Investor’s Guide to Layer-2s

Key Takeaways

• A Layer-2 (L2) protocol is a secondary framework constructed on high 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.
• Buyers can spend money on the tokens of those Layer-2 initiatives, which they will maintain or stake to establish the long-term winners.

Desk of Contents

1. What Are Layer-2s?
2. Why Are Layer-2s Vital?
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 regularly consider blockchain as a singular expertise, it’s layers of expertise working collectively.

Layers aren’t excellent. As soon as we begin attending to greater ranges, we’re, most often, 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 buyers can take into consideration the final word winners of the Layer-2 race so you may spend money on in the present day’s tokens which might be most probably 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 high of layer-1 to scale back bottlenecks (i.e., to assist the underlying blockchain run quicker and cheaper).

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

Whereas Layer-1 is the muse 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, nevertheless it hasn’t scaled nicely. So Layer-2 options like Arbitrum, Optimism, and Base have been constructed to make Ethereum run quicker and cheaper.

Why Are Layer-2s Vital?

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

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

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

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

SWIFT stands for The Society for Worldwide Interbank Monetary Telecommunication and is the first messaging community for worldwide funds. Up to now, SWIFT stays the default customary for worldwide cash transfers and works by sending essential 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’ll 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 unique ache level. Relying on a blockchain’s or a consumer’s necessities, one Layer-2 answer could also be higher than others.

• State Channels: A state channel is a blockchain second-layer answer permitting members to carry out limitless personal transactions off-chain. That is excellent 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 excellent for DApps and DeFi platforms.
• ZK Rollups: Zero-knowledge rollups create safer blockchains than optimistic rollups by compressing transaction information, validating the transactions off-chain, and sending this data to the principle chain. Like optimistic rollups, any such Layer-2 is ideal for dapps and DeFi platforms, providing enhanced privateness and effectivity.
• Plasma: Providing the very best diploma of safety amongst Layer-2 varieties, plasma chains create a collection 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 excellent for purposes that require customizable options and impartial governance from the principle chain whereas nonetheless resolving operations on the bottom layer.

The place Are Layer-2 Blockchains Used?

As a result of Layer-2 protocols prolong the capabilities and scalability of a central blockchain community, they empower these initiatives to help (and disrupt) industries far more readily. A few of these industries embrace:

DeFi

Enhancing transaction velocity is essential 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 enables dapps to operate throughout completely different blockchain platforms with out compromising efficiency.

Micropayments

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

Investor Outlook for Layer-2s

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

Sometimes, a brand new expertise sees an explosion of recent rivals (engines like google, social media websites, and many others.), which step by step coalesce into just a few eventualities:

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

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

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

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

3. Disruptive Know-how: Generally, the basic expertise modifications or is disruptive. (Disk drives, CD-ROMs, digital music shops, and many others.).

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

In the intervening time, Layer-2 options are including worth. However it would possible be a winner-takes-all or a winner-takes-most consequence. Until, in fact, Layer-1s enhance considerably, rendering Layer-2s nugatory.

Investor Takeaway

For buyers, 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 buyers 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’ll both consolidate or be rendered out of date. High quality Layer-1s like Ethereum are nonetheless possible the safer funding for many buyers.

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