Layer2 sector primer

Sector primer: Layer 2 protocols

This article is part of our sector indices primers. Find out more about this series here and get the full report here.

Definition

Layer 2 protocols bring significantly increased scalability to Layer 1 blockchains. They operate on top of an underlying blockchain and seek to improve the efficiency of the underlying technology.

Layer 2 networks allow far greater transaction volumes to be processed at considerably higher speeds and at much reduced costs.

As the demand for blockchains to process large volumes of transactions grows, they provide an important service by allowing established, trusted protocols to scale fast.

History

Some of the innovations that underpin the technology that allows Layer 2 protocols to process transactions very fast date back a long time. Zero-knowledge proofs were invented by Goldwasser, Micali and Rackoff in 1982 and have since been used in many settings.

The general idea of processing transactions off-chain is arguably as old as the very first Bitcoin code released by “Satoshi Nakamoto” in 2009. Bitcoin 0.1 included a raw draft of code that would let users update a transaction before it was confirmed, and Satoshi Nakamoto went into more detail about how payment channels could work in private communication with another developer. Concerns about Bitcoin’s ability to scale were raised very early on, and solutions were proposed as early as 2011. A Bitcointalk forum user outlined a two-tier payment channel, and Dutch developer Corné Plooy was also working on a payment layer for Bitcoin. The concepts all centred around off-chain transactions, which could be processed faster as they do not require blockchain confirmations and would be cheaper as they do not require mining fees.

Several developers (Jeremy Spilman, Mike Hearn, Matt Corallo and Alex Akselrod) worked on the payment channel concept over 2013 and 2014, turning it into working code. Ultimately, the Bitcoin Lightning Network was proposed in 2015 in a paper by two researchers, Thaddeus Dryja and Joseph Poon. Ethereum founder Vitalik Buterin also described the concept of rollups as a scaling solution for Ethereum as early as 2014.

After the Ethereum network launched and gained popularity as a smart contract platform, its scalability limitations quickly became apparent. In 2017, Vitalik Buterin, together with Joseph Poon, proposed solutions in the form of Ethereum Plasma, and Indian developers Jaynti Kanani, Sandeep Nailwal and Anurag Arjun started working on what became one of the first successful attempts at building Layer 2 scaling solutions in the form of Polygon (initially called MATIC).

The Lightning Network launched in 2018, as did a couple of Ethereum scaling solutions, such as the state channel based Raiden Network , or the xDai sidechain. Development work started around this time on optimistic and zero-knowledge rollup solutions.

As use cases for crypto started to proliferate and the demand on the Layer 1 networks grew substantially, the demand for Layer 2 scaling solutions increased. The last few years saw the launch of a large number of Layer 2 protocols, such as Arbitrum, Optimism, zkSync, Starknet, Base and Scroll. Sector specific Layer 2 solutions also appeared – such as Immutable X, which is tailored to the needs of blockchain-based gaming projects.

Subsectors

The Layer 2 sector can be categorised based on the technology the protocol uses. The major categories are: state channels, side chains, plasma, optimistic rollups, zero-knowledge rollups and validium.

State channels or payment channels are sessions of interactions between users. Users communicate with each other off-chain and only interact with the underlying blockchain to open the channel, close the channel or settle potential disputes. The Lightning Network is an example.

A sidechain is a separate, independent blockchain linked to the main blockchain using a two-way bridge. It enables tokens to be transferred between the main chain and the sidechain. An example is the Gnosis chain.

While sidechains enhance scalability by enabling transactions to occur on separate, parallel chains, plasma chains take a hierarchical approach, creating child chains off the main chain. Plasma chains retain the data within their network and only transmit the hash data of crucial block information to the main chain that is necessary to verify if a block is correct. Polygon’s first iteration used plasma chains (although the protocol has been adding various types of rollup technologies since then to offer a comprehensive set of scaling solutions).

Rollups process transactions off-chain, then batch and compress the transaction data and send it to the main chain. The different types of rollup technologies differ in how the validity of the off-chain transaction data is established. Optimistic rollups rely on a fraud-proving scheme to detect cases where transactions are not calculated correctly. After a rollup batch is submitted, there is a time window during which a rollup transaction can be challenged by computing a fraud proof. If the fraud proof succeeds, the rollup protocol re-executes the transaction, and the sequencer responsible for including the incorrectly executed transaction in a block receives a penalty. Currently, most of the largest Layer 2 projects, such as Arbitrum or Optimism, use optimistic rollups.

