2021 Review: Layer-1’s, Layer-2 Scaling Solutions, & The Future of ETH 2.0

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Coinmonks

11 min readDec 25, 2021

Total Value Locked (TVL) in DeFi across all blockchains, with 62.43% in ETH in Q4 2021, down from 96.91% in January 2021 (Source: https://defillama.com/chains)

Ethereum has become a victim of its own success — its decentralized and permissionless approach that has led to the revolution of DeFi has also made Ethereum cost-prohibitive for many users.

Short term, a combination of L2 scaling solutions, notably rollups, along with the ETH 2.0 Phase 1 data layer, and various L1 blockchains such as Avalanche & Solana that have seen jumps in adoption through 2021 are filling the market need for low transaction fees and fast transactions while the community awaits ETH 2.0.

Given that it is unclear when Phase 2.0 (Shard Chains) of ETH 2.0 will happen or if the future will depend on L2’s like roll-ups entirely, there are implications for the L1 protocols market, L2 scaling solutions market, and the implications for ETH 2.0.

Today, the Ethereum network routinely facilitates the transfer of tens of billions of dollars of value daily, with over $150B of value currently sitting in smart contracts on its network to facilitate decentralized asset exchange in lending, insurance, and payments.

Gas (transaction fees) prices have influenced many away from using Ethereum to explore other Layer-1 (L1) platforms that offer similar applications, with lower transaction fees, and varying decentralization and security profiles.

L1 solutions are native blockchains with varying performance and utility, such as Avalanche, Solana, and Terra; Layer-2 (L2) solutions are protocols that integrate with the underlying L1 (Ethereum in this case) to increase throughput and usability.

Competing L1 protocols have innovated with new consensus algorithms, blockchain architectures, and execution environments, but how much is their adoption growing as compared to Ethereum and L2 solutions?

Compared to January 2021, Ethereum dominance in DeFi TVL across all blockchains was at 96.91%, and as of today, Q4, 2021 is at 62.43%.

While we wait for the final form of ETH 2.0, a landscape of L2 projects are already solving some of network congestion on Ethereum itself, allowing for easier access to DeFi platforms with lower network fees.

The question is, how much are these current L2 solutions and bridges actually being used?

What are the impacts of ETH 2.0 for the future of L1 blockchains — will fragmentation in usage continue as trends have shown over 2021?

How would ETH 2.0’s eventual rollout of shard chain affect the current L2 scaling solutions that may gain in adoption until then?

Let’s briefly explore.

Ethereum vs. Layer-1 Blockchains vs. Layer-2 Usage

Live L2 scaling solutions on Ethereum have yet to see large-scale adoption as compared to L1 solutions. Cheaper L1 solutions such as Avalanche and a few others are seeing more usage as is than L2’s on Ethereum.

While Ethereum today achieves 12–60 seconds time-to-finality, ~15–30 transactions per second (tps), this tps is far lower than for legacy payment systems such as Visa, at ~1,700 transactions per second in the real world.

Layer 2 scaling solutions on Ethereum increases this processing power for Ethereum to between 2000–4000 transactions per second.

In contrast, Layer 1 protocols that throughout the course of 2021 have taken DeFi market share from Ethereum — Solana, Binance Smart Chain, and Avalanche, have achieved faster transaction throughput, with Avalanche having achieved <1 second finality and 4500 transactions per second before considering any sharding or layer-2 optimizations.

Solana regularly processes 2,000+ transactions per second daily with ~13 second time to finality, and Binance Smart Chain handles approximately 150 tps with a 3 second block time.

Here is an overview of how much TVL is locked in Layer-1 protocols outside of Ethereum — the leaders today are Terra with $20B TVL, Binance Smart Chain with $16.9B, and Avalanche with $12.68B, closely followed by Solana with >$12B.

The figure above from The Block shows a comparison between Layer-1 blockchains’ TVL growth as compared to their price; Avalanche has been the strongest performer since September 2021.

But what about Layer-2 solutions, how much are they being used?

The Total Value Locked (TVL) in L2 Solutions through 2020–2021 reached only a peak of >$7B USD.

The TVL per specific L2 protocol is noted in the graphic below, with the vast majority in Aribitrum, dYdX, and Loopring, all of which are roll-up L2 solutions, discussed below.

As can be seen, cheaper L1 solutions such as Avalanche and a few others are seeing more usage than L2’s on Ethereum.

For example, AVAX C-chain (Contract chain) adoption has been increasing and has hit over 700K avg. daily transactions as of Dec 2021, with over 70,000 cumulative contracts deployed on the C-chain.

