. The parent blockchain delegates work to child chains that process the work and return it to the parent blockchain when it’s finished. For its part, the parent chain is usually only involved when there’s a transaction dispute with the result of the child chain.
The OMG Network is one of the most popular nested blockchains. By bundling Ethereum transactions, compressing them into one transaction, and validating them on an optimized child chain, the network can process thousands of transactions per second, reducing Ethereum’s transaction costs by a third and addressing its scalability issues.
State channels open two-way communication between a blockchain and an off-chain transaction channel. In the off-chain channel, participants can perform unlimited private transactions that only they can observe. After they’re done, the final state of the transaction is recorded in the underlying Layer 1 blockchain.
The Lightning Network is a popular example of a state channel built on the Bitcoin blockchain. When you want to make a transaction or series of transactions, you can leverage the network to make unlimited payments that occur instantly and at a fraction of the cost. When you decide to close the channel, all the transactions are consolidated and added to Bitcoin.
Sidechains are blockchain-adjacent transactional chains for large batch transactions. While the mainchain maintains overall security and resolves disputes, the sidechains have an independent consensus mechanism optimized for speed and scalability. And a two-way peg ensures that there’s no counterparty risk when using these solutions.
For example, the Liquid Network is an open-source sidechain built on Bitcoin’s blockchain. While Bitcoin has a ten-minute block time, Liquid’s block discovery time is just one minute, which means ten times as many blocks can be added to the sidechain. Rather than proof-of-work mining, Liquid relies on a fast network of functionaries to verify transactions.
Roll-ups are a Layer 2 solution that performs computation and storage off-chain and only submits the final proof to the underlying Layer 1 blockchain. The two most popular types of rollups include zk-Rollups (zero knowledge) and optimistic rollups. And each has its own set of speed, security, and complexity trade-offs.
For example, Optimistic Ethereum bundles multiple transactions together and only sends a summary to the mainchain, dramatically improving throughput and sharply lowering costs. The “optimism” part assumes all transactions are valid unless challenged within a specified timeframe, creating a window for fraud detection.
Layer 1 Strategies
In addition to these Layer 2 strategies, some Layer 1 blockchains are starting to implement changes to become more efficient on their own. For example, some blockchains are transitioning from a proof-of-work to a proof-of-stake consensus mechanism to improve transaction speeds by reducing computational overhead.
Sharding is another Layer 1 strategy for improving throughput. By splitting transactions into small sets and then using a horizontal split processing algorithm to process them in parallel, Layer 1 blockchains can more efficiently work through their backlogs without having to send transactions to dedicated Layer 2 solutions.
Challenges & Risks
Layer 2 solutions help improve throughput scalability but could also increase risk or compromise in other areas of the blockchain trilemma. Before using a Layer 2 solution, take the time to understand how it works and the potential risks involved.
Some challenges and risks to keep in mind include:
- Security: The security of Layer 2 solutions depends on the mainchain, making them vulnerable to any issues impacting the mainchain. In addition, Layer 2 solutions leveraging smart contracts could have potential security risks.
- Complexity: Layer 2 solutions add another layer of complexity to Layer 1 blockchains, which could increase the surface area for bugs, extend development timelines, increase maintenance costs, and negatively impact the user experience.
- Latency: Layer 2 solutions should reduce transaction latency, but the need to reconcile transactions with a Layer 1 blockchain could increase latency round-trip.
The Bottom Line
Blockchains promise to revolutionize the finance industry, but many blockchains face inherent scalability limitations. Fortunately, Layer 2 solutions can help address these challenges without compromising the integrity and track record of the underlying Layer 1 blockchain. And, of course, some Layer 1 blockchains continue to implement their own improvements.
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The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.