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What is Layer 2 in Crypto? Why do we need Layer 2 solutions?

Layer 2 is getting noticed by the community since it can solve the current blockchain trilemma. Top Venture Capitals have poured hundreds of millions of dollars into Layer 2 projects. Let’s explore more about Layer 2, some notable scaling solutions.
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Duy Nguyen
Published Jan 14 2021
Updated Apr 12 2024
9 min read
what is layer 2

What is Layer 2?

Layer 2 (L2) is a separate framework/blockchain built with an aim to extend the capabilities and functionalities of existing blockchain platforms. In crypto parlance, the goal of Layer 2 is to scale the blockchain.

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To get a further understanding of L2, we should know more about Layer 1. In general, the terms Layer 1, Layer 2, Layer 3, and so on are inspired by the OSI layer model. Layer 1 is the base blockchain. Frameworks/ protocols are on higher layers (2,3,4, etc.) built on top of the layer 1 blockchain (the base blockchain).

Why do we need Layer 2 Solutions?

Ethereum is the first blockchain platform with smart contract capability. Over half a decade, it has incurred many congestions coming from the extensive demand of the community. As a result, Layer 2s come to Ethereum as saviors.

The number of transactions on Ethereum in the daily timeframe exceeds over 1M. Compared to that at the beginning of 2020, it has increased by over 100%. In the past, the Ethereum network has incurred many congestions due to overloaded network usage. At this pace, the demand will soon exceed the full capacity of Ethereum. Therefore, it needs complete solutions.

Decentralization: It is challenging to increase the number of Ethereum nodes due to the Proof-of-Work consensus. More nodes can be built on Layer 2s, where transactions are executed.
Scalability: Layer 2 enables the base blockchain with better scalability. It can boost the transaction speed while reducing gas fees. In addition, everything will be scaled without sacrificing security.
Security: This is one of the strong features of Layer 2. It inherits the security of the base blockchain. For example, Ethereum is considered the most decentralized blockchain with high security against manipulation. Layer 2s on Ethereum are responsible for the execution, while Ethereum ensures the integrity of the network.

The advantages outweigh the disadvantages. Layer 2 has been getting traction since late 2021, while Ethereum gave out some drawbacks.

All types of Layer 2s

Layer 2 is the term used to describe solutions for blockchain platforms. It comes in many variants based on the technological approaches and working principles of the solutions.

Layer 2 not only refers to scaling solutions on Ethereum, BNB Chain, Cardano, Solana, and other blockchain platforms do have scaling solutions. Since the narrative is strongly for Ethereum, many crypto newcomers might mistake that there are only L2s on Ethereum.

State Channel

State Channel processes transactions off-chain, and it only submits 2 transactions to Ethereum to validate. This means the throughput will depend on the capability of the computer network that processes the transactions.

Off-chain transactions have a critical limitation that makes the state channel vulnerable to attack. This means your funds in off-chain transactions are delegated to someone who might have malicious intent.

Layer 2s that use the state channels: Connext, Kchannels, Perun, Raiden, State Channels, etc.

Plasma (Off-chain, Fraud Proofs)

Plasma scaling solutions create smaller chains (child chains) connected to the root chain, forming a Merkle tree model. These child chains are built through the use of smart contracts and work separately. A layer 2 using Plasma can scale fast since more child chains can be built on top of a child chain.

Layer 2s that use Plasma technology:

OMG Network launched its mainnet in early 2020. At the moment, the TVL on OMG Network is around $3M, stabilized for a while.
Polygon (MATIC), formerly known as Matic Network, scales the transaction speed and lowers the fees of the Ethereum network by using a Proof-of-Stake commit chain and MoreVP (Plasma) Layer 2. At the moment, Polygon has an ecosystem, including DeFi to GameFi.
LeapDAO, GLUON, and Gazelle are also L2 scaling solutions that use Plasma. However, those L2s are in the early stage. They are not so notable among the community.

Sidechain

Akin to Plasma, An L2 using the sidechain technology is a blockchain network that communicates with the primary blockchain (mainnet like Ethereum). Communication is secured by two-way bridges. The digital asset transfer is validated and ensured by the use of smart contracts.