What about the TVL and present day market share of bridges moving capital away from Ethereum to other protocols such as Avalanche et al.?

The graphics below are from this Dune.xyz query.

As shown, the top 3 bridges by market share are Ronin, an Ethereum-linked sidechain made for blockchain gaming, Polygon, an plasma (child chain) anchored to the main Ethereum chain, and the Avalanche bridge to Avalanche’s C-chain (EVM compatible contract chain), which is at $6.1B USD bridged as of 24 Dec 2021.

EVM-compatible chains and their bridges overall in the second half of 2021 saw a sharp increase in users and activity, partly due to the large increase in incentives offered by L1 development teams and their treasuries.

One example of such an incentive program was Avalanche Rush, an $180M incentive program for DeFi on Avalanche to attract users to interact with “blue-chip” DeFi projects that deploy on Avalanche, such as Aave and Curve. The program is primarily structured as liquidity mining rewards for ecosystem participants.

Most Layer-1 incentive programs are focused on promoting the growth of DeFi in their respective ecosystems, although each program varies in its exact goals and scope, as well as token distribution model.

Brief Overview of Current Layer-2 Scaling Solutions

Layer-2 solutions involve scaling that is off-chain, meaning transactions and computations happen off of the Ethereum base chain, keeping the base layer free of congestion. Layer-1 solutions involve scaling on-chain transactions or scaling solutions that keep all transactions on the base layer.

The existing ETH L2 scaling solution landscape includes rollups of which there are many varieties such as Loopring, Zksync, Optimism, and Arbitrum; Validium solutions such as Starkware and zkPorter; Sidechains such as xDai and Skale Network; State Channels such as Celer; and Plasma solutions such as Polygon and OMG Network.

Each of these scaling solutions includes their own unique optimizations and trade-offs and can be combined, and while some are application-specific such as for payment channels, others are usable for any contract executions.

Out of all L2, Rollups provide the most complete solution vs. Plasma chains or state channels, which do not support application development, and better security than sidechains, which can rely on independent consensus mechanisms.

Rollups execute transactions off-chain and write cryptographic proofs of validity to the chain when complete, which frees up resources on the main chain and reduces congestion and fees.

The scalability of rollups can be magnified by ETH 2.0; because rollups only need the data layer to be scaled, they can be used in ETH 2.0 Phase 1.

Rollups provide Ethereum a path to scalability that can rival the timeline of new Layer-1 solutions reaching maturity to market, in the sense that Layer-1 competitors are partly in a race against a viable rollup solution.

L2 Solutions Disadvantages

While each L2 does improve performance, drawbacks to L2 solutions primarily include their further fragmentation of the network, whereas using the main chain such as a more scalable L1 (like Avalanche) can offer higher security guarantees, in addition to not being as fragmented, more decentralized, and having higher performance to start with as a base layer upon which L2 solutions can be built that will then scale further than starting with a lower performance L1.

With L2, there is no single, global state that supports composable smart contracts, meaning that while most users currently rely on simple L1 systems for use and interaction, L2 scaling solutions require changes in user behavior, wallets, oracle, and dApps, with various tradeoffs in security.

Cross-L2 transfers currently are not seamless, and side chains require bridging, which means an overall lack of communication between various L2 projects.

Drawbacks of plasma specifically include a long waiting period for users to withdraw their funds from the Layer 2.

State channels are application-specific, not for general-purpose smart contracts, and require funds being locked up ahead of time before using.

ZK rollups, although they are faster and more efficient than optimistic rollups, do not provide an easy way for the existing smart contracts to migrate to Layer 2.

Setting up ZK rollups also relies on a centralized party such as a developer, which undermines decentralization and opens the risk of social engineering hacks.

The benefit of ETH 2.0’s sharding, however, over L2 solutions such as rollups include the fact that sharding ensures the entire system functions as a collective with the same validity and access to the data.

There are no deposits or funds staked in shards unlike in rollups or plasma solutions, as shards are a part of the main chain.

ETH 2.0 vs Layer 1 and Purpose-Built Protocols

Certain L1 protocols target niche sectors, or have radically different designs, architectures, and consensus mechanisms.

The future could very well involve multiple primary chains such as Ethereum and Solana, interacting with each other through a series of side chains.

Certain purpose-built, niche blockchains have arisen for specialized tasks — to make supply chains more efficient, for example, or to move and store different types of information, or to capture a higher volume of transactions at a higher throughput.

