Remember when 16 gigabytes of storage space on your smartphone was an incredible amount? Just as your smartphone technology has adapted to today’s demands, so have many of the world’s leading cryptocurrencies.
Why layer 2 is necessary
A few years ago, blockchains were more than capable of handling the traffic on their respective networks. Since then, the number of users has grown exponentially. As more people use cryptocurrencies today, these networks are bogged down with traffic. The traffic on some of these blockchains leads to high costs and slow processing times.
To reduce congestion, developers have created secondary blockchains that interact with the main blockchain. This technology is known as a Layer 2 protocol. They have virtually no capacity limits, increase transaction speeds, lower costs and make Layer 1 blockchains more efficient.
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Processing transactions quickly and cheaply is known as scaling. Bitcoin and Ethereum have become some of the most infamous Layer 1 blockchains that don’t scale well. Bitcoin can only process about 5 to 7 transactions per second, and Ethereum processes about double that amount.
Layer 1 vs. Layer 2: A Real World Comparison
Let’s imagine transactions on a blockchain as mail items. Carriers that deliver mail only by car are similar to a Layer 1 blockchain that doesn’t scale efficiently (Bitcoin or Ethereum.)
Some carriers use airplanes to carry mail. They are able to effectively transport large volumes of mail and parcels over long distances. These planes that carry mail are the equivalent of Layer 2 protocols. The mail still arrives at the same place, albeit much faster and cheaper.
Likewise, Layer 2 protocols can hold more transactions and “deliver” them to the Layer 1 blockchain at a later date. The end result is still the same, but the mode of transport is slightly different.
Rollups, side chains and channels
There are several methods that Layer 2 solutions use to interact with the Layer 1 blockchain they support. Rollups, side chains, and channels are all examples of Layer 2 methodologies. Each has advantages and disadvantages. The most important thing to remember is that they all achieve the same goal; increase transaction speeds and reduce costs for Layer 1s.
Rollups bundle multiple transactions into one and deposit them back to the Layer 1 blockchain at a later date. They are really a second layer on top of the Layer 1 blockchain. One of the most famous roll-ups for Ethereum is Loopring.
Unlike rollups, sidechains are completely separate blockchains that simultaneously connect and forward transactions to the Layer 1 network instead of waiting. Think of a side chain as a bridge connecting the two blockchains. For example, Polygon is a high-profile side chain that helps to scale Ethereum.
Channels track multiple payments between two users, a bit like rollups. Unlike rollups, however, channels record only two transactions on the Layer 1 blockchain. If the same dollar were sent back and forth between two people 20 times, rollups would have 20 transactions. With channels, only the final amount each user owns is added to Tier 1. The Lightning Network is considered a Layer 2 solution and is the most popular scaling option for Bitcoin.
The Blockchain Trilemma
So why don’t all Layer 1 blockchains need a Layer 2 solution? The answer lies in understanding certain limitations of building a blockchain.
Scaling is one of the three defining characteristics that make up a blockchain. The other two are decentralization and security. These three characteristics have come to be known as the “Blockchain Trilemma”, a term coined by Ethereum founder Vitalik Buterin. It is called a trilemma because there is no blockchain that does not compromise at least one of these three facets. As of now, there is no cryptocurrency that can achieve maximum scalability, security and decentralization.
In other words, cryptocurrencies choose two out of three of these features to focus on, at the expense of the third.
An overview of the top 10 cryptocurrencies by market cap today shows that some are scalable and secure, some are secure and decentralized, and some are decentralized and scalable. The important thing to note is that no one can achieve a maximum of all three. There is always some sort of trade-off.
Cryptocurrencies like Cardano, Avalanche or Solana are Layer 1s that have made a name for themselves by taking advantage of Bitcoin and Ethereum’s scaling problem. The aforementioned cryptocurrencies can process thousands of transactions per second, but they sacrifice decentralization or security. In contrast, Bitcoin and Ethereum are two of the most secure and decentralized cryptocurrencies.
Layer 2’s for the long term
As of March 2022, Bitcoin and Ethereum made up more than half of the total cryptocurrency market cap. These blockchains support a large number of users and DeFi ecosystems. Other Layer 1s (Cardano, Avalanche, Solana, etc.) are starting to gain more market share, but they lack some of the intrinsic decentralization and security that makes Bitcoin and Ethereum so unique.
For users who appreciate these features, the Layer 2 utility promotes these blockchains that would otherwise be expensive and slow.