Trends to Watch: Ethereum Layer-2 Solutions

Prediction: ETH Layer-2 Solutions will compete with other L1 blockchains in 2022.

Inside.com Part of   Network December 29, 2021

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Trends to Watch: Ethereum Layer-2 Solutions As the Ethereum blockchain continues to push capacity, it has repeatedly faced significant limitations that have plagued the network over the past year. With high demand for space for the network comes slower transaction times and astronomical gas fees. Even if you weren’t following the performance of the Ethereum blockchain, you’ve certainly experienced these limitations if you’ve purchased an NFT on a secondary market or tried your luck in an NFT minting-fueled gas war.  Source: Etherscan.io Ultimately, the inefficiencies and limitations experienced by the Ethereum blockchain have led to the rise of Ethereum scaling solutions. Scaling solutions are extensions to the Ethereum network that strive to increase transaction speed (faster finality) and transaction throughput (high transactions per second or tps) without sacrificing decentralization or security. Of the various implementations of scaling solutions available, Layer 2 (L2) scaling solutions have experienced a high level of adoption in the second half of 2021.  Over the past year, the total value locked (TVL) in L2 solutions has grown over 1,200% from $48M to nearly $6B and reached an all-time high of $7.16B in late November. What’s more impressive is that this growth metric adopts a narrow definition of an L2 solution that doesn’t even include major L2 players like Polygon, which saw such a high adoption rate this year that the total amount of daily active Polygon addresses surpassed Ethereum back in October. Source: L2Beat The relatively recent rise to adoption for L2 solutions was not without competition, either. In discussions surrounding the scalability of the Ethereum blockchain, there’s always the question: why even build on Ethereum at all when there are faster and cheaper Layer 1 blockchains already out there? Solana already has nearly a 3,000% higher throughput at 1,361 tps with average transaction costs as low as $0.00025. In the alternative, Avalanche can reach speeds as high as 4,500 tps with a transactional finality of less than 2 seconds.  The blockchain developer urge to rage quit Ethereum is real and supported by the fact that Ethereum’s percentage of the total value locked (TVL) across all blockchains dropped from 96.91% at the start of 2021 to 62.45%. Yet, Ethereum’s percentage of TVL is still $154.72B and doesn’t account for the TVL in L2 like Arbitrum ($1.89B).  Source: DeFi Llama While L1 blockchain alternatives certainly dominated the majority of 2021 and will continue to gain in popularity in 2022, I believe that the emergence of Ethereum L2 solutions in late 2021 and their ability to cannibalize Ethereum’s TVL gives L2 solutions their own individual right to be a trend to watch in 2022.

TOP LAYER 2 PROJECTS (market share) # Name TVL Market Share 1 Arbitrum $2.43B 44.06% 2 dYdX $975M 17.68% 3 Loopring $546M 9.90% 4 Boba Network $508M 9.22% 5 Optimism $437M 7.93% Source: L2Beat Note: LRC tokens account for 77.33% of Loopring's TVL. BOBA and OMG tokens account for 52.84% of Boba Network's TVL.