Zero-knowledge rollups publish cryptographic proofs of validity for off-chain transactions, allowing information to be verified without being revealed. Zero-knowledge protocols are increasing in popularity, with several recent launches such as zkSync and Scroll.

Validium is also a zero-knowledge based technology, but unlike zero-knowledge rollups, validium stores the data off-chain. Starkware’s StarkEx uses this technology.

There are also hybrid solutions that have properties of multiple categories, and innovation in the Layer 2 space is focused on combining the strengths of various approaches.

Users

Layer 2 protocols are used to make cryptocurrency payments cheaper and faster.

They are also in demand from decentralised applications that require an underlying infrastructure with a high degree of scalability. The leading Layer 1 protocols, Bitcoin and Ethereum, follow a strategy of scaling their networks through Layer 2 solutions.

Other token types, including stablecoins, tokenised assets and NFTs, can also benefit from the lower cost and faster transaction speed of Layer 2 networks.

Opportunities and challenges

The key opportunity for the Layer 2 sector comes from the ever-increasing demand for scalability as crypto use cases proliferate.

Innovative Layer 1 blockchains that incorporate significant scalability in their design compete with the Layer 2 sector. There is a debate on whether the modular approach (scaling through Layer 2s) or the integrated approach (where substantial scalability is built into the Layer 1 blockchain) is better. Ethereum follows the modular scaling strategy while Solana offers the integrated approach.

Centralisation is a concern for Layer 2 protocols, as the urgent demand for scalability dictated that speed to market and user acquisition were prioritised over decentralisation. Innovation is now focused on decentralised sequencers for Layer 2 protocols to mitigate the risks of censorship and single points of failure of centralised sequencers.

Innovation also continues to fine-tune and improve the technological approaches to scaling and combining the strengths of various approaches. For example, zero-knowledge rollups offer superior security and privacy, while optimistic rollups offer a lower cost and greater ease of implementation. Hybrid rollups are a promising way to combine different architectures to address the scalability and performance challenges while offering stronger security and user privacy protection.

Ethereum’s next upgrade (The Surge) will help Layer 2s on the Ethereum network achieve far greater scalability, which can catalyse further increases in user growth for the Layer 2 sector. Ethereum remains the undisputed market leader as a smart contract platform and their stated strategy for scaling is the use of Layer 2 protocols.

Value drivers

The most important driver for the sector is the overall demand for blockchain-based transactions. As crypto adoption increases and transaction volumes rise, the demand for scalability increases. In turn, the lower costs and higher transaction speeds offered by Layer 2 solutions can ignite further user growth, as they make more transaction types viable or more attractive.

As new use cases of the blockchain technology develop, they broaden the demand for transaction processing capacity. Sectors such as the metaverse or applications related to artificial intelligence require extraordinary scalability, and it is only with advances in transaction speed and cost that these applications become viable.

Shifts in preferences between integrated scaling solutions offered by some Layer 1 blockchains vs modular scaling with Layer 2s will impact the sector’s relative market share within the protocol layer.

Progress in solutions that enhance decentralisation in the Layer 2 sector, such as decentralised sequencers, and fine-tuning the scaling approaches to further improve transaction speeds, cost, security, privacy, and ease of use can catalyse further growth.

As the leading smart contract platform, Ethereum’s impending Surge upgrade will improve the value proposition of Ethereum based Layer 2 solutions, and a successful delivery of the upgrade can be an important catalyst for the sector.

 Find out more about our sector primer series  here.

Disclaimer

This document is purely for educational purposes and has been issued by Sygnum Group. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication. It does not constitute an offer or a recommendation to subscribe, purchase, sell or hold any security or financial instrument. It contains the opinions of Sygnum Group, as at the date of issue. These opinions and the information contained herein do not take into account an individual‘s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes personalized investment advice to any investor. Therefore, you must verify the above and all other information provided in the document or otherwise review it with your external advisors. Some investment products and services, including custody, may be subject to legal restrictions or may not be available worldwide on an unrestricted basis. The information and analysis contained herein are based on sources considered as reliable. Sygnum Group uses its best efforts to ensure the timeliness, accuracy, and comprehensiveness of the information contained in this document. Nevertheless, all information indicated herein may change without notice.

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