Pantera Capital Chief of Staff: How Layer 2 Unlocks the Next Wave of Killer Applications?

Author: Emma Rose Bienvenu, Chief of Staff at Pantera Capital

Original Title: "THE NEXT MAJOR UNLOCK"

Translation: Linqi, Chain Catcher

After the summer frenzy of DeFi in 2020, the skyrocketing demand for Ethereum-hosted protocols led to exorbitant gas fees and severe network congestion. Fortunately, with the explosive release of scaling solutions like Optimism and Offchain Labs' Arbitrum, the "Summer of Layer 2" in 2021 heralded a promising solution.

Next, we discuss why Layer 2 technology is so important. We start with the fundamentals of scaling, then detail how new off-chain tools help address the issues of transaction speed and cost. Finally, we discuss what this means for the broader ecosystem and why Layer 2 will be key to unlocking the next wave of killer applications based on blockchain technology.

Introduction

If the promise of blockchain technology is to democratize access to financing channels—by reducing costs through the removal of rent-seeking intermediaries—the greatest irony is that transactions on Ethereum, which hosts most DeFi protocols, remain prohibitively expensive. In a distributed network like Ethereum, each transaction requires storage and processing by every node: this means that as the user base grows, the network inevitably encounters capacity constraints. This is the well-known reason for high gas fees. Network congestion drives up gas prices and increases processing times, making small transactions unfeasible. This makes it nearly impossible for computation-heavy DApps to operate directly on an increasingly crowded blockchain.

In simple terms, Ethereum has become a victim of its own success. Over the past year, millions have rushed to adopt and use DeFi protocols, NFT markets, and other DApps hosted on Ethereum, spurring a surge in demand for transaction processing. In this context, the limited computational capacity of each node and the size of individual blocks have consistently disappointed.

As more transactions compete for limited block space and computational power, gas fees rise, and transaction volume and speed slow down. In 2021, Ethereum fees increased by 845% compared to 2020; average block capacity rose from about 70% in January 2020 to a sustained level of 98%.

The Problem of Scaling

Increasing the capacity of networks like Ethereum is particularly challenging. There are three main characteristics that define a blockchain: decentralization, security, and scalability. You can choose two of these three characteristics, but if you insist on the most straightforward approach, you will not have all three. This means that improving a blockchain's scalability—so it can handle more transactions, faster, and cheaper—typically compromises its security or decentralization.

This significant dilemma is often referred to as the "scalability trilemma," which has plagued supporters of blockchain technology since the early days of ecosystem development. In 2014, Vitalik Buterin made a memorable declaration: the Ethereum community must solve the scalability problem, "or perish." Fortunately, with recent upgrades in scalability and the introduction of groundbreaking Layer 2 scaling tools, the project's success is now within reach.

Broadly speaking, there are two approaches to overcoming the scalability trilemma. "Layer 1" or "on-chain" scaling focuses on improving the blockchain itself; "Layer 2" or "off-chain" scaling focuses on improving how the blockchain is used.

Layer 1

In the Ethereum ecosystem, the leading Layer 1 scaling proposal refers to "sharding," which reduces the amount of data each validator needs to process by horizontally splitting the transaction database through the creation of new chains or "shards." This allows the distributed network to handle a total transaction volume that exceeds the computational capacity of a single node. Ultimately, this will lower the barrier for new validators to join the distributed network, increase its throughput, and reduce the costs of transacting on it.

However, Layer 1 scaling methods have significant limitations. This approach involves highly challenging computer science and game theory problems, many of which have never been solved before. Hard forks of the protocol are also a critical foundation for implementing them; as a practical matter, this requires building strong consensus among all stakeholders around each Layer 1 upgrade. Like any complex and decentralized system, this is a daunting and time-consuming proposition.

The long-delayed hard fork upgrade plan for Ethereum, known as "ETH-2," has been mired in difficulties, indicating the significant challenges of implementing major Layer 1 changes in terms of technology and community coordination.

Layer 2

Layer 1 solutions focus on improving the performance of the core blockchain, while Layer 2 approaches aim to enhance how the blockchain is utilized. Proponents argue that since distributed ledgers are inherently capacity-constrained, they should only carry the most valuable transaction data. Layer 2 moves low-priority operations off-chain while keeping assets and cryptocurrencies on Layer 2. It allows users to return to Layer 2 at any time to resolve disputes or reclaim their crypto assets. This fixes Layer 2 operations within the security of the local Layer 2, freeing up valuable block space on the core blockchain. Ultimately, this enables Layer 2 to handle a greater volume of transactions at faster speeds and lower costs.

There are three main types of Layer 2 solutions: state channels, sidechains, and rollups. While all three can provide composite benefits to blockchain capacity, the Ethereum community has identified rollups as the most promising way to scale the network. Although other Layer 2 solutions can achieve scalability at the expense of security or decentralization, rollups accept some centralization without sacrificing trustlessness (which is a key priority of decentralization).

Rollups move most computations off-chain and periodically push batch transaction data and the resulting state root to the Layer 1 blockchain. By executing operations outside the mainnet but recording transaction data and/or proofs on Layer 1, rollups can benefit from the security of the core blockchain while achieving greater throughput and significantly lower fees. Broadly speaking, there are two types of rollups: ZK-Rollups and Optimistic Rollups.

ZK-Rollups move computations to Layer 2 and periodically batch and compress transaction data conducted off the main chain, generating validity proofs of their integrity and publishing them to the Ethereum mainnet. By publishing proofs of the correctness of each state transition, ZK-Rollups guarantee the validity of on-chain states and allow users to withdraw immediately. However, the computation of these proofs is complex and time-consuming. Even if developers eventually manage to combine Solidity with ZK Rollup technology, they currently need to rewrite smart contracts in a custom programming language. For now, ZK-Rollups are best suited for projects that implement direct payments, such as decentralized exchanges or payment platforms.

