All About Cryptocurrency Scaling And Layer 2 Scaling Solutions - Beginner's Guide

If you spent any time interacting with DeFi or NFTs on Ethereum, you likely encountered infamously high gas fees and slow transactions.

That's the cost of decentralization.

By design, blockchain and other distributed ledger technologies are slower and more expensive than centralized alternatives. Yet today some of the world's best minds are working on various scaling solutions to make cryptocurrencies faster and more affordable for everyday users.

In this article, we'll explore cryptocurrency scaling solutions, covering popular Layer 2 networks and answering the most common questions.

What are cryptocurrency Layer 2 scaling solutions?

Since the inception of Bitcoin in 2009, blockchain technology has offered significant benefits.

Decentralization, transparent record-keeping, and security are among the most discussed advantages. Blockchain technology has launched a thriving cryptocurrency ecosystem that is constantly pushing the boundaries with use cases that range from finance and currencies to identity and governance.

Despite this growth, scalability has consistently been a major issue for many blockchain networks. When the volume of pending transactions exceeds the available capacity of the blockchain at a given moment, we experience scaling issues: transactions are slow or just never happen and you need to pay higher fees.

In an ideal world, any blockchain could accommodate an infinite number of transactions per second (TPS), commonly called throughput. The Bitcoin main chain, however, can only manage 3 to 7 TPS. VisaNet, Visa’s centralized electronic payment network, can process around 20,000 TPS.

The difference in TPS is due to the decentralization that Bitcoin and other blockchains aim to achieve.

To replace a basic centralized system, you need a lot of time and processing power. In a decentralized system, instead of a single database, a global network of nodes accepts, distributes, and validates each transaction.

Layer 2 scaling solutions seek to increase the throughput while maintaining decentralization. By building on top of the existing blockchain (the Layer 1), Layer 2 solutions aim to:

• Increase the speed of transactions,
• Increase transaction throughput (the number of transactions per second),
• Decrease transaction fees.

While there are always some tradeoffs, Layer 2 scaling solutions could potentially move the blockchain community closer to realizing its common goal of making cryptocurrencies and blockchain-based systems accessible to everyone in a secure, convenient, and efficient manner.

What are Layer 2 solutions and what are they for?

Layer 2 refers to a network or technology that runs on top of a blockchain protocol to help it scale and be more efficient.

Blockchains, such as Ethereum, have increased in popularity in recent years due to their programmability (smart contracts) and resistance to censorship, allowing a wide range of businesses and use cases to be developed on top of them.

However, Ethereum can only process 7 to 11 transactions per second, compared to over 20,000 transactions per second on the Visa network.

As the blockchain gets overburdened, users compete to have their transactions completed as quickly as possible. This promotes a bidding war for space in each block, causing transaction prices to skyrocket. It cost over $80 to send a token to another address on the Ethereum network at one point in 2021.

Layer 2 solutions aim to alleviate the burden on Ethereum and to overcome the bottleneck problem outlined above.

Layer 2 solutions separate transactions from the underlying blockchain, allowing for the processing of thousands of transactions per second. Zero-knowledge rollups and optimistic rollups are the two most common types of layer 2 solutions.

Layer 1 vs Layer 2

Bitcoin Layer 2 scaling solutions

As the first cryptocurrency, Bitcoin was also the first to experience scaling issues.

At the peak of the 2017 bull market, the Bitcoin average transaction fees exceeded $45. During the 2021 bull run, the average fee reached $65.

One of the most well-known Layer 2 solutions for Bitcoin is the Bitcoin Lightning Network, which was first proposed in 2015.

This Layer 2 solution creates payment channels between two parties and only updates the balance privately among themselves. Once the channel is closed, the final balances are published to the main net Bitcoin blockchain. The Lightning Network also adds some smart contract capabilities to Bitcoin, which is a significant upgrade to the network as a whole.

