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Overview of Layer 2 Scaling Solutions

Layer 2 Scaling Solutions Overview

Written by Kyle Niedzwiecki

Co-founder & CTO of Black Mountain Investment Group and Portfolio Manager & CEO of The Jupiter Fund.

December 18, 2022

A relatively new blockchain technology called the “layer 2” become one of the most prevalent crypto buzzwords during the last cycle’s mania.

This is partially from investors and entrepreneurs latching on to any new technology to enter the space, but also from larger, more well-established projects like Polygon and Loopring leading the pack in terms of both adoption and development of distributed ledger technology.

In this article, we breakdown how layer 2 technology works and is related to layers, some key features and benefits to using the second layer on top of the Ethereum network (compared to more vertically integrated layer 1s), as well as some of the potential challenges layer 2s face.  

In general, but especially during the last cycle as they became more popular, many blockchain networks started to experience scaling issues, as evident in one way by extremely high Ethereum gas prices. A layer 2 blockchain protocol presents a solution to this problem.

Layer 2s allow blockchain networks as a whole to process more transactions faster and cheaper without increasing the load on the primary, layer 1 network. This makes layer 2 blockchain technology a valuable tool for businesses and organizations that want to use popular layer 1s without the massive costs and congestion. 

What is a Layer 2 Blockchain?

Layer 2 blockchain technology seeks to improve the scalability and speed of transactions on a blockchain network in its entirety. These technologies usually include features like off-chain payment systems, data storage solutions, and more. By using layer 2 tech, users can take advantage of the security and stability of the primary blockchain network while also enjoying the benefits of faster transaction speeds and lower costs. 

There are several different layer 2 blockchain technologies, including side chains on Ethereum, The Lightning Network on Bitcoin, and Plasma (a separate blockchain anchored to Ethereum Mainnet but executing transactions off-chain with its own mechanism for block validation). 

Each of these technologies have their own benefits and drawbacks, but they all share the common goal of making layer 1 blockchain technologies more efficient and scalable. 

How does a Layer 2 Blockchain Work?

Layer 2 blockchains work by creating a second layer of transactions that are not stored on the main blockchain. Instead, they are stored on a secondary blockchain that is linked to the main, layer 1 blockchain, such as Ethereum. 

Layer 2 Scaling Solutions Overview

Layer 2 blockchains work by creating a second layer of transactions that are not stored on the main blockchain. Instead, they are stored on a secondary blockchain that is linked to the main, layer 1 blockchain, such as the Ethereum blockchain. Layer 2 blockchains, an example of this is called the Bitcoin Lightning Network on Bitcoin, handle their cryptographic computation off chain in order to lower transaction costs, improve transaction speed, and the overall time for processing transactions. The Bitcoin Lightning Network is a scaling solution that offers lower transaction fees, extremely high transaction throughput, and is responsible for the emergence of more complex transactions on the network with creating the first NFTs on chain.

Second, they use what’s called “state channels” to keep track of the transactions between pairs of users. These channels significantly reduce the amount of data needed to be stored on the blockchain, making the network faster and more efficient.  

Lastly, most layer 2 networks use a framework called “payment channels” which allow users to make payments without having to wait for each transaction to be confirmed by the blockchain, in turn making the network more user-friendly by creating much faster transactions. Payment channels are what you call the fraud proof layer of the Ethereum network and is an integral part of layer 2 scaling solutions.

There are several layer 2 scaling solutions that are currently being developed. These include payment channels, state channels, and side chains. Each of these technologies has the potential to help networks grow and scale. Payment channels can help networks process payments faster and more efficiently, state channels can help networks manage their data and operations more effectively, and side chains can help networks create new products and services.  

Payment Channels — Payment channels are a way to send value back and forth between two parties without putting the transaction on the blockchain. This feature has the potential to save a lot of time and money, as well as keep transactions private if desired. There are two main types of payment channels: layer 2 and off-chain. Layer 2 payment channels are built on top of a blockchain, while off-chain payment channels are separate from any blockchain.  

Layer 2 payment channels have the advantage of being more secure, as they are backed by the underlying blockchain technology, however, they can also be more complex to set up. Off-chain payment channels, on the other hand, are much simpler to set up, but they are not as secure. This is because they are not backed by any blockchain technology. If security is your top priority, then a layer 2 payment channel is the way to go. However, if you want something simpler and faster, then an off-chain payment channel may be the better option. 

State Channels — State channels are a type of blockchain technology that allows for fast, cheap, and private transactions. They are an important tool for scaling blockchains and can be used for everything from payments to smart contracts. Layer 2 state channel solutions have become increasingly popular in the blockchain space as they offer a way to scale without sacrificing decentralization or security. State channels are a key part of The Lightning Network’s layer 2 Bitcoin solution, which is one of the most well-known scaling solutions for the Bitcoin network.  

