Gas fees skyrocket, can Layer 2 expansion solve the urgent need?

The programmability of Ethereum allows developers to devise several scaling solutions that are not possible on Bitcoin. In the past, this often just meant creating new smart contracts. This allows teams to quickly access funding, usually in the form of ERC-20 tokens, and shift their focus to building a scalable protocol. Several of these protocols launched a year or so later with extremely low adoption. This is due to the bear market leading to diminishing interest in the crypto, coupled with low interest prior to the launch. At the end of 2019, however, the tide started to turn. A market reversal, increased interest, increased network utilization, and several technical developments have brought Layer 2 projects back into the limelight.

Since January 2020, increased utilization of the Ethereum network, along with a 10x increase in transaction costs, has encouraged some teams to officially launch projects they have long been working on. Recently, we have seen many projects launched in the past few months, and they are engaged in a fierce competition for adoption and attention. This article describes these solutions and discusses why they have been successful so far from an investment perspective.

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The external chain scale solution has entered a fierce competition mode

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2. Categories of Ethereum Layer 2 Solutions

3. The first includes payment scalability solutions such as Raiden, Liquidity Network, and Spankchain (based on Connext). Most of these solutions use state channels and are inspired by Bitcoin's Lightning Network. These projects were successfully funded through ICOs in late 2017 or early 2018.

A third Layer 2 solution intersects the first two sets of solutions, focusing on adding additional functionality not found on the Ethereum blockchain, specifically privacy. Prominent projects in this regard are Keep and Aztec.

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Simplified diagram of an Ethereum sidechain"secondary title"Off-chain general scalability solution

This group is currently the most active and discussed Ethereum scalability solution. Although

While projects in this space can be categorized in various ways based on different technical indicators, we organize them into:

On the upper layer, Plasma solutions create an alternate space where arbitrary transactions can be performed. In this category, off-chain transaction data is hidden in the Ethereum main chain, which creates challenges when users want to exit the sidechain and return to the Ethereum main chain. This is the so-called data availability problem.

compete

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Within each of the aforementioned categories, there are efforts with different goals and different technical structures. A detailed comparison of these projects would take several articles, so we'll focus on the higher-level issues.

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Taxonomy of general scalability solutions for Ethereum

Plasma-based solutions

Plasma scaling solutions were the first to hit the market after Vitalik's Plasma paper. Plasma implementations vary widely for different use cases. The first production implementation of Plasma was done by Loom Network in 2018 using a variant of Plasma called Plasma Cash. Plasma Cash focuses on non-variable tokens (NFTs) and games. The project eventually left the Ethereum ecosystem, created an independent blockchain, and shifted its focus to enterprise applications. Loom is an interesting case study of the struggles Layer 2 projects face when targeting mainstream use cases such as Gaming that are not closely related to ETH as a financial asset.

Two other projects, Matic and OMG Network, followed Plasma and successfully launched their respective mainnets. These two projects are primarily focused on scaling general Ethereum transactions. Matic uses a PoS consensus mechanism on the sidechain using its own token. The OMG network is similar in direction, but the network currently relies on a fixed number of validators.

Rollups solution

Rollups extension implementation is a relatively new entrant in the market. They aim to solve the data availability problem by keeping transaction data stored on Ethereum's blockchain in a bundled/compressed format. The main goal of this grouping of transactions is to reduce verification costs. Grouped transactions are not directly verified by the Ethereum consensus mechanism. Instead, different mechanisms are used to prove the validity of these transactions. There are two broad categories of rollout solutions. Optimistic Rollups and zk Rollups, perform these verifications differently. In Optimistic Rollups, Fraud Proofs are used to catch any invalid transactions and punish validators who allow them. In zk Rollups, zero-knowledge proofs, such as SNARKs, are used to prove the validity of Layer 2 transactions. These proofs are also stored on-chain along with transaction data.

zk Rollups is another Rollups scaling solution that aims to achieve greater scalability of Ethereum Layer 2 in terms of Layer 2 transactions per second (TPS). However, the technology is still limited to specific use cases, such as payments or exchanges, and is bottlenecked by the complexity of zk proof generation. In this field, there are two competing projects. Loopring and Matterlab's zkSync. Loopring initially implemented a secondary DEX using zk Rollups, and has since expanded to secondary payments with the launch of Loopring Pay. In contrast, zkSync focuses on secondary payments first. The team recently launched the product.