Pros

• Faster Transactions: Bitcoin has a transaction rate of about seven transactions per second (TPS). Furthermore, Bitcoin keeps track of transactions in ten-minute blocks. After the addition of six blocks, which takes almost an hour, you will know that your transaction has been successfully recorded onchain. Instead, transactions within the Lightning payment channel are nearly instantaneous.
• Enhanced Privacy: The Lightning transaction is only recorded on the public blockchain when the payment channel is eventually closed and the amount is distributed to both parties. Unlike onchain payments, transactions that happen within the channel are not visible to the public.
• Transaction Costs are Reduced: The Lightning Network allows transactions to be made for as little as 0.00000001 BTC ($0.01). The Lightning Network has effectively reduced transaction costs to one satoshi (1 SAT = 1/100,000,000 BTC).

Cons

• Risks of Offline Transactions: On the Lightning Network, going offline has its own set of issues. While you're away, the other party can close the channel and pocket payments. Fraudulent Channel Close is the term for this.
• Online Vulnerability: Because all parties involved in the transaction must be online and sign with their private keys, the whole wallet could be compromised if the computer storing the private keys is hacked.
• Malicious Attacks: Congestion caused by a malicious attack is another network risk. Participants may not be able to get their money back quickly enough if the payment channels become congested as a result of a malicious hack or attack.

Now that we explored the most popular scaling solution for Bitcoin, let's see what approaches are used to scale Ethereum.

Types of Layer 2 scaling solutions

Two of the most discussed Layer 2 scaling solutions for Ethereum are two types of rollups: zero-knowledge rollups and optimistic rollups.  

Rollups are Layer 2 blockchain scaling solutions that perform transactions outside of the Layer 1 blockchain and then post the data from the transactions to the Layer 2 blockchain. Rollups rely on Layer 1 for security.

Pros

• Rollups help to increase transaction throughput.
• The Layer 1 chain stores all transaction data, making it secure and decentralized.
• Rollups reduce gas fees for users.
• Since Optimistic rollups are EVM and Solidity compatible, you can do there anything you can on Ethereum Layer 1.

Cons

• Due to the risk of fraud, onchain transactions have relatively long wait times.
• A transaction's order can be influenced by the network operator.
• Greater centralization as teams that run rollup projects typically have control over smart contracts.

Zero-knowledge rollups

ZK-rollups (Zero-knowledge rollups) are Ethereum smart contracts that scale the network by executing numerous transfers outside the primary blockchain (off-chain).

ZK-rollups aggregate or "roll up" hundreds of off-chain transactions into a single transaction. This transaction is then returned to the main chain (the Layer 1 Ethereum) with a cryptographic "zero-knowledge" proof of validity. Zero knowledge proof is essentially a way of proving that you know some information without actually revealing that information.

Because most data is stored off-chain and only the proof goes to the main chain, the ZK-rollups Layer 2 scaling approach outperforms Layer 1 Ethereum in terms of transaction speed and throughput. And because there is less competition for block space, gas prices fall and transactions become less expensive.

Optimistic rollups

An optimistic rollup is a Layer 2 scaling solution that moves most transaction processing off-chain and only posts a summary of these transactions to the main net Ethereum. This helps to save up on gas fees.

The system updates the "state" of the rollup on the main Ethereum blockchain by publishing a Merkle root of the transactions that occur within the rollup.

Before the state is updated, a network of external validators validates the Merkle roots to ensure they are correct. If there is any inconsistency, the validator can publish a fraud-proof during the dispute period, causing the system's state to be rolled back to the previous valid state.

The main difference between optimistic rollups and ZK-rollups is that optimistic Layer 2 transactions take longer. Before the state can be updated, optimistic rollups must rely on external validators to check the Merkle roots. However, optimistic rollups have the advantage of supporting smart contracts in the same way as the underlying smart contracts blockchain does.

Despite their recent prominence, ZK-rollups and Optimistic rollups are not the only scaling solutions for Ethereum.

Nested blockchain: Plasma

Plasma is an approach to scaling Ethereum by creating additional nested blockchains, which connect to the main net.

Also known as 'sidechains' or 'child chains', these additional blockchains can be designed to specific needs and offload most transactions from the main chain (also known as 'root chain'). Each sidechain does all the computations and only submits the minimum data to the main chain. However, any disputes could be settled on the main chain. This delegation greatly increases the overall bandwidth of all blockchains.

Finally, each side chain can have additional child chains, branching out like a tree.