A Brief Guide to L2 Solutions Layer 2 scaling is an off-chain solution, meaning that they are implemented separately from the Ethereum Layer 1 Mainnet and require no changes to the existing Ethereum protocol. As an off-chain scaling solution, Layer 2 solutions operate independently from the Ethereum mainnet but continue to derive their security directly from the layer 1 Ethereum consensus.  In general, L2 transactions are submitted on L2 nodes instead of directly on L1 before later reattaching the L2 transactions on the Ethereum blockchain. The specific implementation of how this communication transaction works varies depending on which type of L2 solution is being utilized. Of the different types of L2 solutions, there are two major categories (not including sidechains): Rollups and Plasma. Layer 2 scaling is an off-chain solution, meaning that they are implemented separately from the Ethereum Layer 1 Mainnet and require no changes to the existing Ethereum protocol. As an off-chain scaling solution, Layer 2 solutions operate independently from the Ethereum mainnet but continue to derive their security directly from the layer 1 Ethereum consensus.  In general, L2 transactions are submitted on L2 nodes instead of directly on L1 before later reattaching the L2 transactions on the Ethereum blockchain. The specific implementation of how this communication transaction works varies depending on which type of L2 solution is being utilized. Of the different types of L2 solutions, there are two major categories (not including sidechains): Rollups and Plasma. Rollups Rollups are scaling solutions that execute transactions off-chain but later store the information back on the Ethereum blockchain. In doing so, rollups enjoy the continued security and validity of the Ethereum blockchain while increasing state storage and transaction speeds by storing the information off-chain. Rollups are primarily useful for three reasons: (1) reducing fees for users, (2) open participation, and (3) fast transaction throughput. Rollups can be further broken down into subcategories based on how they receive security from the Ethereum blockchain. The two main categories of rollups are optimistic rollups and zero-knowledge (ZK) rollups.  Optimistic rollups assume by default that transactions are valid and will only review for fraud in the event that a transaction is challenged. Four of the top 10 L2 solutions utilize an optimistic rollup solution (Arbitrum, Boba Network, Optimism, and Metis Andromeda). Instead of sending transactions to the blockchain by default, zero-knowledge rollups confirm their transactions off-chain ahead of time before sending a validity proof back to the Ethereum blockchain. These proofs are known as succinct non-interactive arguments of knowledge (SNARK). Though ZK rollups are less vulnerable to economic attacks than optimistic rollups, they lack compatibility with Solidity and cannot utilize smart contracts. Zero-knowledge rollups are the second most common L2 solution behind optimistic rollups and are used by projects like dYdX, Starkware, Loopring, ZKSwap, and zKSync. Plasma Plasma is the second major L2 solution that functions as its own chain. Plasma chains are anchored to the Ethereum chain and are often known as “child” chains to the Ethereum mainnet. Like optimistic rollups, plasma solutions utilize fraud proofs as a way of verifying the validity of data in the event of a dispute. Popular plasma solutions include the OMG Network (transitioning to Boba Network), Polygon, and others. Because these chains can rely on separate node operators, they are sometimes not considered to be L2 solutions and more closely resemble sidechains.

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Ethereum 2.0 Will Further Boost L2 Adoption While L2 solutions have proven successful for this iteration of the Ethereum protocol, some have been skeptical of their continued success, seeing these solutions as temporary holdovers until the launch of the proof-of-stake (PoS) Ethereum 2.0 protocol release, which is expected to merge with the Ethereum mainnet in Q1/Q2 2022. To get an idea of the potential effects Etheruem 2.0 could have on the future of L2 solutions, it can be helpful to take a look at how a recent scalability upgrade, EIP-1559, affected L2 solutions. EIP-1559 Source: @cembar, EIP-1559 Dashboard (Dune) EIP-1559 was an Etheruem improvement proposal written by multiple contributors, including Etheruem’s co-founder Vitalik Buterin. The proposal’s goal was to implement a transaction pricing mechanism that would burn a fixed amount of Ethereum and dynamically change block sizes to combat network congestion and variable gas fees. The proposal was implemented as part of Ethereum’s London upgrade on Aug. 7 and quickly burned $30M in ETH within its first 48 hours. The launch of the upgrade brought about changes to the macroeconomic policies of the Ethereum network but ultimately didn’t cause a drop in actual gas fees. In fact, it did the opposite. EIP-1559 was able to relatively stabilize gas fees at its launch, but it did so by reducing the bottom half of the extreme, making gas fees consistently high. Just over a month after the launch of EIP-1559, the TVL in L2 solutions jumped by over $3B. Ethereum 2.0 Source: Ethereum.org Ethereum 2.0 is a major upgrade to the Etherum network’s infrastructure that will see the transition of Ethereum’s consensus algorithm from proof-of-work (PoW) to proof-of-stake (PoS). Among other things, the upgrade will be implemented in stages, aimed at increasing the network’s throughput and scaling its transaction speeds. Similar to EIP-1559, it seems that Ethereum 2.0 will cause an impact on ETH’s macroeconomic policy, but not the need for L2 solutions. In a note written by Vitalik regarding the implementation of the upgrade, Ethereum 2.0 is anticipated to strike a balance between L1 and L2 features.  While the upgrade will tackle scalability and computation issues, doing so will provide additional benefit to the L2 solutions that interact with the Ethereum blockchain. The Ethereum blockchain currently operates at around 15 tps, with rollup solutions offering throughput speeds of around 3,000 tps. Ethereum 2.0 brings a theoretical maximum throughput of 1,000-2,000 TPS, giving way for rollup solutions to offer a potential maximum of 100,000 TPS. Further, the Ethereum 2.0 upgrade deliberately leaves open innovations in privacy and scalable state storage for L2 solutions. Although not touched on in this newsletter, L2 solutions can be implemented for purposes other than scalability. For example, privacy rollup solutions like StarkWare have grown in popularity for their ability to solve scalability issues while simultaneously offering a way to make transactions less transparent on a public blockchain. In summary, Ethereum 2.0 presents an opportunity for the improvement of L2 transaction and finality times in the same way that it will help Ethereum L1. Due to the multi-phased release of Ethereum 2.0 starting in Q1/Q2 2022, L2 solutions will continue to operate in the same capacity for the beginning of the new year and will feel a positive impact from the release of the upgrade within the mid- to long-term horizon.

