What is a Layer 2 protocol and why is it important?

What are Layer 2 protocols?

Summary: A Layer 2 (L2) protocol is a secondary or external framework that builds on top of an existing blockchain network to make it more scalable, flexible, and responsive. Crypto investors can buy the underlying tokens behind these projects, which is like buying shares in the “company” that makes L2.

Blockchain networks like Bitcoin and Ethereum are referred to as “Layer 1” networks: they are the base layer on which transactions take place. As these L1 networks become more popular, they cannot handle the increasing demand as they can only handle around 20 transactions per second (tps).

To solve this, developers are building “Layer 2” solutions that can improve the performance of their underlying chains:

• Bitcoin (L1) has the Lightning Network (L2)
• Ethereum (L1) has Plasma (L2)
• There are many others all vying to be the primary L2.

Our investment thesis is that there will likely be a big L1 blockchain or two in the long run (tech industries tend to consolidate over time). Likewise, we believe that for each of these L1 blockchains there will be a big L2 winner or two (developers and users tend to commit to the L2 that performs best).

investor take-away: Just as we invest in the early L1 winners now and hold for the long term, we believe that smart and patient investors can invest in the early L2 winners and probably see a huge return in 5 years or less.

L2s accelerate L1s

Layer 2 protocols help Layer 1 blockchains move faster: they can process more transactions per second and be deployed on a larger scale.

You can think of it as modifying a car’s tuning: you add external elements to improve its performance, such as speed, control, and power. Likewise, we can add secondary frameworks to existing blockchains to boost their performance and support their adoption at greater scale.

Like a modified car, while L2s improve the speed of the underlying L1, they come with their own tradeoffs:

• Different technology means more things have to break.
• Users and developers need to learn how to connect to different networks.
• To speed things up, L2s may require more centralization.

Layer 2 methods

There are many Layer 2 protocols with different designs and approaches. Today we distinguish four main Layer 2 methods: ZK rollups, sidechains, channels and plasma.

ZK rollups

Zero-knowledge rollups are stacks of data structured as Merkle trees and stored in a smart contract on the L1 chain. Instead of doing the entire account reconciliation on-chain, the data is first offloaded for processing and calculation, and then recorded in a batch on the L1 chain.

By doing the “heavy work” off-chain, ZK rollups can generate a new block every minute, capable of processing around 2,000 tps. (“Zero-knowledge” comes from zero-knowledge proofs: a method you can use to prove that the data is true without actually having to reveal the data.)

opportunities for investors: Some of the most popular ZK rollup solutions are:

• StarkNet used by Ethereum-based decentralized exchanges dYdX and ImmutableX. As of this writing, StarkNet does not have a token, although one is in the pipeline;
• zkSync, used by dApps like FRAX and Yearn Finance. No token yet, although one has been announced.

side chains

Unlike ZK rollups, which depend directly on Layer 1 networks, sidechains are separate blockchains of smaller size. They work independently and use their own consensus algorithms. Sidechains connect to Layer 1 networks like Ethereum via a two-way bridge.

As an example, consider a factory with a main conveyor carrying crates: if there are too many crates for the conveyor, workers can move the crates to side rooms with secondary conveyors.

Most sidechains are developed for Ethereum and are compatible with the Ethereum Virtual Machine (EVM), but there are also examples of sidechains developed for Bitcoin. It’s worth noting that sidechains are less decentralized as they have fewer nodes. (They’re built for speed, not decentralization.)

Unlike the other Layer 2 solutions discussed here, sidechains are responsible for their own security, which is guaranteed by their consensus algorithm.

Sidechains can increase scalability and increase throughput by handling transactions independently, processing them faster and at lower cost.

opportunity for investors: One of the most popular sidechains is Polygon, a layer 2 solution (token: MATIC) developed for Ethereum.

channels

Channels allow the creation of a peer-to-peer (P2P) channel between two parties that can exchange an unlimited number of off-chain transactions while only sending two transactions to the underlying Layer 1 network, namely:

• The first transaction triggers the connection between the mainchain and the channel.
• The final transaction closes the connection between the main blockchain and the Layer 2 solution.

The popular analogy is a bar tab: you open the tab when you arrive, grab a few drinks and a plate of nachos, and close it when you leave, paying the full amount. Like a pub rider, channels open the connection between two parties and then close it when their business is done.

Channels take most transactions away from the main network and process them off-chain. This greatly increases the transaction speed between any two parties and reduces fees and delays.