Enabled by smart contracts, funds on the sidechain and the main chain (Ethereum) are ensured without fraudulent acts. Furthermore, a world of blockchains is built on top of a base blockchain (Ethereum), which will allow a strong level of interoperability.

Here are some notable examples of sidechains:

Skale is an L2 sidechain network designed to enhance the throughput of Ethereum. Besides acting as a scaling solution, Skale is an independent chain. This means that if Skale is vulnerable to attack, the Ethereum network will be safe.
xDAI is an Ethereum-based sidechain using the Proof-of-Stake consensus, focusing on a stablecoin named xDAI. It went live in late 2018, and it empowers Ethereum with fast and cheap transactions.

Rollups

After going through 3 types of technology that Layer 2 scaling solutions use, we may understand that they are mainly used for scaling up the base blockchain. Everything has its limitations, and so do they. At the time of writing, Layer 2s that the usage of State Channel, Plasma, and sidechain technology has not been so popular among the community.

On the other hand, L2 scaling solutions using Rollup technology are getting strong traction from the community. All top L2s by the TVL are using this technology. So what is so special about it?

Rollup technology executes the transactions outside the base blockchain (Ethereum). Once done, the transaction data will be submitted to the layer 1 blockchain. Nowadays, there are two types of Rollups that are widely used in the crypto space: ZK-Rollups and Optimistic Rollups.

Zero-knowledge rollups (ZK-Rollups) process transactions off-chain and create validity proofs. Then it submits them to the main blockchain. With the use of validity proofs, the bridges from Layer 2 to Layer 1 (main blockchain) can execute fast without any delay.

Notable names that use ZK-Rollup: zkSync, StarkEx/StarkNet, Loopring, Aztec, etc.

Optimistic Rollups run in parallel with the main blockchain (Ethereum) to provide scalability enhancement. It uses fraud proofs to detect fraudulent transactions. This increases the performance of the main blockchain while maintaining security.

Notable names that use Optimistic Rollups: Optimism, Cartesi, Fuel, Arbitrum One, Boba Network, etc.

EVM Compatible Layer 2

As its name suggests, EVM compatible Layer 2 is the blockchain that can run code written in Solidity, the main programming language of smart contracts on Ethereum. This allows the implementation of existing protocols written in Solidity to advance faster without having to build the whole new protocols from scratch.

As shown in the table, not every L2 scaling solution is compatible with EVM (Ethereum Virtual Machine). Ethereum is the largest smart contract platform with a TVL dominance of 65% (updated: May 24th, 2022). As a result, it will be a huge advantage if a blockchain is compatible with EVM.

Optimistic Rollups and Sidechains are natively compatible with EVM. On the other hand, Plasma, State Channel, and ZK-Rollups are not EVM-compatible. This means if the developer team wants to upgrade the chain to an EVM-compatible chain, they will need to build a built-in EVM.

For example, zkSync 2.0 is an EVM-compatible ZK-Rollup solution. Its team, Matter Labs, has built zkEVM, a virtual machine inside zkSync 2.0. Matter Labs considers this a turning point for the ZK-Rollup chains since it took years to deliver.

Top Layer 2 solutions in Crypto

On Ethereum

Arbitrum is an Optimistic Rollup Layer 2 on Ethereum that is leading the L2 race in terms of TVL. Here are some highlights:

150+ projects, 80+ on mainnet
Over $123M raised from top VCs
ATH TVL was $4.1B
Token release: ??

Optimism came as a surprise since it released the $OP token airdrop to early contributors. It is an EVM-compatible chain using Optimistic Rollup.

110+ apps
$178M raised
$500M in TVL
Token release: Airdrop

StarkNet & StarkEx are being developed by Starkware, a company

120+ projects
$165M and 6k ETH raised after 5 investments
StarkEx TVL: $1.1B+
StarkNet TVL: $444k
Token release: ??

zkSync, developed by Matter Labs, is a ZK-Rollup scaling solution for Ethereum. Its first version, zkSync 1.0, went mainnet. Its latest version with the EVM-compatible feature, zkSync 2.0, is on the way to mainnet.

