What Is the Difference Between Layer 1 and Layer 2 Blockchain Solutions and Why Do Investors Use Layer 2?
Cryptocurrency is more than a peer-to-peer payment platform providing security in a trustless world; it is a world-changing technology. What separates crypto from all other technologies is its ability to build and develop on top of existing infrastructure continually.
If you are following cryptocurrency in 2021, you have undoubtedly heard of slow transaction processing and high network fees plaguing the space. The good news is, crypto is incredibly resilient and adaptable to the changing conditions and needs of users.
Just like in nature, the financial platforms that will survive in the future are the ones that are most adaptable to change.
As scaling issues with cryptocurrencies increase as more and more people are using the networks and the demand for transactions to process quicker increases, gas costs rise and make it too expensive for many people to transact.
How do we create an environment where users can transfer crypto for pennies on the dollar like they could five or six years ago, and avoid the problem of $500 transaction fees we’re seeing now?
That’s where layer 2 solutions come in. To understand what layer 2 solutions are, we will need to explain the foundations of layer 1 (Layer 1) and the proposed solutions.
No, we are not talking about the L1 and L2 trigger buttons on your Playstation 5 controller.
In this week’s edition of Netcoins Progressive Investor, not only will you learn the fundamental differences between Layer 1 and Layer 2 solutions, you’ll also see the potential layer 2 solutions have and how you can get ahead of the next wave of innovation in crypto.
Layer 1: The Foundation of Cryptocurrency
To understand the differences between layer 1 and layer 2, we will need to define each and how they relate.
Simply put, Layer 1 is the base layer of any blockchain. Bitcoin, Ethereum, and Litecoin are all independent blockchains existing as layer 1 solutions. The main blockchain protocol is where all transactions occur.
As these blockchains increase in popularity, the need to process more transactions per second increases, and this is where they run into problems with scalability.
How does the network improve while at the same time maintain the security and scalability that Layer 1 affords while continuing to operate uninterrupted?
Layer 1 solutions aim to improve the base layer of the blockchain to augment scalability. For example, Layer 1 solutions change the protocol rules to increase transaction speed and capacity while also adding new users and data.
Currently, the three most common Layer 1 solutions include: increasing the amount of data stored in block size, improving consensus protocol (move from proof work like Bitcoin, which is very safe, to proof of stake, which newer networks are employing), and lastly, sharding which breaks up the entire network into smaller shards that can process data simultaneously.
One thing to note is that throughout this year, Ethereum has seen increasingly high network usage, which causes congestion and drives up gas fees (higher network fees means you as an investor will have to pay a higher cost per transaction.
As new protocols come into the crypto space, many will employ new technologies and methodologies to mitigate the limitations of Layer 1 to solutions, known as Layer 2 solutions.
Layer 2: Scalability Without Compromising Core Values
As Layer 1s move into problem-solving and evolving ultimately, they are met with the scalability dilemma.
A simple proposed solution is to use more nodes and increase centralization, which is not favourable as it does not align with the vision and mission of crypto. In a perfect crypto world, solutions should account for scalability, security and decentralization. Sacrificing any of the three for the sake of the other two (which many projects do) should come with clear and obvious advantages.
What is the solution to a clogged-up Layer 1? Indeed, trying to jam transactions through the network is not the answer. Giving up on creating a more robust and transparent financial system is also not an option. Developers have proposed to scale the base layer or scale the network by offloading it to another layer.
Layer 2 solutions are built on top of layer 1 while leveraging the security of Layer 1. Generally speaking, layer 2 solutions offer more flexibility, speed and cost savings than interacting with a layer 1 solution.
While staying true to the transformational characteristics of layer 1 protocols, layer 2s shift some transactional burdens from the blockchain to a sidechain (runs adjacent to the mainchain protocol). At the same time, transaction confirmations are sent to the main chain in order to finalize a transaction.
Layer 2 Decongests and Builds The Future
Layer 2 solutions do not transform the protocol but rather use elements of layer 1 protocols such as smart contracts, which are crucial elements of DeFi and NFTs.
A simple way to look at layer 2 in comparison to layer 1 is that the goal of layer 2s is to decongest the network, similar to taking an over-the-counter medication when you are feeling stuffed up. Not only do you feel better in the short term, but it also gives you a framework for problem-solving any future issues.