Pros

• This solution not only reduces the load in the root chain but also increases scalability exponentially if properly implemented.
• Each child chain can be tailored to specific needs such as micropayments or computation-heavy applications.
• Plasma is compatible with other scaling solutions such as different block sizes or sharding.

Cons

• To allow for disputes, withdrawals are postponed for several days. Liquidity providers can mitigate this, but there is a capital cost associated with this.
• To ensure the security of your funds, you must periodically monitor the network (liveness requirement) or delegate this responsibility to someone else.
• Increased centralization as Plasma counts on an operator to store and serve off-chain data when needed.

What is a sidechain?

A sidechain is a blockchain ledger that is linked to the main chain of a cryptocurrency, such as Bitcoin or Ethereum.

Sidechains could be viewed as a cross between Layer 1 and Layer 2 scaling solutions. They do not create an alternative Layer 1 blockchain but instead run in addition to the main blockchain (also known as the native layer). Sidechains are linked by two-way bridges, which allow cryptocurrency transfers from the main chain to a sidechain that requires some third-party trust.

Sidechain typically has an independent consensus mechanism from the native layer. To improve scalability and processing speed, the mechanism can be tweaked. The mainchain must still confirm transaction records, maintain security, and resolve disputes in this situation.

The Liquid Network, which is linked to Bitcoin's main chain, is an example of a sidechain. Like Layer 2 solutions, it aims to address scalability issues by unloading some of the confirmation and transaction processing processes to another network. This allows the main chain to handle a greater volume of transactions.

Pros

• Sidechains are a well-established technology.
• It is compatible with the Ethereum virtual machine (EVM) and supports general computation.

Cons

• A sidechain is often less decentralized. It has its own consensus mechanism, which might not be fraud-proof.

What is a parachain?

The term "parachain" refers to a "parallel chain" that connects to the main relay chain. These chains run parallel to one another in a network of interconnected blockchains.

Parachains are usually all built within the same framework, so they have the same security features, and they are all linked to the central relay chain. They can, however, have different specifications to address their respective applications.

Polkadot is based on this concept of relay and parachains. Because the distribution is spread to handle workloads, parachains can enable very fast transactions.

What is a hashgraph?

Hashgraph is not a scaling solution but is a separate distributed ledger technology described as a blockchain alternative.

Hedera Hashgraph is the only ledger that uses hashgraph at the moment, as the technology is patented. Leemon Baird invented hashgraph and it is the intellectual property of the Swirlds Corporation, which Baird founded.

Hashgraphs, unlike blockchains, do not use miners to validate transactions. Instead, hashgraphs employ a "gossip about gossip" protocol in which individual network nodes "gossip" about transactions to generate directed acyclic graphs that time-sequence transactions without grouping them into blocks. Each "gossip" message includes one or more transactions, as well as a date, a digital signature, and the cryptographic hashes of two previous occurrences.

A hashgraph can handle thousands of transactions per second, whereas Bitcoin allows for about 5 transactions per second and Ethereum allows for about 11 transactions per second.

Yet Ethereum is constantly evolving and its throughput is set to increase if it would successfully execute its 'ETH2' upgrade.  

What is Ethereum 2.0?

Ethereum 2 (ETH2) is an upgrade that aims to improve the network's security and scalability. This upgrade included a transition from Ethereum's mining model ("Proof of Work") to a staking model ("Proof of Stake"). This move is known as the Merge.

This set of improvements will increase Ethereum's scalability and put it on par with other leading blockchains in terms of throughput (TPS).

As part of this move, ETH holders can stake their coins to earn rewards for their contributions to validation efforts. To stake coins on their own, they need a minimum of 32 ETH and lock up the coins until ETH2 launches. However, some liquid staking protocols let holders stake any amount of ETH while also keeping liquidity.

Ahead of the upgrade, Ethereum also underwent a code change known as the Ethereum improvement proposal 1559 (EIP-1559) in August of 2021 to improve transaction fee pricing.

The cost for a transaction is now calculated using EIP-1599 instead of the first-price auction process. There is a base fee for all transactions to be included in the next block in the EIP-1599 update, as well as a priority fee (tips for miners) that speed up transaction processing. The base fee is set algorithmically depending on network congestion and is then burned. The priority fee (tips) is set by the user.

