Ethereum, the second-largest cryptocurrency by market capitalization behind Bitcoin, has a blossoming decentralized finance (DeFi) ecosystem that has directly attracted users and indirectly pushed others away. Layer 2 projects may be the solution to Ethereum's problems.
Decentralized applications (DApps) like Uniswap and Compound Finance use smart contracts on Ethereum to provide financial services like lending, borrowing and trading crypto. Smart contracts are simply self-executing code written on the blockchain for any number of uses.
DeFi brought many users to the Ethereum network to use these new DApps. Unfortunately, smart contracts take more computations to process than regular transactions and when they became incredibly popular, they slowed the network to a crawl. With this congestion came ludicrous transaction fees with everyone trying to push their transaction to the top of the queue.
Direct changes to Ethereum are in the works, but developers are also trying to build solutions on top of the network — Layer 2 — in the meantime. Vitalik Buterin, the visionary founder of Ethereum, believes Layer 2 solutions are going to be a cornerstone of the network’s scaling efforts in the short, medium and possibly long terms.
Ethereum Layer 1 vs. Layer 2
Upgrades to Ethereum are divided into 2 categories: Layer 1 and Layer 2. Layer 1 describes the architecture of the main blockchain; Layer 2 is another blockchain on top of and at least partially secured by the main network. Ethereum is in the middle of an important series of Layer 1 updates, hopefully launching in late 2022. The project is deemed so impactful that it is called Ethereum 2.0 and rightly so.
Ethereum 2.0 will have 2 major infrastructure alterations, changing the consensus mechanism from Proof of Work to Proof of Stake and sharding. Proof of Stake will lower the environmental impact of Ethereum dramatically and increase network security. Sharding, on the other hand, will split the blockchain into shards allowing for more validators and higher transaction throughput. The move to Proof of Stake should occur soon whereas sharding is still planned for the relatively distant future.
Many believe that sharding will not be the ultimate solution people seek. Layer 2 solutions could be Ethereum’s greatest hope for scalability both before and after the update is completed. There is still much debate between developers on the final stage of Ethereum 2.0. It’s undecided whether Layer 2 projects will decrease congestion enough and if they don’t, Ethereum developers will have to give shards more functionality. Either way, Layer 2 projects will help lower network congestion to some degree for the foreseeable future.
Is Layer 2 Safe?
Many Layer 2 blockchains have similar security to the underlying Layer 1 blockchain but usually have at least one additional vulnerability (if not more). Data from Layer 2 chains is sent back to the underlying network to be verified. You might ask how a Layer 2 project speeds up the main blockchain if it's still sending the transaction data back to it. They still send some data back, but only enough to verify the block of transactions and the new state of the network. Network participants on Layer 2 chains perform the computation necessary to process a batch of transactions off-chain. Then the minimum amount of data required to verify and secure the network is sent back to the main chain.
The extra vulnerabilities mostly arise within the Layer 2 network’s consensus and fraud prevention mechanisms. Network participants on Layer 2 chains need to ensure that all added batches are valid and most methods of doing this have points of failure. Some projects use their own Proof of Stake mechanism where users stake cryptos on the network to process and validate new batches. This would be less secure than Ethereum because there are fewer validators that need to be corrupted to change the network maliciously. There are a couple of noticeable exceptions, like ZK-rollups, that don’t seem to have many extra vulnerabilities. Token bridges that let users swap tokens between networks are also notoriously flawed and multiple bridges have been entirely drained of their funds.
Best Layer 2 Ethereum Cryptocurrencies
Layer 2 solutions are often divided into 3 categories: state channels, Plasma and rollups. The Lightning Network on Bitcoin is based on state channels and builds 2-way channels for users to transact quickly with low fees. Plasma, co-founded by Vitalik Buterin, was one of the 1st Layer 2 projects on Ethereum and eventually evolved into a rollup company, Optimism. Both Plasma and state channels can be useful on their own, but they can’t fully simulate everything on Ethereum. Remarkably, rollups might provide a solution to state-channel and Plasma’s issues.
Rollups are likely the Layer 2 solution with the most potential both in the short and long term for Ethereum scalability. Two subsets of rollups, optimistic rollups and ZK-rollups, currently exist. They diverge mostly in how network participants agree on whether each new block leads to the correct state of the blockchain. Optimistic rollups assume that all blocks are valid unless they are challenged and proved to be false by any network participant within a challenge period.
ZK-rollups rely on each block containing a cryptographic proof called a ZK-SNARK that confirms the new state is the correct one. Instead of sending all the transaction data of each block to the main blockchain, a concise version of the new state and the ZK-SNARK is relayed. ZK-SNARKs take a lot of computation on Layer 2 to create for each block, but they can be quickly verified on the main network. ZK-rollups are fantastic Layer 2 solutions and many believe them to be the best long-term scalability solution for Ethereum. They don’t rely on challenges, like optimistic rollups, and can dramatically lower transaction fees and network congestion.
Developers and mathematicians haven’t built enough proofs to cover all smart-contract functionality. However, there is already a successful decentralized exchange (DEX) called Loopring that uses ZK-rollups to minimize transaction fees and maximize speed for its users. Loopring boasts over 1,000 times greater transactions throughput than mainnet Ethereum and minuscule fees. Loopring has its own token that is used for governance, staking for interest and more.