90+ projects
$58M raised and $200M DAO for ecosystem growth
$80M+ in TVL
Token release: Confirmed

Metis Andromeda is an EVM-compatible scaling solution on Ethereum that was arguably forked from Optimism. The TVL of Metis used to be over $700M. As time went on, it was drained to $150M.

On other blockchains

Lightning Network is a payment Layer 2 designed to scale Bitcoin and Litecoin. As the description suggests, it enables payments on Bitcoin to process faster. In April 2022, Lightning Labs, the developer of Lightning Network, concluded a $70M investment to bring stablecoin to the Bitcoin network.

Aurora is a bridge and a scaling solution for Near Protocol. It is now building an ecosystem containing many legos such as DeFi and Bridges. In May 2022, it launched a $90M developer fund to boost the development of DeFi.

Milkomeda is an EVM-compatible Rollup Layer 2 on Cardano. Akin to Aurora on Near, it has a whole ecosystem of many DeFi protocols and bridges. It used to achieve the $100M TVL in just two days after the mainnet release.

Limitations of Layer 2 Solutions

Withdrawal Time

The withdrawal time of crypto assets transferred from Ethereum to other L2s is a drawback, affecting users’ experience. For example, bridges to chains using Optimistic Rollups take about one week to bridge crypto assets. Imagine how the prices of the crypto assets change after one week. On the other hand, there are Layer 2s that allow the bridging process to be executed at a glance.

Hack/Exploit

Moving crypto assets from L1 to L2 and vice versa requires bridges. Many hack/exploits have occurred due to the potential vulnerabilities of bridges. For example, in April 2022, the Ronin sidechain bridge hack caused $650M to be lost. This made the Ronin sidechain go under water, and it is challenging to recover.

EVM Compatibility

As mentioned, only some Layer 2s support ideas written in Solidity. This will be a huge drawback for an ecosystem if the chain is not EVM-compatible. Without huge major changes in code, projects can migrate to the EVM-compatible Layer 2s faster.

Interoperability and Liquidity fragmentation

Chains are connected through bridges, and liquidity is fragmented on each chain. As we can see, TVL on each chain is poorly distributed according to each ecosystem. However, if the liquidity is somehow connected across chains, users’ experience will undoubtedly be improved.

Future of Layer 2

The future of Layer 2 is near since there are numerous scaling solutions running mainnet, such as Arbitrum, Optimism, Methis Andromeda, etc.

Ethereum is going to turn into a new leaf with Ethereum 2.0. Despite many concerns about the upcoming upgrade, Layer 2s are fueling the Ethereum network with numerous improvements. From our perspective, Layer 2 and Ethereum 2.0 will co-exist as lego parts that scale Ethereum in the long run.

The Dapp ecosystems are being built on top of Layer 2s. As mentioned earlier, each Layer 2 project has its ecosystem full of Dapps. We believe that in the future, more innovations will land on Layer 2s, where they are favored to thrive.

Token launches of Layer 2 chains are coming. After the $OP token airdrop by Optimism to the community, many chains started to plan for token releases. A sustainable tokenomics is the key driver that sails its entire ecosystem to thrive. Here is the playbook for airdrop hunters:

FAQs about Layer 2

Layer 2 vs. Ethereum 2.0?

Ethereum 2.0 will change the Ethereum network completely. But the process can take years to complete. The upcoming upgrade is Ethereum Merge which is planned to take place in Q3 or Q4 2022. On the flip side, many Layer 2s are coming to scale in the crypto space. Ethereum 2.0 and Layer 2 share the same goal of tackling blockchain trilemma.

How to bridge assets to Layer 2?

Bridging crypto assets from L1 to L2 require cross-chain bridges. They allow users to move their crypto assets for usage on other Layer 2s. The lego part of the bridges is completed for some L2s, while others are not.

Do other blockchains need Layer 2?

There is always at least one L2 project building for every blockchain. However, the actual demand for more scalability might mainly exist on Proof-of-Work blockchains or non-EVM chains. As investors, the solutions to problems are where we find opportunities.

Conclusion

That is everything you should know about Layer 2. The Layer 2 race is happening with numerous teams who are building day and night.

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