Opportunity for investors: The most popular channel solution is the Lightning Network, created to scale Bitcoin. A merchant can integrate the Lightning Network to accept Bitcoin payments with instant confirmation at low fees. Lightning Network has no token; An investor would simply buy and hold Bitcoin.

plasma

Plasma solutions share some similarities with both rollups and sidechains. They are made up of Merkle trees that create additional chains to the underlying blockchain: let’s call them subchains.

This scaling solution can support faster transactions at lower cost because the blocks are settled on the lower-level L2 chains and not on the main L1 chain. The L1 chain and subchains are linked by smart contracts that set the rules governing each subchain.

Because of this, Plasma solutions can work with smart contract blockchains like Ethereum. The contracts act as bridges, allowing participants to move tokens between the main and subchains.

Still, Plasma solutions don’t lend themselves to more complex transactions, which is why they may not be ideal for certain decentralized finance (DeFi) activities.

One of the downsides of Plasma solutions is the long wait time for users withdrawing their tokens from Layer 2 to Layer 1. Sometimes they have to wait more than a week for the system to confirm that the withdrawal transaction is approved.

The most popular Layer 2s

Here are some examples of Layer 2 solutions designed to scale Bitcoin and Ethereum:

Lightning Network (investment token: BTC)

As mentioned earlier, the Lightning Network is a layer 2 channel solution aimed at accelerating bitcoin transactions. Used as a payment channel, it can move bitcoin transactions off-chain, allowing bitcoin to be used for near-instant payments.

The Lightning Network uses blockchain smart contracts to enable users to create off-chain payment bridges between two parties. For example, a local restaurant can set up a payment channel that allows users to pay in bitcoin. Once the channel is live, users will be able to make an unlimited number of bitcoin payments, with transactions being instantly confirmed off-chain. Once the restaurant closes the payment channel, all transactions are consolidated and transferred to the main bitcoin blockchain.

Without the Lightning Network, Bitcoin payments are slow and expensive, making them impractical for most payments.

Polygon (investment token: MATIC)

Polygon, formerly known as Matic, is a layer 2 sidechain solution for Ethereum. It was developed in 2017 and has managed to break into the top 20 largest cryptocurrencies by market cap ($5 billion at the time of this writing).

Using our conveyor analogy above, think of Polygon as a large factory of conveyors with the goal of scaling Ethereum using a sequence of sidechains. The platform consists of the main chain, which uses the Proof of Stake (PoS) algorithm, as well as the Polygon Software Development Kit (SDK), which developers use to build Ethereum-compatible dapps.

The great thing about Polygon’s side chains is that they can support multiple L2 technologies, including plasma chains, ZK rollups, and optimistic rollups.

Loopring (investment token: LRC)

Loopring is an Ethereum-based protocol that allows developers to build efficient decentralized exchanges (DEXes). Founded by ex-Google software engineer Daniel Wang, the Loopring ecosystem includes the protocol itself, a DEX, and a token.

Loopring aims to support efficient DEXs on Ethereum by routing and processing trades off-chain through ZK rollups. If you’re just getting started with us, DEXs don’t use central exchanges like in the case of Binance and Coinbase, but instead bring buyers and sellers together in a decentralized way using “liquidity pools”.

With ZK rollups, Loopring is helping its DEXes provide faster settlements for traders. Rather than settling trades directly on Ethereum, ZK rollups allow Loopring DEXes to perform key calculations off-chain.

Arbitrum (investment token: ETH)

Arbitrum is a Layer 2 solution for Ethereum that uses so-called optimistic rollups. While Ethereum’s mainnet can handle around 15 tps, Arbitrum can boost that number to around 40,000 tps. It’s also cheaper: transactions on Arbitrum cost less than two cents compared to several dollars on Ethereum.

Last year, Arbitrum — developed by Offchain Labs — raised $120 million in a Series B funding round, reflecting institutional investors’ confidence in Layer 2 solutions that can scale Ethereum.

As of this writing, there is no custom token for Arbitrum: investors need to invest in ETH, the underlying L1.

Investor Takeaway: Find the winners, buy and hold

Layer 2 solutions are essential for blockchain adoption in financial and other sectors. In the early years of blockchain, Layer 1 networks could handle all transactions with little effort. However, as the number of users grows, Ethereum and other Layer 1 networks have to deal with congestion and high transaction fees, hampering adoption and angering users.

Layer 2 solutions do a great job of scaling Ethereum, Bitcoin and other Layer 1 networks and helping them become more flexible. In this way, they are accelerating the adoption of blockchain.

The smart and patient investor can find the early winners and hold them for the long term: It could be like investing in Microsoft in 1999.

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