As always, this article is made for educational purposes. This does not constitute financial advice nor trading advice. Past performance does not indicate future results.
Do not invest more than you can afford to lose. This is not financial advice; always do you own research :)
Yesterday, I talked about the bullish future for Ethereum — both as a network and for its native coin Ether.
Ether is the most useful coin in all of crypto right now; you can hold it and it appreciates, generate a yield on it, use it for DeFi apps, and more and more use cases are coming out every week.
Ethereum also has an insanely packed roadmap for the rest of the year. From a supply perspective, ETH2 will allow users to stake their ETH and generate a ‘conservative’ yield of 5–8% per annum and potentially upwards to 25% — locking it away from the liquid markets. EIP-1559 will make ETH a deflationary asset, beating Bitcoin’s fixed inflation rate.
From a demand perspective, gas fees are being contained through a series of initiatives like the Berlin hard fork, Flashbots, and Layer 2 scaling solutions rolling out.
I mentioned the terms ‘scaling’ and ‘Layer 2’ a lot in my previous post, but I wanted to take time to create a dedicated post on what it actually means.
We know that Ethereum has been plagued with high network congestion — leading to high gas fees on the network.
This wasn’t the first time that this has happened in a bull run. In 2017, the NFT app CryptoKitties and the ICO bubble also caused an insane spike in the Ethereum gas fees — with periods of time when fees were as high as 500 gwei.
Layer 2s will save Ethereum
Layer 2 scaling solutions have come to save the day from these terrible gas fees — with the hope that their roll outs will solve the network congestion issue forever.
“Layer 2” refers to a group of solutions that plan on scaling a Layer 1 blockchain (in this case, Ethereum — but any ‘core’ blockchain is referred to as a Layer 1. E.g. being Bitcoin, Solana, etc.) through increasing the speed and the throughput of the network.
These solutions are called Layer 2s because they conceptually sit on top of the Ethereum network.
At a high level, these solutions want to offload transaction and network activity from Ethereum onto their L2 chains, and periodically communicate with the L1 in order to reconcile states, funds, data, etc.
You can think of it as a triaging mechanism, where Ethereum will only know the most important information from the L2 solutions.
Funny enough, many of these solutions look a lot like separate blockchains that are ‘friendly’ with the Ethereum platform and the ecosystem — meaning, instead of stealing away activity from Ethereum like other L1s, they collaborate with Ethereum to process its transactions.
The issue with L2s is that there’s so many solutions — in an industry that has extreme network effects and honestly would greatly benefit from one cohesive L2 solution on top of Ethereum.
But each chain has a different approach to the technological solution with trade-offs and are racing to launch and win over both dapps and users.
Types of Layer 2 solutions
Sidechains are essentially separate, independent blockchains entirely. However, they are a fork of Ethereum, so they are EVM-compatible for quick deployment of existing dapps that run on Ethereum.
Plasma / Child Chains
Plasma is a framework to scale building apps on Ethereum. At a high level, Plasma allows for the creation of child chains, copies of Ethereum on another chain.
So instead of having every transaction processed on the Ethereum network, some transactions can be triaged and offloaded onto multiple child chains — and reconciliation of funds and states can happen less frequently in a predetermined cadence.
Polygon/Matic is an example of a Plasma implementation — and I’m a big fan of this solution because they’ve done so much leg work on the GTM side to win over two large dapps: Curve and Aave.
Rollups, broadly, are also sidechains that deploy a novel technical framework in order to scale and process transactions.
They bundle (called “roll up”) transactions from their chains and send them back to the Ethereum L2 in the bundled state (called a proof, or more accurately a SNARK)— only exposing the most important information.
Vitalik Buterin is very pro-rollup with his blog post “a rollup centric Ethereum roadmap”.
Optimistic roll-ups are a type of roll-up that allow for compatibility with the Ethereum Virtual Machine (EVM) — meaning smart contracts deployed on Ethereum can be re-deployed on L2 with relatively minimal additional technical lift.
They’re called “optimistic” roll-ups because they assume that the proof (i.e., the rolled up batch of transactions) provided for each transaction batch is valid.
Every 1–2 weeks, anyone can challenge the submitted proof and claim that they’re fraud. As a result, optimistic roll-ups have a long onboarding period in order to ensure that fraud is detected before submitting the batch onto Ethereum.
Zero knowledge roll-ups (ZK roll-ups) are different than optimistic roll-ups in the sense that there’s no long onboarding/off-ramp timing.
Instead, these proofs cryptographically ensure from the onset that a transaction is valid by using a zero-knowledge proof — thus, eliminating the need for a challenge period to detect fraud.
Moreover, ZK roll-ups are much faster and more efficient than optimistic roll-ups — where zkSync’s zkPorter promising to process 20K+ TPS, faster than even centralized networks like Visa.
ZK roll-ups were long thought to be a tradeoff with optimistic roll-ups because the former doesn’t support EVM compatibility — thus trading off speed with smart contract deployment ease. However, zkSync 2.0 is promising EVM compatibility and will launch tentatively this August.
In my opinion, the winner of the L2 wars will have to satisfy two conditions:
- The technology that they utilized (e.g., child chains, optimistic roll-ups, zero knowledge roll-ups) will solve the necessary user issues that are currently prevalent in Ethereum L1
- There’s a network effect of dapps and users on the platform
On the first condition, each L2 technology has various trade-offs — whether it be EVM compatibility, long onboarding times, transaction throughput, etc.
I think the most important thing for current DeFi users when thinking about an L2 is: is it cheap to use? can I move in and out of this L2 easily and quickly? are my favorite dapps there? is there ample liquidity? can I still do composable fun defi stuff / interop with other L2s?
The second condition may be a function of the first one. For example, more dapps may choose to integrate with an L2 that has full EVM compatibility — meaning that its a simple deployment of the existing L1 smart contract onto the L2 network.
The second condition means they put in the go-to market (GTM) elbow grease to acquire users: both from a product growth perspective, as well as partnerships and marketing.
Lots of dapps mean lots of users. Great liquidity mining programs means lots of users. And users will have a sticky relationship with their L2 solutions (at least for now) — given the friction of moving funds onto L2 currently.
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