INSIDE CRYPTO EVENT RECAP: The Future of Finance is DeFi In August, Inside held a DeFi event exploring layer-2 solutions, decentralized finance, and other key industry insights with thought leaders, investors, and founders in the DeFi space, including: Camila Russo - The DeFiant Santiago Roel Santos - ParaFi Capital Jehan Chu - Kenetic Ramon Recuero - Babylon Finance If you missed the event, check out the full event playlist on our YouTube page!

Prediction: L2 Solutions Will Compete With L1 Alternatives in 2022 Based on the trends of L2 solutions in 2021, my prediction for 2022 is that L2 solutions will compete with L1 blockchains. In doing so, Ethereum will become a "blockchain of blockchains" by creating a base layer for communication among L2 solutions while providing security across the ecosystem. This concept has been discussed on several occasions by Vitalik, with a 2020 prediction that the Ethereum ecosystem will likely be "all-in on rollups (plus some plasma and channels) as a scaling strategy" for the near- and mid-term future. This opinion was supported by a recent proposal from Vitalik suggesting the future of Ethereum could be furthered through sharding and ZK rollup solutions. When looking at L2 solutions in light of the upcoming Ethereum 2.0 upgrade, phase 1 of the upgrade plans to create "data availability layers" for the blockchain but will not support smart contracts. To enable early access to this data, some upgrades have been proposed for the Ethereum blockchain to allow for rollups to verify data from Ethereum 2.0, reducing overall network congestion. As stated in the Ethereum 2.0 section, this will enable a theoretical 100,000 TPS and give rollup solutions the first chance at accessing it and seamless integration into future developments in the upgrade's progression.  Source: @0xTrent, Twitter The throughput speeds that could be experienced by rollups in the mid-term future would far surpass Solana, Avalanche, or other L1 blockchains in their current state and would have the additional advantage of being able to verify data from other L2 solutions due to their shared L1. Given the advantage that Ethereum already has in terms of network effects, its ability to bring operational L2 solutions directly on the Ethereum blockchain would further drive mass adoption to Ethereum and maintain the blockchain's virtual monopoly on NFTs, DeFi, and Web3.  Whether or not you believe that blockchains are competing against each other or that Cardano or some other blockchain could be the next Etheruem killer, L2 solutions have the potential of putting Ethereum in a league of its own. For their ability to create a better experience on the Ethereum blockchain and the opportunity for them to compete against L1s in their own right, L2 solutions are definitely going to be a trend to watch in 2022.

Do you think Ethereum Layer-2 solutions will emerge as competitors to Layer-1 blockchains in 2022? Yes No

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Griffin McShane is a New York transplant currently living in Brooklyn, NY. He is a graduate of Providence College, where he studied both computer science and business, and the University of Maine School of Law, where he earned his JD. Beyond his work at Inside, Griffin has written articles for CoinDesk and is a member of the International Association of Privacy Professionals (IAPP). Editor Aaron Crutchfield is based in the high desert of California. Over the last two decades, he has spent time writing and editing at various local newspapers and defense contractors in California. When he's not working, he can often be found looking at the latest memes with his kids or working on his 1962 Ford.

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