Sidechains are sometimes referred to as Layer 2 technologies, but many see them as impure because they don’t harness the full security of the underlying network. They run parallel to the main blockchain and can have much lower fees and vastly greater transaction throughput.
Polygon Network is likely the largest sidechain and its low fees, high throughput and incredible ease of porting Ethereum DApps to the network has made it wildly popular. Polygon Network’s utility token, Polygon (MATIC), is used for governance, staking for interest and paying transaction fees.
Pros and Cons of Layer 2 Solutions
Each type of Layer 2 solution has its own pros and cons. Most will improve the transaction throughput of the network (on a DApp-to-DApp basis until they become universal). They also have similar downsides, usually relating to security. Layer 2 solutions introduce another attack vector and more possible points of failure.
Users want to move as much computation and data storage off the main network as possible, but that requires someone or an algorithm to decide what information gets sent to layer 1 and what is omitted. ZK-rollups seem to be the perfect solution for this but they aren’t generalized enough to be used in all necessary circumstances yet.
Best Cryptocurrency Exchanges for Loopring (LRC)
Loopring is available on a long list of trading platforms and the best options include Gemini, Coinbase, Crypto.com and Binance. Purchasing cryptocurrency has become streamlined over the years and is incredibly simple using major exchanges like the ones listed above. Once you sign up for your account on one of these exchanges, you will reach the 1st and only major speed bump in the process.
U.S. regulations require crypto exchanges to verify your identity before you can start trading. This entails providing your Social Security number, address and a picture of your driver’s license or other valid ID. You can fund your account with cryptocurrency or with fiat currency by linking your bank account, debit card, Paypal and other methods. When your account is verified and funded, just find the Loopring trading pair you want and complete the trade.
Best Cryptocurrency Exchanges for Polygon (MATIC)
Polygon is a much larger cryptocurrency in terms of market capitalization than Loopring and is tradable on even more exchanges. Some of the top choices are Coinbase, Binance, Binance.us, Gemini and Crypto.com. Coinbase and Binance each have Polygon trading pairs with multiple different fiat currencies, too. To purchase Polygon, just sign up for and verify your exchange account as described in the above section, add funds and make your trade.
How to Store your Tokens Safely
Most of the top cryptocurrency exchanges today employ impressive security measures to prevent hacks or loss of funds. For example, Coinbase keeps 98% of user funds in geographically separated cold storage (hardware wallets kept offline) and insures any funds kept online for day-to-day trading. This doesn’t eliminate the need for a personal wallet, however. With a hardware or software wallet, you retain more control over your cryptocurrencies. Hardware wallets are generally safer than software wallets, but they are often less flexible and a little more clunky to use.
Best Software Wallet: Coinbase Wallet
Software wallets are vital tools for DeFi users and cryptocurrency investors in general. Most DeFi platforms require you to connect to them with a software wallet before you can use them. Some projects support a shortlist of hardware wallets, but it's not universal. Coinbase Wallet is one of the best software wallets on the market. It’s completely free and it supports most of the largest cryptos including Bitcoin, Ethereum, Dogecoin, Litecoin and all ERC-20 tokens (including Loopring and Polygon).
Coinbase Wallet has more features than most of its competitors such as a crypto swap tab for swapping between supported cryptos, a collectibles tab for your nonfungible tokens (NFTs) and a decentralized application (DApp) browser. The DApp browser lets you interact with DeFi seamlessly and it even supports the Polygon Layer 2 network.
- Crypto enthusiasts
Best Hardware Wallet: SafePal S1
The SafePal S1 is an incredibly secure hardware wallet that is basically invulnerable to cyberattacks. The device is almost never connected to any other internet-connected device physically or through Bluetooth so it removes nearly all remote attack vectors. The only exception is for firmware updates. Instead of these types of connections that other hardware wallets use, it uses QR codes to send and receive transactions.
The SafePal S1 randomly generates your wallet’s private keys and stores them in an industry-grade secure element within the device. Security isn’t the device's only triumph. The SafePal S1 is beautiful with a sleek minimalist design and a sizable screen. The device brings all you need in a secure hardware wallet together in a pretty package. If you worry about losing your cryptos to hacks, the SafePal S1 might be the best wallet to bring you peace of mind.
What Happens to Layer 2 Solutions when ETH2 Launches?
Layer 2 solutions might lose a little bit of steam after the Eth2 launch, but they have always been part of the plan for Ethereum scaling. Sharding by itself will not bring the incredibly high transaction throughput most count on. The number of people using Ethereum will likely still increase too, causing more congestion that will only be partially reduced with sharding. The intention of the Ethereum core developer team has been to build Eth2 to work alongside Layer 2 solutions, not replace them. They will almost certainly still play a role in lowering fees for users if nothing else. Ethereum 2.0 will not bring fees to $0, and unless users find a solution to eliminate them, Layer 2 and other scalability projects will likely remain useful.
Frequently Asked Questions
Is Solana a Layer 2?
Yes, Solana uses Layer 2, offering more functionality than other tokens.
What does Layer 2 mean?
Layers 2 is a technology that extends the Ethereum blockchain, providing more functionality than projects that remained on Layer 1.
About Henry Stater
Henry is an expert in all things crypto. He stays up to date with all the latest coins, platforms and technologies in the field. He has particular expertise in the burgeoning decentralized finance ecosystem and loves trying out all the new platforms. He also always follows major events in other financial markets and geopolitics as a whole, especially when an event’s effects ripple through the crypto market.