Large scale and complex applications need custom blockchains that are optimized and scalable to solve a specific set of problems that do not require compromising with the limitations of “catch all” blockchain architecture such as that of Bitcoin or Ethereum.

While purpose-built blockchains could be deployed for specific situations, such as in enterprise, a combination of L2 scaling solutions, ETH 2.0, and various L1 blockchains that interoperate can provide the level of throughput required at low cost to implement the true vision of DeFi, making the financial system accessible and affordable to all.

What is ETH 2.0?

ETH 2.0 is a multi-phased upgrade that addresses the network’s scalability through changes to the infrastructure itself, starting with a switch from the proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) consensus model.

Ultimately, ETH 2.0 will lead to Ethereum being able to process more transactions at a faster throughput, ease scalability bottlenecks that currently exist and make the network unusable for the average user, changing Ethereum from a single blockchain to a multi-chain network.

ETH 2.0 is launching in several phases, the first of which, called the Beacon Chain (Phase 0), went live in Dec 2020. The Beacon Chain introduces native staking to Ethereum, a feature of the shift to a PoS consensus mechanism.

The second phase of ETH 2.0 is called The Merge and is expected by Q2 of 2022, and it will merge the Beacon Chain with the Ethereum mainnet and mark the official move from PoW to PoS.

In this phase, the Ethereum network in its current state will be ported over the Ethereum 2.0 as a shard.

The final phase is Phase 2.0 or Shard Chains, which takes transaction execution into the shard chains, expected during 2023, which will play a role in scaling by introducing sharding to spread the settlement of all operations across 64 new chains instead of one single blockchain, ultimately increasing the transaction throughput on the base layer significantly.

The current Ethereum infrastructure has a blockchain consisting of a single chain with consecutive blocks which is very slow and inefficient. With the introduction of shard chains, this one blockchain is split up, enabling transactions to be handled in parallel chains.

The benefit for ETH 2.0?

With ETH 1.0, the network can support around 30 transactions per second max, but ETH 2.0 promises up to 100K transactions per second.

ETH 2.0, in contrast to most PoS networks that have a small set of validators, requires a minimum of 16,384 validators to make it more decentralized and therefore secure, but has reached more than 200K validators with over 6.6M ETH staked, totaling $14B USD as of Q3 2021.

Avalanche, in comparison, currently has 1205 validators, and Solana has 1331 validators.

The Future of ETH 2.0 & Layer 2 Solutions

Since ETH 2.0 is expected to solve many of the scalability problems the L2 scaling solutions are starting to solve, there is the question of whether the increased throughput and speed from ETH 2.0 will make the adoption of L2 scaling solutions obsolete.

“Blue chip” DeFi apps on Ethereum will likely end up on rollups, if they move from the base layer at all.

Community sentiment and financial incentives will play a part in what ultimately happens.

According to The Block, if the future is “roll-up centric,” then the Ethereum 2.0 network will solely be used for security and data availability rather than transaction execution.

We do not yet know with real world certainty the level of scalability ETH 2.0 provides, and given that Ethereum adoption and development as a whole will continue to increase, L2 solutions may still have a use case even with ETH 2.0.

If rollups scale and remain viable, Ethereum will likely maintain its monopoly on DeFi applications while ETH 2.0 is being developed.

Furthermore, L2 solutions are not exclusive only to Ethereum and are designed to provide services across multiple blockchains in the future.

Most of the community regard ETH 2.0 as a long-term solution, with continued Ethereum development ensuring stability of the network, but L2 solutions that broaden their function to move beyond the Ethereum ecosystem can continue to do well.

Vitalik Buterin, the creator of Ethereum, has publicly said in 2020 that ZK-rollups may become “the dominant scaling paradigm for at least a couple of years” before shard chains are implemented.

As Vitalik notes, ETH 2.0’s data capacity will be upgraded before its computation power, meaning it will be able to store more data before it can process more transactions.

The final phase of migration to ETH 2.0 will unlock smart contract execution capabilities within shards, estimated during 2023.

By the time ETH 2.0 and rollups work together, there should theoretically be a capacity of 100,000 transactions per second worth, which will greatly help adoption scale to billions of people.

Ultimately, the evolution of Ethereum is a dynamic process and the need to solve the problem of high gas fees, scaling, and competition means various stages of the ETH 2.0 transition may be prioritized.

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2021 Review: Layer-1’s, Layer-2 Scaling Solutions, & The Future of ETH 2.0

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Written by Bakul Badwal