Blockchain

Investor’s Guide to Layer-2s

Key Takeaways

  • A Layer-2 (L2) protocol is a secondary framework constructed on prime of an present, safer blockchain community to make it extra accessible.
  • They improve transaction effectivity by offloading the method from the principle chain and have shut similarities to the SWIFT messaging community in TradFi.
  • Traders can spend money on the tokens of those Layer-2 tasks, which they’ll maintain or stake to determine the long-term winners.

Desk of Contents

  1. What Are Layer-2s?
  2. Why Are Layer-2s Necessary?
  3. Layer-2s vs SWIFT
  4. Prime Layer-2 Blockchains
  5. The place Are Layer-2 Blockchains Used?
  6. Investor Outlook for Layer-2s
  7. Investor Takeaway

Whereas we frequently consider blockchain as a singular expertise, it’s layers of expertise working collectively.

Layers aren’t perfect. As soon as we begin attending to larger ranges, we’re, generally, compensating for an absence of scalability with the underlying chain. They’re a hack.

On this information, we’ll clarify what Layer-2s are and the way traders can take into consideration the last word winners of the Layer-2 race so you’ll be able to spend money on at this time’s tokens which are almost definitely to win in the long run.

What are Layer-2s?

Blockchain expertise consists of 4 layers:

  • Layer-0 (L0) includes the web and the {hardware} required to attach and talk throughout networks.
  • Layer-1 (L1) refers back to the main blockchain community, like bitcoin or Ethereum, specializing in recording transactions, forming consensus, and sustaining safety.
  • Layer-2 (L2) focuses on scaling these options
  • Layer-3 (L3) focuses on internet hosting purposes to advertise adoption.

Layer-2 refers to a set of expertise options constructed on prime of layer-1 to cut back bottlenecks (i.e., to assist the underlying blockchain run quicker and cheaper).

They depend on the L1 blockchain for safety and knowledge availability and sometimes comprise two components: knowledge packets and protocol layer. The place knowledge packets symbolize the encoded and decoded bits of data, the protocol layer focuses on transferring knowledge from one community section to a different.

Whereas Layer-1 is the inspiration of decentralized finance, Layer-2 blockchain options had been constructed to enhance scaling and compatibility with third-party purposes.

For instance, Ethereum is a well-liked Layer-1, but it surely hasn’t scaled effectively. So Layer-2 options like Arbitrum, Optimism, and Base have been constructed to make Ethereum run quicker and cheaper.

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Why Are Layer-2s Necessary?

Because the variety of blockchain customers grows, so do their scalability points. Layer-2 blockchains handle these challenges by offloading transactions from the principle chain and processing them individually. Layer-2 networks sometimes supply:

  • Decrease charges: Layer-2 protocols bundle off-chain transactions right into a single Layer-1 transaction, lowering the information load on the mainnet whereas retaining the advantages of safety and decentralization.
  • Extra utility: By permitting for larger transaction throughput, Layer-2 tasks can enhance the person expertise whereas specializing in scope and real-world usability.

Think about having to ship cash to a overseas nation within the early 1900s. You’d have to make use of gold or silver foreign money to buy a financial institution draft that might be honored abroad. You possibly can mail a financial institution draft to the particular person you needed to ship cash to.

When SWIFT was invented in 1973, the remittance course of was sluggish, reliant on particular person couriers, and susceptible to delays and loss.

SWIFT stands for The Society for Worldwide Interbank Monetary Telecommunication and is the first messaging community for worldwide funds. So far, SWIFT stays the default commonplace for worldwide cash transfers and works by sending vital details about the transaction from one financial institution to a different, together with sender title, recipient, transaction quantity, and foreign money alternate charges.

Layer-2 blockchains function equally to SWIFT. They construct and enhance present infrastructure to ease the method of sending cash. SWIFT represents a situation the place one Layer-2 blockchain turns into the first answer to scalability – we are going to all be leveraging a single messaging system to work together with the main community.

That stated, key factors additionally differentiate Layer-2 from SWIFT. Layer-2 options are decentralized, that means no central authority oversees their transactions. SWIFT is a centralized system managed by a consortium of banks.

Due to the involvement of a number of intermediaries and the rigorous processes of TradFi, SWIFT transactions take longer to settle than their blockchain counterparts.