While state channels have many benefits, they also come with some risks. For example, if one party to a state channel goes offline, the other party may not be able to access their funds. Additionally, state channels are not yet widely adopted, so there may be limited options / opportunities for using them.

Overall, state channels offer a promising solution for scalability and privacy on blockchains. They are still relatively new, so there are some risks to consider. But as adoption grows, state channels could become an important part of the blockchain ecosystem as a whole.  

Side Chains — Side chains are essentially separate blockchain networks that are connected to the main blockchain. This allows for transactions to be processed off-chain, which can greatly improve scalability. There are a few different ways to implement side chains, but the most popular is probably the Plasma protocol. Plasma is a framework for creating side chains that allows for potentially unlimited scalability.  

Plasma works by dividing the blockchain into small chunks, or “blocks.” Each block can contain a certain number of transactions. Once a block is full, it is sent to the main chain for verification. This process is repeated for each new block, and then the side chain can scale to potentially millions of transactions per second.

This is a drastic improvement over the current scalability of most blockchains. 

Layer 2 Blockchains with the Highest Recorded Transactions Per Second (TPS) 

Highest Recorded TPS by Blockchain
  1. Loopring
  2. Ethereum
  3. Arbitrum One
  4. ZKSync
  5. Optimism
  6. Sorare
  7. ZKSwap
  8. Polygon Hermez
  9. Metis
  10. DeversiFi

What does the Max Recorded TPS signify?

Max Recorded TPS is a technical term that signifies the maximum number of transactions that can be processed by a blockchain network per second. In other words, it’s a measure of how fast a system can handle multiple transactions together.

After all, the faster a network can handle transactions, the more efficient it is. And efficiency is key to ensuring that users are happy, and that the network is profitable. Without ease of use and efficiency, there will be no users, and without users that blockchain network has no value.  

the above table identifies the leading layer 2 blockchain networks which concludes that Loopring has the highest max recorded TPS by far and is arguably the fastest L2 network. Ethereum came in 2nd place, although it is a layer 1 network, so it isn’t calculated in the total.  

If you’d like to learn more about layer 1 transaction fees and block finality times, you can check out our layer 1 article here. Arbitrum One and ZKSync are next in the list and great layer 2 networks, however, they don’t come close to stacking up against Loopring’s max recorded TPS.  

Finally, we have Polygon Hermez. Polygon’s layer 2 solution is interesting because of how talked about this technology has been in the media. Examining this network up close though, we can easily see that the average 1 day TPS is 0 and the max recorded TPS is a little above 4.

In the next section, we’ll examine the key similarities and differences between ZK rollups & optimistic rollups, a key function of layer 2 technology used to reach these max recorded TPSs.  

ZK Rollups & Optimistic Rollups

Given the astronomical gas fees, especially before switching from PoW to PoS, the Ethereum community is one of the communities that has been at the forefront of exploring different ways to scale the network for some time now. One promising solution is called “rollups”, which can be used to improve the efficiency of a network.  

There are two types of rollups: ZK (Zero-Knowledge) rollups and “Optimistic” rollups. ZK rollups use zero-knowledge proofs to allow users to validate on-chain transactions without having to download the entire blockchain. This can lead to even more significant efficiency gains as it allows for much smaller data sets to be processed.  

The Zero Knowledge Rollups are anchored by two on-chain smart contracts: the main contract and the verifier contract. These contracts are responsible for several functions and are critical to the build of the ZK-rollup. The main contract stores rollup blocks, monitors the blockchain’s state and tracks fund deposits / withdrawals. The verifier contract, on the other hand, authenticates the zero-knowledge proofs submitted to Ethereum’s mainnet.  

Optimistic rollups, on the other hand, use a technique called “data availability” to allow users to keep track of the data they need without having to download all the transaction data and entire blockchain. The key difference between the two is that optimistic rollups rely on fraud proofs to process transactions, while zk-rollups rely on zero-knowledge proofs to verify changes to the main chain (a state transition).

Optimistic rollups are a trust-based system in which the smart contract on the layer 1 chain does not check the validity proofs of state transitions until a fraud proof is posted. In optimistic rollups, when a validator posts a new state root, the smart contract on the layer 1 simply takes the validator’s word at face value and accepts the state transition. Hence, optimistic rollups’ name, optimistic rollups assume transactions.

The Ethereum community is still exploring which type of rollup is best suited for the network. However, both types of rollups have the potential to notably improve the scalability of Ethereum transactions. You can think of the Ethereum layer 1 network as the island of Manhattan, where the Manhattan Bridge, Brooklyn Bridge, Williamsburg Bridge… etc., are the current layer 1 scaling solutions of hard / soft forking the consensus mechanisms. 

