What is Layer 2 on Ethereum?
Deep dive into Layer 2 solutions for ETH: faster transactions & cheaper fees
Dear Sunday Investors:
Welcome to this week’s edition of the Sunday Investor! To our new members, the format of this weekly newsletter will be a deep-dive into one investment-topic. This week, we will focus into layer 2 protocols on Ethereum. We will discuss what Layer 2 is, why it is needed for Ethereum, the different technology powering Layer 2 protocols on ETH, as well as potential opportunities to invest Layer 2 protocols moving forward.
Read, enjoy and share with any friends. Let’s build wealth together.
Weekly Market Recap
Let’s dig into some of the most important events that happened in the markets in the last week:
Bitcoin hash rate (mining power) has made a new all time high. A little over six months following the China mining ban, the Bitcoin Network is stronger than ever before. (graph) — Dylan LeClair
The US consumer price index (CPI) inflation rate came in at 6.8% which is a 39 year high. "Energy prices have risen 33.3% since November 2020. Gasoline alone is up 58.1%." — Michael Ippolito
Metaverse social mention trends have eclipsed all-time-highs since the initial announcement from Facebook changing their name to Meta back in October. This week, Bill Gates shared his bullish belief that the metaverse will facilitate all of our corporate meetings in the near future.
Ledger, the company well-known for its crypto hardware wallets, announced its working on a debit card that connects directly with a crypto wallet.
What are Layer 2 Blockchains?
Ethereum ($ETH) is one of the most popular blockchains for both developers and end-users for the plethora of decentralized applications that are being created every day. With this exponential growth has come some challenges for the Ethereum network as a whole which are average transaction speeds and high gas fees to facilitate transactions.
The limitations of slow transactions and high gas fees are where Ethereum Layer 2 solutions come into the picture
In the Ethereum developer docs, Layer 2 is defined as a collective term for solutions designed to help scale decentralized applications by handling transactions off the Ethereum Mainnet (layer 1) while taking advantage of the robust decentralized security model of Ethereum. Think of Layer 2 solutions as taking transactions off of Ethereum’s main Layer 1 chain, completing them on a faster L2 chain, and then bringing the completed transactions back to the L1 chain when done to ensure proper decentralization and security.
Layer 2 solutions are built on top of the Ethereum network and require no changes to the Layer 1 solution. Layer 2 is needed for specific use-cases like blockchain game games which need instant transaction times. More on other reasons for why Layer 2 solutions are needed below:
Ethereum’s Layer 1 can handle about 15 transactions per second, while some Layer 2 projects can ramp it up to 4,000 transactions per second.
Scalability upgrades to the Layer 1 Ethereum network are slated for the upcoming years, but for now, Layer 2 seems to be enough to prevent dApps from leaving Ethereum in the short term.
Surge of Layer 2 on Ethereum
The total value locked (TVL) on Ethereum layer-two networks has surged to a new peak as gas fees continue to steadily rise which is a core reason for driving further adoption.
Layer-two analytics platform L2beat currently reports that the total value locked (TVL) across various layer-two protocols and networks has reached an all-time high of $5.64 billion.
Layer-two scaling solutions provide much higher transaction throughput and lower transaction fees, and they have surged in terms of adoption in the last few months which have seen the highest average gas fees in Ethereum network history as shown above.
Let’s now dig deeper into the different technology behind the ways that layer 2 protocols accomplish lower transaction fees and faster transaction times.
The Two Types of Rollups
Rollups are solutions that perform transaction execution outside of Ethereum’s chain (Layer 1), but after they execute the transaction on Layer 2, they post back all of the data from the transaction back onto Layer 1, which makes it just as secure.
There are two main types of rollups which power Layer 2 solutions with different security models which we will go into below:
Optimisic Rollups:
Benefits: Fast, low fees, compatible with anything on Ethereum (even DeFi) and secure as all transaction data is stored on the layer 1 chain as well
Challenges: Long wait times for on-chain transactions and withdrawals due to there being 1 week for invalid transactions to be removed by network participants
Examples: Arbitrum, Optimism, Boba
Zero-Knowledge Rollups:
Benefits: Faster finality times as the transaction is instantly verified right when the proof is sent back to Ethereum, secure as all transaction data is stored on the layer 1 chain as well
Challenges: Some do not have support for everything that can be done on Ethereum like DeFi, and the proofs for transactions require intensive computation and there needs to be specific proofs for every type of transaction to work properly.
Examples: Loopring, Starkware, Matter Labs, zkSync, Polygon Hermez
Sources: Much more on L2 solutions written on Ethereum.org here. For videos that go into depth on this, check out the Finematics YouTube channel.
Investing in Layer 2 & ETH Side-Chain Protocols:
So now that we know why Layer 2 protocols have started experiencing exponential growth, lets look into ways we can invest in this.
As Bankless says, while the design space for L2 tokens is emerging, and it is unclear if all networks will have one, L2 tokens play a similar role to L1 tokens in providing index-like exposure to a given network. And although it is unclear if all L2s will issue tokens, there are investing opportunities for users to put themselves in position for retroactive farming rewards.
Polygon ($MATIC)
Polygon Network is the largest ETH sidechain and its low fees, high throughput and incredible ease of porting Ethereum DApps to the network has made it wildly popular.
Polygon has plans for L2 solutions in both ZK-rollups, and optimistic rollups in the works as well with its array of recent acquisitions.
Polygon Network’s utility token, Polygon ($MATIC), is used for governance, staking for interest and paying transaction fees and can be bought on many exchanges.
Loopring ($LRC)
Loopring is one of the most prominent application-specific rollups within the Ethereum scaling ecosystem, providing a suite of products built on their ZK-rollup including an AMM and order-book exchange.
Investors can gain exposure to the protocol, which has generated over $2.7 million in revenue over the past year through the LRC token, which governs the system.
Optimism & Arbitrum ( No tokens…. yet)
The two largest optimistic rollups networks which both of which have raised millions of dollars in funding, currently both do not have tokens.
Possible Airdrop? While it is unclear if these projects will ever have tokens, it is likely worth being an active user of these systems in the event that they ever launch a retroactive airdrop for users who would get “dropped tokens” into their wallets for being early adopters.
One to way to get paid to use Optimism’s network:
If you want to use a decentralized exchange with an L2 solution like Optimism today, a popular DEX Perpetual Protocol that I use is offering a $200 USDC airdrop for any new user who deposits $100 or more to their platform, and who makes 1 trade on their exchange. More info here for those interested!
Next Week
Next week, we will be be back in business taking a deep dive into a new investing topic!
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Not financial or tax advice. The content in this newsletter is for informational purposes only. Every investment and trading move involves risk. Do your own research when making a decision.