Prime Layer-2 Blockchains

Every sort of Layer-2 solves a distinct ache level. Relying on a blockchain’s or a person’s necessities, one Layer-2 answer could also be higher than others.

  • State Channels: A state channel is a blockchain second-layer answer permitting contributors to carry out limitless non-public transactions off-chain. That is perfect for conditions that require frequent, bidirectional transactions, like in-game microtransactions and live-stream donations.
  • Optimistic Rollups: To course of transactions faster, Layer-2 options can mixture a number of off-chain transactions into one, assume that they’re legitimate by default, and solely run computations in case of a dispute. That is how optimistic roll-ups function and are good for DApps and DeFi platforms.
  • ZK Rollups: Zero-knowledge rollups create safer blockchains than optimistic rollups by compressing transaction knowledge, validating the transactions off-chain, and sending this info to the principle chain. Like optimistic rollups, the sort of Layer-2 is ideal for dapps and DeFi platforms, providing enhanced privateness and effectivity.
  • Plasma: Providing the best diploma of safety amongst Layer-2 sorts, plasma chains create a sequence of kid chains as secondary chains that help the principle blockchain with verifications, linked by sensible contracts that allow the principle chain to information the kid chains.
  • Sidechains: Sidechains are impartial blockchains that run parallel to the principle blockchain. It’s good for purposes that require customizable options and impartial governance from the principle chain whereas nonetheless resolving operations on the bottom layer.
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The place Are Layer-2 Blockchains Used?

As a result of Layer-2 protocols lengthen the capabilities and scalability of a central blockchain community, they empower these tasks to help (and disrupt) industries rather more readily. A few of these industries embody:

DeFi

Enhancing transaction pace is vital for DeFi, particularly in buying and selling, the place well timed execution is the distinction between earnings and losses. Loopring, for instance, makes use of ZK-Rollups to facilitate high-speed trades and transfers for his or her merchants.

Dapps

With batch processing and enhanced interoperability, dapps might course of extra transactions throughout many purposes. Polygon is a Layer-2 scaling answer that permits dapps to perform throughout totally different blockchain platforms with out compromising efficiency.

Micropayments

As a Layer-2 answer lowers common transaction charges, micropayments come at a a lot decrease value for customers. Gaming ecosystems and stay streamers can use this characteristic for monetization functions or pay-per-use fashions.

Investor Outlook for Layer-2s

The historical past of expertise may give us some clues as to how the Layer-2 race will play out.

Usually, a brand new expertise sees an explosion of recent opponents (serps, social media websites, and so on.), which steadily coalesce into a number of situations:

  1. Monopoly: You’ve one dominant answer that beneficial properties many of the market share as a result of it turns into too inconvenient to make use of the rest. (Suppose Google in search.)

    Underneath this situation, one huge Layer-2 will dominate every of the first Layer-1 blockchains. (And there might solely be one main Layer-1 blockchain as effectively.) On this situation, the present winners can be Ethereum (ETH) and Polygon (MATIC), so traders would alter their bets accordingly.

  2. Oligopoly: You’ve two or three dominant options that successfully crowd out the remainder of the market (assume Apple and Home windows or iPhone and Android).

    Just a few Layer-2s might survive on this situation, every providing considerably totally different developer advantages. For traders, the Layer-1 guess would nonetheless most likely be Ethereum (ETH), however the Layer-2 bets would nonetheless be too early to inform.

  3. Disruptive Know-how: Typically, the basic expertise adjustments or is disruptive. (Disk drives, CD-ROMs, digital music shops, and so on.).

    No Layer-2 might win out on this situation as a result of Layer-1s determine a strategy to turn into extra scalable with out them. Ethereum (ETH) can be the first long-term funding on this case.

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In the interim, Layer-2 options are including worth. However it should doubtless be a winner-takes-all or a winner-takes-most final result. Until, in fact, Layer-1s enhance considerably, rendering Layer-2s nugatory.

Investor Takeaway

For traders, Layer-2 options current each alternatives and challenges.

An clever investor ought to analysis the distinct options of every Layer-2 answer, however extra importantly, their market traction. Are they attracting actual customers – not simply traders hoping for the airdrop, however actual customers utilizing them and actual builders growing on them?

That is the early days for Layer-2s. Sooner or later, they may both consolidate or be rendered out of date. High quality Layer-1s like Ethereum are nonetheless doubtless the safer funding for many traders.

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