Blockchains and cryptocurrencies promise to revolutionize finance, but mass-market adoption requires a lot more scalability. For example, the Bitcoin network processes about five transactions per second compared to about 1,700 transactions per second for Visa. Meanwhile, Ethereum is prone to sudden spikes in gas fees from network congestion.
There are many ways to improve scalability. For example, at the blockchain level (Layer 1), some networks are moving from proof-of-work to proof-of-stake to process transactions more efficiently. Meanwhile, Layer 2 solutions sit atop or adjacent to primary blockchains to improve processing efficiency without changing the battle-hardened core.
Let's look at the difference between Layer 1 and Layer 2 blockchains and what it means for crypto traders and investors.
Blockchain layers are essential to improving scalability and ultimately competing with centralized networks.
What Are Layer 1 Blockchains?
Layer 1 blockchains refer to primary blockchains, such as Bitcoin, Ethereum, or Litecoin.
These networks sometimes make foundational changes to improve scalability. For example, Ethereum 2.0 uses a proof-of-stake consensus algorithm rather than a conventional proof-of-work algorithm. Rather than requiring miners to solve cryptographic problems, POS systems validate transactions by requiring individuals to stake collateral.
Another up-and-coming foundational change is sharding—or breaking the blockchain into distinct pieces rather than requiring all nodes to maintain the entire network. By processing transactions in parallel, sharding could significantly improve transaction throughput. Ethereum 2.0, Tezos, and other blockchains are actively exploring the concept.
These changes could significantly improve performance, but they also increase risk. For example, Ethereum experienced a significant hack in 2016 that resulted in 3.6 million lost tokens. The iconic cryptocurrency eventually needed a hard fork to solve the problem, creating Ethereum Classic and resulting in substantial losses at the time.
What Are Layer 2 Blockchains?
Layer 2 blockchains refer to technologies that operate on or adjacent to an underlying blockchain.
These networks take on a portion of a Layer 1 blockchain's transactional burden to improve efficiency. While they still use Layer 1 features, such as smart contracts and security protocols, they aren't burdened by the same transaction limitations, helping boost throughput to as much as 2,000 to 4,000 Tx/s—putting crypto on par with many centralized networks.
There are several types of Level 2 blockchains:
- Nested Blockchains: Nested blockchains sit atop another blockchain. The primary blockchain delegates work to the secondary blockchain through a parent-child relationship. Once work is complete, the child sends it back to the parent.
- State Channels: State channels facilitate two-way communication between a blockchain and off-chain channels. The Layer 2 network is sealed off from the Layer 1 network, only sending the final state to the primary blockchain.
- Sidechains: Sidechains are another blockchain-adjacent solution that uses independent consensus mechanisms optimized for speed. Unlike state channels, sidechain transactions aren't private, and any security breaches do not impact the mainchain.
- Rollups: Rollups are smart contracts that store transaction data on the primary blockchain, but move transaction activity to sidechains. When a new batch is published, the smart contract ensures that transactions match up.
There are also nuances with each of these approaches. For instance, there are two types of rollups—ZK-Rollups and Optimistic Rollups—that have different pros and cons. ZK-Rollups are much cheaper and faster, but the initial setup involves centralization, whereas Optimistic Rollups are Turing-complete but have slower throughput than ZK-Rollups.
Examples of Layer 2 Blockchains
Many Layer 2 blockchains aim to improve the scalability of Bitcoin, Ethereum, and other Layer 1 blockchains. Lightning Network and Ethereum Plasma are the two primary approaches endorsed by Bitcoin and Ethereum, respectively, while other solutions are adopted by organizations with different priorities, like speed or security.
The Lightning Network runs atop the Bitcoin blockchain to improve speed and scalability. After locking in an initial Bitcoin payment, the network enables two users to efficiently transact with each other off the Bitcoin blockchain at a much lower cost. Then, when they're ready, they close the channel, and a single transaction is recorded on the Bitcoin blockchain.
Ethereum Plasma is a native sidechain that uses smart contracts and Merkle trees to create a limitless child chain. Each child is a near replica of Ethereum with their own consensus mechanism and business logic. Plasma keeps the transaction data and computation in the child chain and then posts the state data to the mainnet at regular intervals.
The Polygon Network is a sidechain that runs adjacent to the Ethereum blockchain and is compatible with other Layer 2 solutions. Using Commit Chains, the network bundles batches of transactions together using its own validation—including transactions on additional Layer 2 solutions—before returning the data to the Ethereum blockchain.
Optimism is an off-chain solution for Dapps. Rather than running computations and data on Ethereum, Optimism puts all transaction data on-chain and runs computations off-chain, increasing Ethereum's throughput and reducing transaction fees. With over six million transactions processed, it has saved $335+ million in gas fees.
The Bottom Line
Blockchains are becoming increasingly popular in financial services and other use cases, but scalability remains a significant concern. While many blockchains are making changes to improve scalability, Level 2 blockchains are working atop or adjacent to them to shortcut the process and open the door to lower costs and greater efficiency.
The Layer 2 ecosystem remains highly fragmented, but there is a growing consensus around certain solutions. Over time, the superior solutions will emerge as winners and niche solutions will cater to specific subsets of the market. However, the overarching result will be lower fees and faster transaction speeds—a win-win for everyone.
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