Other extension solutions

There are other scaling solutions for Ethereum that do not technically fit into the Plasma/Rollup classification. One example is Starkware, which implements an off-chain scaling solution for transaction data, similar to Plasma. However, off-chain transactions are also bundled using a form of zero-knowledge proofs that do not require a trusted setup, called STARKs. Starkware and Vitalik call this approach Validium.

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In 2017 and 2018, the payment scale solution was the first to go to market. They are all heavily influenced by Bitcoin's Lightning Network. These solutions focus on scaling payment transactions, but they do not allow arbitrary off-chain execution of smart contracts. Therefore, they do not support DeFi, dapps or games. This is a key weakness in the Ethereum ecosystem and likely explains why these types of solutions have not managed to gain much traction. The main underlying technology common between these solutions is state channels. Raiden Network, Connext/SpankChain, and Liquidity Network are all projects trying to build off-chain payment networks on top of Ethereum.

liquidity network

The Raiden Network is considered to be the closest equivalent to the LN on Ethereum. Similar to LN, it enables 1-to-1 channels between different nodes on the network to create a micropayment network running on top of Ethereum. Raiden’s first mainnet launch took place in May 2020. Using the Raiden explorer we can see that at the time of writing, the network only has 25 unique accounts and about 50 channels. As the focus in the ethereum space has mostly shifted to more flexible scaling solutions, it's hard to see a strong future for a network of 1-to-1 payment channels like Raiden.

Similar to the Raiden Network, the Liquidity Network aims to implement payment channels on top of Ethereum. However, instead of following the 1-to-1 channel model used in Raiden and LN, the project utilizes a 1-to-N channel model. The network relies on payment hubs to which multiple users can connect. In this sense, Liquidity is decidedly similar to sidechains compared to payment channel networks. The project is led by a group of academic researchers from Imperial College London who take pride in presenting their academic research on the project website. Launched on mainnet in 2018, the project has largely failed to attract users — despite recent increases in Ethereum network utilization and gas fees.

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ROI of Tokens Related to Layer2 Payment Solutions

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The final set of Ethereum Layer 2 focuses on adding features to Ethereum that cannot be achieved on the base layer, the most popular feature: privacy. This includes hiding transaction amounts and completely hiding the addresses of transaction participants. These privacy features cannot be implemented directly on the Ethereum main chain and need to be implemented as a separate Layer 2 solution. Two major projects in this space are Aztec and Keep.

Aztec aims to build a UTXO layer on top of Ethereum where zk proofs can be used to increase the privacy of transactions. The project used a public massive multi-party computation (MPC) ceremony to complete the initial trusted setup and develop zk.money for the community to try out the product. Since the Layer 2 privacy scheme and scaling scheme run orthogonally, the Aztec team is working on combining the two, merging the privacy-enhancing technology stack with the zk Rollup technology stack to create zk² Rollup.

Likewise, Keep Network is also developing an off-chain privacy layer for Ethereum. Rather than focusing on private transactions, the project creates storage for private data, called Keeps, that can be accessed and used by Ethereum's smart contracts. The Keep mainnet was launched in early May 2020 to support the project's flagship product, TBTC. We discussed TBTC in the first part of this series as a viable candidate to help scale the Bitcoin network. In order to achieve the high security guarantee of TBTC, its transactions only support on-chain transactions (on Ethereum). However, there are no fundamental restrictions preventing these transactions from being executed off-chain.

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On the other hand, wider experimentation in the Ethereum ecosystem could mean a faster path to identifying scalability solutions that actually work. A well-performing scalability solution may eventually defeat or absorb a less efficient solution.

in conclusion

There is something about transfers that reduce potential fragmentation by building off-chain bridges between different Layer 2 chains, i.e. bridges that don't require back to the Ethereum main chain. This is reminiscent of the vision of Cosmos’ inter-blockchain (IBC) protocol. Off-chain bridges can be the glue that glues together different Layer 2 projects to achieve Ethereum’s network-wide scalability. However, given the early state of most Layer 2 projects, there has been little discussion around Layer 2 bridges.