What are all these blockchains?
To understand DeFi, it’s important to grasp how blockchains operate and the various layers in which they are organized. At a high level, we’ll dive into what people mean when they talk about Layer 1s, 2s, and even 0s — and why it’s so difficult to navigate between the different chains.
Understanding the DeFi landscape
The world of decentralized finance is relatively new but it’s vast. After what’s known as “DeFi Summer” in 2020, the industry saw immense growth. A number of notable projects arose, the total value locked (TVL) in DeFi skyrocketed, and more people started seriously exploring blockchain technology, beyond just Bitcoin and Ethereum.
Before we dive in we’d like to preface that there is a general lack of consistent definitions in the web3 space. In the span of researching a bit to write this, we’ve seen Avalanche referred to as a layer 0, 1, and 2 chain. The most important takeaway is that there are a variety of different blockchains and, at the moment, it is difficult to trade tokens from one ecosystem with another. Layer 1s are able to operate entirely on their own and Layer 2s, however they are developed, rely on a Layer 1 in some shape or form.
“Layer 1s” (L1s)
Chances are, if you’re new to DeFi, you’ve mostly heard about layer 1 blockchains like Bitcoin and Ethereum. At the highest level, you can think of these as main blockchain architectures or ecosystems. These chains don’t need any other networks to validate or process transactions. Other notable L1s include NEAR, Cardano, Binance Smart Chain (BNB Chain), and Solana.
Some L1s struggle massively with scalability. By this, we mean that as blockchains see more and more transactions, they often struggle to handle the volume. In turn, they are faced with high fees and slow processing times. Chains with these challenges have also made changes to the base protocols to improve the speed and throughput of the blockchain. (You may have heard about the recent Ethereum Merge which changed the chain from a proof-of-work (PoW) to a proof-of-stake (PoS) system to improve scaling.)
Not all L1s have these same problems with scalability and some of the newer chains have been developed to confront (or address) these issues from the start. The great thing about L1s is that they don’t rely on any other chains and can be designed to best serve their use cases. For example, Solana was designed from the get-go to scale for use. But designing a new chain from scratch is much more complex than building on top of one.
“Layer 2s” (L2s)
Insert L2s. To combat the issues that some L1s face with speed and scalability, blockchains have been built based on the core infrastructure of L1s. These L2 blockchains rely on L1s for things like security and reliability but have made improvements to make their chains more efficient.
How are L2 scaling solutions developed? L2s are developed in a number of ways, the main being sidechains and rollups. The core differences in how these are established come down to how the smart contracts that rule these environments are written.
Sidechains: An example of this is Polygon. Sidechains are their own chains that connect to the parent blockchain via a two-way peg. In the case of Polygon, the chain is compatible with the Ethereum Virtual Machine (EVM) and connected to Ethereum via a bridge (the two-way peg). Because the smart contract does not verify the integrity of the underlying L1 and transactions are not confirmed on the L1, they do not have the same security as the parent chain.
Rollups: All that you need to know about rollups is that they roll up transactions from the L2 and onto the underlying parent chain directly. In contrast to a sidechain, rollups can rely on the security of the underlying L1. Below is a brief explanation of Optimistic and ZK-Rollups, but if you’re interested in learning more, we would recommend exploring here.
- Optimistic Rollups: Examples of these on Ethereum are Optimism and Arbitrum. These chains make the assumption that all of the data rolled up (in these cases to Ethereum) is valid. If an invalid transaction is spotted, the network will cancel the transaction and penalize the party responsible. This is implemented by a dispute resolution mechanism. This relies on parties submitting and validating fraud proofs.
- Zero-Knowledge Rollups (ZK-Rollups): Examples of these on Ethereum would be ZKSnync and Loopring. Where Optimistic rollups rely on believing the underlying assumptions from the parent blockchain are valid, ZK-Rollups rely on the cryptography of zero-knowledge proofs. This means there is no need for a dispute mechanism since all transactions are rolled up into a single transaction and the main chain is provided with a ZK-SNARK as mathematical proof of validity.
“Layer 0s” (L0s)
In an effort to not further complicate things, we will not go very deep into L0 solutions. What you need to know is that L0s are the infrastructure that sets the stage for other blockchains. The hope is that these solutions will facilitate cross-chain interoperability. To read more about these, we would recommend exploring the Cosmos and Polkadot ecosystems.
Issues with interoperability
If you’ve traded on any decentralized exchanges, you’ll notice that you often need to toggle between blockchains both on the trade interface and in your wallet. And many exchanges only offer trading across a handful of chains. This is because each of the blockchains described above lives in isolated environments and tokens cannot be freely moved between them. Even between an L1 and L2 built on that parent chain, one will need to use something called a bridge to move tokens between the ecosystems. This is one of the major obstacles that people are describing when they talk about interoperability in DeFi.
This inability to seamlessly move funds across chains (without jumping through hoops) is also why many users choose to trade on centralized exchanges over getting directly involved in the decentralized world of finance. Further, these issues go beyond the experience of the average trader. They also front developers who are creating protocols on various cryptocurrency networks. Why can’t you easily build a project that will work and operate across numerous chains? Especially when we’ve covered that there are so many different blockchains out there!
As DeFi gains traction, more smart and talented individuals are coming to work in the space to tackle these challenges. Hopefully, in a few years, we won’t even need to think about what chain we are operating on and can effortlessly trade cross-chain.
Try it out on Bebop
If you’re new to DeFi and starting to explore chains outside of Ethereum, why not begin now with Bebop? To get started, bridge some assets via the Polygon Bridge and then navigate over to bebop.xyz to start trading!
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