StarkWare, in which we previously invested, is now a leading pioneer in ZK-Rollup technology. In mid-2020, StarkWare demonstrated the powerful capabilities of StarkEx (its ZK-Rollup scalability engine supporting decentralized trading) by setting up 1.3 million accounts on Ethereum and establishing initial balances for each account within 12 hours. If this operation had run directly on the mainnet, it would have consumed the entire capacity of the Ethereum network for 4.5 days. StarkEx managed the entire process in just 12 hours at an astonishing average cost of $0.003 per transaction, occupying only 2.5% of Ethereum's capacity.

In contrast to ZK-Rollups, Optimistic Rollups assume transactions are valid and only run fraud proofs in the event of a challenge. Optimistic Rollups rely on parties to verify the data submitted to Layer 2—and challenge incorrect states—to maintain the integrity of transitions. While this is computationally efficient, it forces users to wait for a challenge period before they can access their funds. Nevertheless, the scalability advantages brought by Optimistic Rollups are immense, reducing Ethereum's gas fees by over 10,000% and increasing throughput by up to 200 times.

Projects like Arbitrum use Optimistic Rollup technology to easily integrate existing DApps and support the execution of arbitrary EVM code at the off-chain level with minimal changes to the underlying smart contracts. Since its launch in August 2021, over 250 development teams have begun building on Arbitrum. The project has been chosen by Reddit to launch its own Layer 2 rollup, and Aave, Balancer, Band Protocol, Coinbase Wallet, Chainlink, Curve, DAI stablecoin, Etherscan, Dodo, Metamask, Shapeshift, Sushiswap, and Uniswap have all gone live or are set to integrate with Arbitrum's technology.

The capabilities and promises of Optimistic and ZK Rollups are that by anchoring transactions in the security of local Layer 1, users can choose to revert to Layer 1 to reclaim their assets or resolve disputes. They create game-theoretic incentives for users and operators to act honestly. This makes them important catalysts for creating secure and scalable networks where users can transact without trusting centralized intermediaries or their counterparts. In short, the promise of blockchain and cryptocurrency is evident. With the recent launch of highly anticipated Layer 2 scaling projects, this promise is now more attainable than ever.

What Solving Scalability Means

For blockchain-based protocols to replicate and ultimately replace the pillars of traditional finance, they need to match or exceed the performance of its infrastructure. Without the help of Layer 2, the Ethereum mainnet can only handle 15-20 transactions per second (TPS). The Bitcoin main chain can only handle 7 TPS. In contrast, the VisaNet payment network processes an average of about 1,700 TPS, while Nasdaq handles about 500-1,000 TPS. With the introduction of Layer 2, this gap will narrow or disappear. It is expected that using Rollups alone will increase Ethereum's TPS to between 1,000 and 4,000.

Other Layer 2 solutions, such as state channels and sidechains, will increase the capacity of the ecosystem, and highly scalable Ethereum alternatives like Polkadot will also contribute. Overall, these tools will make it possible to create blockchain-based point-of-sale payment systems that offer instant transfers for fast checkouts and guarantee settlements, with throughput comparable to the Visa network.

In the short term, the benefits of higher transaction speeds and lower costs will be most strongly felt in the DeFi space. Applications migrating to Layer 2 will offer lower transaction fees and lower minimum transaction sizes, passing their significant cost savings onto users. This will drive overall transaction volume in DeFi, attracting retail users who were previously reluctant to transact directly on Ethereum or who opted for less secure alternatives like Binance Smart Chain.

For example, the integration of Starkware allows dYdX to offer users higher maximum leverage thresholds, reduced liquidation penalties, and cross-margin trading features.

DeFi protocols themselves will also improve. Applications like Perpetual Protocol and dYdX allow users to long or short cryptocurrency assets using margin and leverage; collateral will be automatically liquidated when the value of the posted collateral falls below a specified threshold. When transactions take minutes to process, the functionality of this liquidation mechanism is suboptimal, but in a scaled ecosystem approaching instantaneous transactions, it plays a more effective and precise role. This significantly enhances the capital efficiency of DeFi protocols. For instance, the Starkware integration allows dYdX to provide users with higher maximum leverage thresholds, lower liquidation penalties, and cross-margin trading features.

More broadly, the emergence of high throughput, nearly free, and instant transactions will enable blockchain-based protocols to match or exceed the user experience of traditional web browsers. Historically, attempts to build decentralized versions of Facebook, World of Warcraft, Visa, or Second Life have stagnated in development primarily due to the inability of public blockchains to handle the hundreds or thousands of computations per second required by applications.

With scaling tools that increase throughput by 50-1,000 times, applications that were previously too slow or computationally intensive to run on the core blockchain will become viable. This will mark an unprecedented expansion in the scale and scope of the addressable market for blockchain-based projects, opening the door to the next generation of decentralized social media, virtual worlds, micropayment platforms, gaming ecosystems, and more.

Conclusion

To realize the vision of blockchain-based systems as transparent, secure, censorship-resistant, and privacy-protecting financial infrastructures, expanding the ecosystem's capacity will need to become an iterative, ongoing project. For now, Layer 2 solutions can provide powerful, flexible, composite tools. Over time, the best way to scale Layer 1 will likely be to enhance its efficiency as a data availability engine to optimize Layer 1's capabilities, allowing Layer 2 to run on it. In the true spirit of decentralization, the issue of scaling is being—and will continue to be—addressed by various complementary solutions.

For the time being, Layer 2 is leading the way toward a scalable, composable blockchain ecosystem, and we can’t wait to see the wave of innovation it unleashes.