Because of the limited access routes, there is pretty much gridlocked traffic at all times of the day, which is the same congestion Ethereum is facing today, and especially was at the top of last market cycle when there was so much attention around it and therefore an influx in users.  

Layer 2 scaling solutions essentially add additional on and off ramps to the main network. More bridges would drastically reduce traffic in the city and would greatly reduce network congestion and improve transaction throughput and the scalability of Ethereum as less transactions would be stuck or have numerous transactions pending in a block.

What are the Challenges of Layer 2 Blockchains?

One of the biggest challenges of layer 2s is that it can be difficult to get everyone on board. For example, in order to use Bitcoin’s Lightning Network, both parties need to be using a Lightning-enabled wallet. Another challenge branching out from this is that layer 2 solutions are not as secure as layer 1 solutions as they don’t provide the full validity of the primary blockchain. 

Another extension of this challenge is seen on Polygon’s Hermez network. Polygon Hermez has an average of 0 transactions daily, as it appears nobody is utilizing the layer 2 technology provided by the Polygon team. The Ethereum main chain handles the majority of the network participants and is one scaling solution away from being the undisputed leader of decentralized finance. The low transaction fees as a selling point in the blockchain industry ins’t enough when it’s too confusing to switch between multiple chains just to be able to buy an NFT or a token.

This is a groundbreaking blockchain infrastructure out there for public use, though not many seem to be capitalizing on it. A very possible explanation to this is that the astronomical gas fees have come back to Earth and users don’t feel the need to transfer their funds over to a layer 2 network in order to settle transactions with gas fees that are already pennies on the dollar.

Ethereum Virtual Machine (EVM)

The Ethereum Virtual Machine (EVM) is a runtime environment that executes smart contracts on the Ethereum blockchain. It is responsible for executing the bytecode of smart contracts and is designed to be deterministic, meaning that given the same input, it will always produce the same output.

Layer 2 solutions are protocols that are built on top of the Ethereum blockchain and aim to solve the scalability issues of the network. They work by processing transactions off-chain and then settling them on the main Ethereum blockchain.

The EVM plays a critical role in layer 2 solutions as it provides a secure and decentralized way to execute smart contracts, which is essential for the functioning of many layer 2 protocols. For example, some layer 2 solutions use sidechains, which are independent blockchains that can interact with the Ethereum network. These sidechains have their own EVMs, which allow them to execute smart contracts and interact with the Ethereum network.

Other layer 2 solutions, such as state channels and plasma, rely on the EVM to execute smart contracts off-chain. In these solutions, smart contracts are executed in a separate environment, called a “commit chain,” before being settled on the main Ethereum blockchain. This allows for faster and cheaper transactions while still maintaining the security and decentralization of the Ethereum network.

Concluding Thoughts on Scaling Solutions

In conclusion, layer 2 scaling solutions are becoming increasingly important for addressing the issue of blockchain scalability and high transaction fees on the Ethereum network. By moving transactions off-chain and settling them on the main Ethereum blockchain through cryptographic proof and Ethereum smart contracts, these solutions offer a way to scale while maintaining network security and avoiding fraudulent transactions.

Rollup smart contracts, for instance, are one such solution that can process a large number of transactions off-chain before submitting them to the main Ethereum network. This not only improves on-chain scaling but also mitigates the effects of network congestion.

Furthermore, layer 2 solutions also help to maintain the network’s consensus mechanism by avoiding the need for a hard fork. With the increasing number of applications on the Ethereum network, on-chain scaling may no longer be enough to address the scalability issues, and layer 2 solutions provide a practical alternative.

While there are challenges associated with implementing layer 2 scaling solutions, the potential benefits of these solutions far outweigh the drawbacks. Overall, these solutions offer a promising way to address the scalability issues facing the Ethereum network and provide a more efficient, secure, and cost-effective way to execute transactions on the blockchain.

One of the ways layer 2 solutions prevent any fraudulent transaction by using cryptographic proof. These solutions rely on cryptographic proofs to verify the validity of transactions off-chain before submitting them to the main Ethereum blockchain. This ensures that only legitimate transactions are settled on the blockchain, while fraudulent transactions are rejected.

Overall, we do think layer 2s bring a lot to the ecosystem and will likely be an important part of blockchain technology moving forward. That being said, we are also very interested in both layer 2 solutions and 1 protocols that are able to solve for speed, scaling, and low costs in one single vertically integrated platform. Read our layer 1 article to learn more about how different layer 2 solutions and 1s stack up against each other and why ICP is a threat to the layer 2 ecosystem as a whole.

Please note that nothing put forth in this article is or should be considered financial advice.

Happy investing,

The Black Mountain Team 

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