What is Layer 2 on Ethereum?

Contributor, Benzinga

Ethereum (ETH) is the 2nd-largest cryptocurrency in terms of market capitalization at $200 billion. It performed exceptionally well in 2021, rising above $4,000 at its peak in May after beginning the year around $800. One of the main drivers of Ethereum’s success is the diverse ecosystem of decentralized finance (DeFi) platforms built on its network. 

DeFi platforms attracted boatloads of users looking to lend, borrow, earn interest and much more. A consequence of widespread adoption was that the number of transactions on Ethereum skyrocketed, slowing the network and increasing transaction fees. While there are some easy fixes to this problem, the simplest ones can sacrifice security and decentralization to speed up transaction fees. Layer 2 projects may be a vital stop-gap solution for Ethereum’s future.

What is Ethereum?

Ethereum
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Ethereum is a decentralized and open-sourced blockchain network that uses its native token Ether to pay transaction fees. Ethereum was first visualized in 2013 in a whitepaper written by, Vitalik Buterin. It launched on July 30, 2015, and has grown to be the 2nd-most successful cryptocurrency, behind Bitcoin

The network set itself apart with 2 main functionalities. The first is that it functions as a platform for hundreds of thousands of other cryptocurrencies to build on top of. The most common type of these is ERC-20 tokens, which make up a large portion of the top cryptos in the world. 

The second and likely the most important function of Ethereum is that it can compute code within the network called “smart contracts.” These are self-fulfilling contracts that only require trust in the code and not with the other parties in the contract. DeFi platforms use smart contracts to give users improved financial tools for lending, borrowing, interest-earning, insurance and much more. 

Smart contracts can be much more complex than simple transfers or trades, which increases congestion and transaction fees. Massive adoption of smart contracts have recently caused Ethereum transaction fees to skyrocket and has driven many users to low-cost, more centralized competing blockchains. However, due to the recent crash of the cryptocurrency market and the success of the Polygon sidechain, Ethereum fees have returned to much lower levels — for now.

Layer 1 vs Layer 2 on Ethereum

Layer 1 is the term used for the underlying blockchain architecture and changes to it are called Layer 1 solutions. For example, Ethereum could be scaled easily by increasing the block size and therefore the number of transactions verified per block. However, this would make mining prohibitively expensive – centralizing the network to only the richest miners with the best equipment. This could leave the power of verifying the chain in the hands of few, endangering the network to malicious attacks. The Ethereum community doesn’t want to make this Layer 1 change because it would sacrifice decentralization and thus network security. 

Layer 2 solutions build on top of the network and require no changes to the Layer 1. Layer 2 solutions still leverage the security of the consensus mechanism of the Layer 1 network, but they can drastically speed up transactions. Ethereum’s Layer 1 can handle about 15 transactions per second, while some Layer 2 projects can ramp it up to 4,000 transactions per second. Scalability upgrades to the Layer 1 Ethereum network are slated for the upcoming years, and Layer 2 will prevent dApps from leaving Ethereum in the short term.

Optimistic Rollups 

Optimism is a for-profit Public Benefit Corporation that is working on launching mainnet optimistic rollups. It was born out of a nonprofit group called Plasma Group, founded by the Ethereum creator Vitalik Buterin and a co-creator of Bitcoin’s Layer 2 solution, the Lightning Network. Plasma Group transitioned to the for-profit company Optimism in January 2020 and has been a leading optimistic rollup project.

A rollup is a Layer 2 solution where a large batch of transactions are aggregated and processed off of the mainnet network (Layer 1) and then condensed transaction data is posted to Layer 1. This can dramatically increase the throughput of the network, decreasing congestion and transaction fees. 

A new kind of key actor in this solution is called an aggregator, who posts a batch of transactions to a smart contract on Layer 1. Invalid transactions are removed via challenges from other network participants. They have approximately 1 week to post a proof that the transaction was computed incorrectly. 

