Government Abstract: Layer-2 blockchains have been developed to assist overcome the weaknesses in scalability seen in Layer-1 blockchains corresponding to Ethereum. Their success has performed a significant position within the progress of DeFi, NFTs, and different Web3 options on Ethereum. However after the profitable completion of its ongoing PoS improve, the Ethereum Layer-1 blockchain is anticipated to grow to be quicker and extra scalable than ever. What position, if any, will Layer-2 protocols have in the way forward for Ethereum 2.0? Are they nonetheless value your funding? Discover solutions to those questions and extra as we take a deep dive into the highest Layer-2 blockchains.
Trade Overview
Blockchain builders must stability three main wants when designing a protocol – safety, decentralization, and scalability. In conventional layer-1 protocols like Ethereum and bitcoin, improved safety and decentralization typically comes at the price of scalability. That is generally known as the “Blockchain Trilemma.”
Ethereum was the primary main blockchain to offer good contract capabilities. This primary-mover benefit allowed it to draw builders and customers at a price that different newer Layer-1 blockchains discover nearly unattainable to emulate.
However because the variety of transactions on the blockchain elevated dramatically, the community began experiencing crippling delays. And for the reason that protocol has a bidding system for obtainable block house, this led to astronomically excessive transaction prices (gasoline charges).
In some cases, the gasoline charges shot as much as 500m gwei or round $1600 in present costs. And in these occasions of peak congestion, a single transaction might take greater than 24 hours. For reference, a traditional transaction throughout low site visitors solely takes a couple of seconds or minutes.
The primary cause for this congestion is the extraordinarily low price of transactions per second (TPS) the unique Ethereum blockchain might deal with – between 12 to fifteen transactions. The quantity for bitcoin is even decrease – simply 5 TPS.
These older Layer-1 blockchains use a Proof of Work (PoW) consensus mechanism. The system, whereas wonderful at offering safety, is severely missing in terms of effectivity and scalability.
As community congestion grew to become a serious headache on Ethereum post-2020, Layer-2 blockchains have been created to enhance transaction speeds and scale back gasoline charges.
A Layer-2 blockchain is a separate community that’s constructed on prime of an present Layer-1 blockchain. Its fundamental function is to take away or scale back the widespread transaction bottlenecks that forestall a blockchain from rising to accommodate extra customers and decentralized apps.
Throughout heavy community exercise, Layer-2 networks take the majority of transactions away from the mainnet. After processing the transactions, the information is posted again onto the Layer-1 by means of a connecting bridge.
Completely different Approaches to Layer-2 Blockchains
Through the years, builders have created a number of approaches to implementing Layer-2 options. Probably the most adopted Layer-2 options within the business by way of market cap and TVL use one of many following 3 approaches
Plasma
A Layer-2 protocol utilizing the plasma framework creates a number of “baby chains” related to the Ethereum mainnet. Whereas it boasts of a excessive TPS functionality, plasma chains will not be straightforward to design. They’re extra helpful in particular use circumstances like decentralized exchanges, gaming, or token transfers. Polygon is a number one Layer-2 blockchain that deploys plasma chains.
Optimistic Rollups
A rollup is a Layer-2 answer designed to execute tons of of Layer-1 transactions outdoors the mainnet. The answer then “rolls up” these transactions and compresses them right into a single piece of information earlier than posting them again on the mainnet.
Optimistic rollups are a subcategory of rollups that function below the belief that each one transaction knowledge dedicated to the mainnet is right by default. However customers can nonetheless problem it on-chain and set off a dispute decision course of.
By shortly processing transactions in good religion off-chain, optimistic rollups dramatically enhance transaction speeds. However there’s a slight delay in affirmation of transactions on the Ethereum mainnet, because of the provision for dispute decision.
Optimistic rollups are finest suited to conditions that contain many low-cost transactions. Maybe not surprisingly, two of the preferred Layer-2 protocols by community exercise – Arbitrum and Optimism, use Optimistic rollups.
Zero-Data Rollups (zk-rollups)
As a substitute of counting on an on-chain dispute decision mannequin, zk-rollups use cryptography to validate and authenticate transactions. Aside from that, the whole lot else is broadly an identical to how optimistic rollups work.
Zk-rollups are usually thought of to be extra environment friendly in conditions that contain advanced computations or enhanced safety issues. However they lack the complete Ethereum Digital Machine (EVM) compatibility that you just get from optimistic rollups. This hinders interoperability, which is turning into more and more essential within the blockchain ecosystem. Moreover, zero-knowledge rollups and proof methods are sophisticated to construct and deploy, which has restricted their utilization in real-world circumstances.
Layer-2 Trade Progress
Layer-2 blockchains performed a serious position within the fast evolution and explosion of the DeFi ecosystem between 2020 and 2022. As Ethereum launched into a multi-year transition into Proof of Stake (PoS), Layer-2 protocols enabled customers to keep away from excessive gasoline charges and community congestion.