A high level of network congestion was initially experienced with the introduction of the NFT game CryptoKitties in 2017 on the Ethereum blockchain and has come back with a vengeance.
2021 has seen the explosion of NFTs and new applications such as DeFi, all of which bring added demands to the networks.
Currently, the most common Layer 2 solutions on Ethereum are called “roll-ups,” which perform transactions executions outside the main chain and post transactions on the mainchain. These are very useful in reducing fees, open participation, and fast transaction throughput.
There are two types of roll-ups in development: optimistic roll-ups and zero-knowledge roll-ups.
Optimistic Roll-Ups are parallel to the main chain and simply post or notarise transactions to the main chain. They can offer up to 10-100x in scalability.
Zero-Knowledge Rollups bundle or “roll-up” hundreds of transactions off-chain and generate a cryptographic proof on the main chain meaning only validity proof is needed without requiring all transaction data. This makes block validations quicker and cheaper.
In addition to the above layer 2 solutions, Ethereum has proposed ETH 2.0, which will shift the consensus algorithm from proof of work to proof of stake.
This change moves away from traditional mining, where miners cryptographically confirm transactions. It will increase the processing power of the Ethereum network while simultaneously increasing decentralization and security!
For investors of the HODLing type, many of the ETH layer 2 solutions offer attractive solutions as users can stake their tokens to the network and receive rewards.
Layer 2 Innovations Provide Investors With Opportunities
As ETH 2.0 continues to be built, many Layer 2 solutions are being made compatible with the ETH ecosystem. Knowing how these solutions work and what may separate one from the other may pay off handsomely for investors.
Some of the key players in layer 2 for investors (outside of ETH 2.0) currently have a total value locked (TVL) of $4.66 billion. Some of the top projects according to TVL include: Arbitrum ($2.81 billion) ; dYdX ($1.08 billion); Diversifi ($57.4 million) ; Immutable X ($16.9 million).
For more information on the above projects (some of which offer native token staking and rewards) and an exhaustive list, investors seeking an advantage in the Layer 2 space should visit Layer 2BEAT.
To date, the most mainstream use of a Layer 2 solution is the integration of Lightning Network to Bitcoin. In late September, Twitter integrated the lightning Network to facilitate tipping in BTC on the social media platform.
If you currently interact with any of the big layer 1s and layer 2s, good on you as you are certainly on track to keeping up with new developments in crypto and are in a position to be rewarded handsomely in the future.
Next Steps to Layer 2 and Get Ahead
Crypto investors who have been riding the highs and lows of 2021 may have worried about the utility, and the long-term success of crypto as the scalability dilemma seems insurmountable.
As more investors begin to immerse themselves in new and potentially explosive applications such as NFTs and DeFi, they will certainly feel the frustration of slow confirmations and high transaction costs. Investors need not fret as there is beauty in the struggle.
Rest assured, all of the above Layer 1 and Layer 2 solutions are ambitious and very well supported by some of the best and brightest leaders and developers in crypto.
As new technologies keep being built on top of existing ones, we will certainly see some new and exciting innovations.
Investors should keep in mind that many blockchain protocols are experimenting with both Layer 1 and Layer 2 solutions. Some are exploring combinations of the two. They promise to increase scalability without cutting corners on the basic tenets of crypto: security, scalability, and decentralization.
As many of these solutions are in the development phase, some may undoubtedly outperform other projects. Competition is healthy for the development of any technology as it forces developers to think of creative and realistic solutions. After all, this is how cryptocurrency emerged as an alternative to the traditional financial world.
As with all new investment ventures, consider your risk tolerance, knowledge of protocols, trends, and belief in new and emerging projects before investing.
Layer 1 and Layer 2 Knowledge Sharing for Investors from Netcoins
Now that you can calm down fellow crypto investors suffering from high fees and slow throughput and explain the differences between Layer 1s and Layer 2s and the proposed solutions, get them to sign up for a free Netcoins account.
You can deposit cryptocurrencies like Bitcoin, Ethereum, Litecoin to get started. You can also deposit Canadian dollars through an e-transfer from your bank account and then convert your balance to crypto to get started.
Now you know all about layer 1 and layer 2!
Written by: Jack Choros
Writer, content marketing at Netcoins.