An important feature of Optimistic rollups (ORUs) is that they will be compatible with most smart contracts, unlike Plasma and many other Layer 2 solutions. This is vital for keeping the transaction fees of DeFi users low and reducing congestion in the network. ORUs could increase transaction speed on the platforms that incorporate it by a factor of 100. This is fast enough for the current transaction throughput of Ethereum and should help DeFi and other platforms attract more users, even before Eth 2.0 is completed. 

zkRollups

zkRollups (ZKRs) are a powerful scalability solution utilizing zero-knowledge (ZK) proofs. A ZK proof simply proves you know something without revealing what that something is. A ZKR introduces the relayer, who adds a ZK-SNARK (a special ZK proof that doesn’t require interaction between the relayer and the verifier), which proves the batch of transactions is valid. This drastically reduces the amount of information posted to Layer 1, increasing transaction throughput as high as 10 times more than ORUs. 

Whereas ORUs rely on challenges to remove invalid blocks, ZKRs make it impossible to publish an invalid block. Therefore users don’t need to trust aggregators as they do with ORUs — they need to trust the main chain’s ability to compute and verify the ZK-SNARK signature. 

ZKR’s main downsides are that they require intensive computation and they need to build specific proofs for every type of transaction to work properly. Only a few proofs are available so far for direct transfers and other simple transactions. Therefore, ZKRs will not be compatible with many smart contracts and DeFi platforms until the right proofs are constructed. Although ZKRs seem to be a vastly superior method and may eventually overtake ORUs, they are not as useful for the time being. 

Where to buy Ethereum

Because Ethereum is the 2nd-largest cryptocurrency, it is available on many different trading platforms. Brokers like WeBull and Robinhood support ETH along with nearly all cryptocurrency exchanges. Some of the best exchanges are Coinbase, Gemini, Crypto.com, eToro and Voyager.

Investors in the U.S. will have to comply with Know Your Customer regulations by verifying their identity on the platform before purchasing any cryptocurrencies. This requires your address, driver’s license (or other valid ID, and Social Security number.

Where to buy Layer 2 Cryptocurrencies

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Some of the most exciting Layer 2 cryptocurrencies include Polygon (formerly known as Matic) and LoopRing. Polygon mostly functions as a side-chain to Ethereum, boasting minuscule fees and lightning-fast speed. It has already been incorporated into 10s of large decentralized applications (dApps) like Curve Finance and has exciting plans to expand Ethereum scalability.

LoopRing uses zkRollups to scale and facilitate swap and exchange transactions, improving decentralized exchanges that use it enough to start to compete with centralized ones. Both of these cryptos can be purchased on Coinbase, Binance, Crypto.com, Gemini and a few other exchanges.

Cryptocurrency Price Movements

The cryptocurrency market has mostly traded sideways over the past few weeks after partially recovering from the recent crash. This crash was caused by a ban on cryptocurrency services in China and Tesla deciding it would no longer accept Bitcoin as payment. 

Further recovery has sprung up in the last week after a few major world events. El Salvador added Bitcoin as a legal tender in the country and Tesla announced it will resume Bitcoin payments after fossil fuel usage has decreased. Bitcoin is back above $40,000 and Ethereum is about $2,550, although they both sit far below their all-time highs.

What Effect will Layer 2 have on Ethereum?

Layer 2 projects will likely be most important as a stop-gap solution for Ethereum (and other cryptos) scalability. Ethereum 2.0, which is slated to join with Ethereum 1.0 sometime between 2021 and 2022, will hopefully diminish the issues of congestion and slow transaction speed enough that Layer 2 projects will not be as necessary. However, Layer 2 solutions will not go away after 2.0 fully launches and will further maximize transaction speed and minimize fees.

Frequently Asked Questions

Q

Is Ethereum a Layer 1 or Layer 2 blockchain?

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Is Ethereum a Layer 1 or Layer 2 blockchain?
asked
A
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Ethereum is a Layer 1 blockchain.

answered
Q

What are examples of a Layer 2 blockchain?

1
What are examples of a Layer 2 blockchain?
asked
A
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Some examples of Layer 2 blockchains on Ethereum include Polygon, Arbitrum, and Optimism.

answered

Recommended lecture: BEST ETHEREUM LAYER 2 INVESTMENTS

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