Resulting from its widespread adoption and options, Ethereum stays the business chief in DeFi progress. In keeping with DeFiLlama, the blockchain accounts for 58.58% of the overall worth locked into the ecosystem – valued at almost $25 billion in Q2 2023.
Throughout its peak in This fall 2021, the overall DeFi ecosystem was value north of $174 billion, with near $110 billion residing on the Ethereum community. This type of progress would have been unattainable with out the help of Layer-2 blockchains.
Funding Thesis
Layer-2 blockchains primarily revolve round Ethereum, the most important and hottest Layer-1 blockchain that helps good contracts and DeFi apps. That begs the query “Why not simply spend money on Ethereum?”
Whereas Ethereum is massive on safety and decentralization, it has a vital weak spot in its lack of scalability. With out the power to scale with demand, the expansion and additional evolution of Etheruem appears unattainable. That is why we’ve seen the expansion within the variety of L2 options trying to deal with Ethereum’s scalability points.
This religion has been validated to some extent by the fast progress we witnessed within the DeFi house after 2020. In keeping with Nansen, the TVL in DeFi grew greater than 6,900% between 2020 and 2022. Even after a 76% market correction in 2022, the house nonetheless retains billions of {dollars} in locked capital.
Outdoors of the cryptocurrency house, blockchain know-how has functions in conventional finance and banking. And right here, simply as a lot as in crypto, scalability is essential. Even when the broader crypto-markets fail in the long run, Layer-2 blockchains will nonetheless have a serious position to play in the way forward for conventional finance, making them engaging targets for buyers trying to capitalize on this rising want.
Whereas there are lots of compelling causes to spend money on Layer-2 initiatives, vital dangers additionally exist. Chief amongst them is the likelihood that Ethereum fails to succeed long-term. As a result of the L2s rely upon Ethereum that may be a blow to the sector that it won’t be capable of settle for.
Finally, if you’ll spend money on certainly one of these Layer-2 initiatives, it is very important select the most effective. That’s the one with essentially the most progress, essentially the most person traction, and the one most probably to succeed. As a result of if L2s stay needed it’s possible that finally will probably be a winner-takes-all state of affairs.
Who’s Investing: Institutional Backing
All the main layer-2 blockchain initiatives have acquired tons of of thousands and thousands of {dollars} in funding from well-known buyers within the crypto house.
Polygon’s backers embrace Sequoia Capital, SoftBank, Galaxy Digital, Tiger World Administration, Alan Howard, Kevin O’Leary, and Makers Fund, to call a couple of. Collectively, these entities have poured over $450 million into the venture throughout 8 funding rounds.
Arbitrum counts Mark Cuban, Polychain Capital, Ribbit Capital, Redpoint, Pantera Capital, Coinbase Ventures, and Compound VC amongst its fundamental buyers. Complete capital inflows into the venture exceed $143 million.
In its Sequence A funding spherical, Optimism raised round $25 million from Andreessen Horowitz (a16z), Paradigm, and IDEO Colab Ventures. Paradigm and a16z doubled down on their investments within the Sequence B spherical, pooling one other $150 million into Optimism in 2022.
Immutable raised round $75 million by means of its Sequence A and B funding rounds. Main buyers included Apex Capital, AirTree Ventures, Alameda Analysis, and Galaxy Interactive. In one other huge funding spherical in 2022, the agency acquired $200 million from Temasek, Tencent, ParaFi Capital, and 9 different buyers.
High Layer-2 Initiatives
| Challenge | Market Cap | Protocols | Income (Annualized) | TVL | Avg Day by day Lively Customers |
| Polygon | $5.73b | 427 | $25m | $890.31m | 389.17k |
| Arbitrum | $1.27b | 361 | $13.24m | $2.06b | 185.48k |
| Optimism | $741m | 144 | $16.09m | $779.44m | 77.17k |
| Immutable X | $660m | NA | NA | NA | NA |
Polygon (MATIC)
Market Cap: $5.73b
Variety of Protocols: 427
Token Worth: $0.62
Twitter Followers: 101.45k
Polygon is a Layer-2 ecosystem for Ethereum that was launched in Mumbai, India because the Matic Community in 2017. Initially, the venture was a plasma sidechain community. By 2021, it had expanded to incorporate zk-rollups and optimistic rollups and was rebranded as Polygon.
Polygon in its current state consists of an eponymous software program growth equipment – the Polygon SDK. Builders can use it to construct any sort of Ethereum-compatible sidechain and decentralized functions.
The primary Layer-2 blockchain on the core of the Polygon community is a PoS sidechain. The native token is known as MATIC. The Polygon community has a TPS capability of 65,000. And the gasoline charges are extraordinarily low.
Builders have entry to all main sidechain structure choices on Polygon – plasma, zk, and optimistic. Though it lags behind different Layer-2 protocols by way of TVL, Polygon leads the sector in market capitalization at $5.7b.
A excessive market cap is a marker of wider recognition within the business and higher help from buyers. It exhibits that the venture is in good monetary well being and has the sources to decide to additional growth and growth.
Polygon is means forward of each different Layer-2 venture on this side. The closest contender, Arbitrum, is barely one-fifth its measurement at $1.2b. With a wider deal with range, flexibility, and class-leading TPS of 65,000, it nonetheless has an extended option to go.
Arbitrum (ARB)
Market Cap:$1.27b
Variety of Protocols: 361
Token Worth: $1
Twitter Followers: 805.5k
Arbitrum is a Layer-2 protocol for Ethereum launched in 2021 by a blockchain startup based mostly in New York. The corporate, referred to as Offchain Labs, was based in 2018 and has main buyers together with Pantera Capital, Lightspeed Ventures, and the now-defunct Alameda Capital.
Not like Polygon, Arbitrum is barely centered on optimistic rollups. Transactions and good contracts are settled on the Arbitrum sidechain after which reported again to the Ethereum mainnet. The Layer-2 protocol boasts a TPS of 40,000 and absurdly low gasoline charges.
Arbitrum can be absolutely suitable with all EVM programming languages. The blockchain has gained some traction within the DeFi house lately. Main DeFi protocols like SushiSwap and Curve have Arbitrum integrations.
In 2023, the protocol additionally airdropped its extremely anticipated native token referred to as ARB. Arbitrum is mostly thought of a secure, mature, and dependable scaling answer for Ethereum. It additionally leads by way of TVL amongst all Layer-2 rollups, with $2.06b or 67.12% of the market.
The next TVL signifies that extra customers are actively collaborating in contracts and transactions utilizing the Layer-2 blockchain. Particularly within the early phases of a blockchain, it is a signal of excessive progress potential.
Optimism (OP)
Market Cap: $741m
Variety of Protocols: 144
Token Worth: $1.16
Twitter Followers: 516k
Optimism is one other Layer-2 blockchain answer for Ethereum with its base in New York. The venture was first unveiled in 2019 earlier than its eventual launch in late 2021. As its title signifies, Optimism makes use of optimistic rollups, very similar to its rival Arbitrum.
The Layer-2 blockchain relies solely on Ethereum and gives full EVM compatibility. All Ethereum-based decentralized apps can run seamlessly on Optimism as effectively. It has a most TPS of two,000 which is on the decrease finish of the spectrum for Layer-2 transaction speeds.
The native token on Optimism is known as OP. It’s based mostly on the ERC-777 normal and features because the governance token on the blockchain. It may also be purchased and offered on all main crypto exchanges.
Though it has been round for a number of years now, Optimism has failed to realize the identical stage of traction as its direct rivals like Arbitrum. Nevertheless it nonetheless accounts for about 25% of the TVL in rollup chains. Whether or not will probably be in a position to maintain its market share and develop remains to be an open query.
Immutable X (IMX)
Market Cap: 660m
Variety of Protocols: NA
Token Worth: $0.63
Twitter Followers: 317.9k
Immutable X is a Layer-2 blockchain venture with a devoted deal with NFTs. It was launched in Australia in 2018. It is without doubt one of the first Layer-2 options to focus completely on NFTs and Web3 gaming. The startup was closely backed by Coinbase and Alameda Analysis.
Not like Optimism and Abritrum, Immutable X depends on the zk-rollup structure for its Ethereum sidechains. The venture makes use of a proprietary model of the zero-knowledge proof system referred to as ZK-STARK for enhanced safety.
Immutable X gives a most TPS of 9000, together with near-zero gasoline charges. The venture additionally claims that each one its transactions are 100% carbon impartial. The protocol helps all Ethereum desktop NFT wallets.
The native token on the protocol is known as IMX. It’s an ERC-20 token that can be utilized for paying gasoline charges and for staking. IMX additionally pulls double obligation because the governance token for the Immutable X DAO.
With a market cap of $670m, Immutable X is actually fairly well-known within the Ethereum NFT circles. However with the crypto market downturn, NFTs and the Web3 gaming mannequin of play-to-earn could also be on their means out. Immutable X most likely has the weakest prospects of all Layer-2 blockchains featured on this record because of its slender focus.
Investor Takeaway
Layer-2 blockchains offered the very important respiration house that Ethereum required in the course of the unhealthy outdated days of community congestion and excessive gasoline charges. After the whole transition to PoS, Ethereum 2.0 is anticipated to have transaction speeds of as much as 100,000 TPS.
Nonetheless, in line with the roadmap shared by Vitalik Buterin, that milestone remains to be a number of years away. And present Layer-2 blockchains will proceed to play a big position sooner or later, even after upgrades deliver options like sharding to the mainnet.
Together with bitcoin, Ethereum is without doubt one of the most dependable blockchain investments by way of longevity and mainstream acceptance. And common Layer-2 protocols like Arbitrum and Polygon nonetheless have a future within the Ethereum ecosystem.