For each transaction, the user submits a fee that is higher than the base fee. Users can set a cost cap because the base fee varies depending on network congestion. Users only pay the difference between the final base fee and the fee cap after it is included.

While EIP-1559 somewhat improved the speed of including the transaction, it's still far from solving scalability issues. For now, Layer 2 solutions for Ethereum are in demand.

Ethereum Layer 2 scaling solutions

Given the great diversity of scaling solutions, there are many projects that aim to scale Ethereum by creating Layer 2 networks.

Let's briefly review some of the most prominent projects.  

Polygon

Polygon, formerly known as Matic, is an up-and-coming platform for creating and connecting Ethereum-based blockchain networks.

Polygon contains a range of tools and components for developers to create optimized Ethereum instances that function as sidechains. The instances include all of the characteristics of a standalone blockchain, such as sovereignty and scalability. With the delay in Ethereum's transition to ETH 2.0, Polygon is slowly becoming one of the most popular Ethereum Layer 2 solutions.

Polygon uses MATIC tokens for gas payments. To start using Polygon in your non-custodial wallet, you can transfer MATIC from an exchange. Or you can first buy MATIC on an Ethereum DEX and then use a bridge to move the tokens to Polygon.

Pros

• Polygon uses a hybrid system that combines PoS and the Heimdall architecture to boost scalability.
• Polygon can access and use the full power of Ethereum thanks to the multi-chain system.

Cons

• Although more decentralized than many Layer 1 alternatives, Polygon still has much greater centralization than the Ethereum mainnet.
• There's a chance that, as Ethereum 2.0 evolves, Polygon will no longer be required as Ethereum's second layer.

Arbitrum

Arbitrum is an Optimistic Rollup Layer 2 solution for Ethereum smart contracts that improve their speed and scalability while also adding privacy features.

Developers can use this Layer 2 platform to run unmodified EVM contracts and transactions on Layer 2 without compromising Layer 1 security.

Arbitrum positions itself as the ideal scaling solution for DeFi apps, allowing any Ethereum contract to be scaled using Arbitrum rollup. AAVE, 1Inch, Balancer, and many other well-established DeFi projects have versions that run on Arbitrum.

Arbitrum uses ETH for gas payments. To start using this Layer 2 network, you first need to bridge ETH to Arbitrum and any other tokens from mainnet Ethereum or another network.

Pros

• With only 2% of the fees, you can get 100 times the throughput.
• Arbitrum is a decentralized platform, so there are no KYC requirements to use it.

Cons

• The challenge period is required to implement the Optimistic Rollup security protocols. This would not affect retail customers, but it could be a problem for Dapp developers.

Optimism

Optimism is an Ethereum Virtual Machine-based optimistic rollup chain.

The main benefits of using Optimism for deployment are its speed, simplicity, and security. Projects interested in deploying can fill out a form to be whitelisted by Optimism. Projects that meet the launch criteria will be approved within two weeks. In July 2021, Uniswap V3 launched its alpha on the Optimistic Ethereum mainnet. Many other DeFi projects followed suit.

Optimism uses ETH for gas fees. Users can move ETH and other assets in and out of the network by using the Optimistic Ethereum Gateway or Zerion's bridge aggregator that helps to find the cheapest and fastest bridges.

The Optimism team also recently announced an Optimism airdrop to the community and early users.

Pros

• Because Optimistic rollups are EVM and Solidity compatible, with them you can do anything you can on Ethereum Layer 1.
• The Layer 1 chain stores all transaction data, making it secure and decentralized.

Cons

• Due to the risk of fraud, onchain transactions have longer wait times.
• Optimism is still centralized and the team has a high degree of control over the network. The whitelisting process for projects is the most obvious example.

zkSync

zkSync is a Zero-knowledge rollup scaling solution for Ethereum.

Developed by Matter Labs, zkSync is backed by some of the best-known Web3 investors. Also, many of the most successful DeFi projects are working on integrating with zkSync.

zkSync reportedly has the lowest transaction fees across all rollups, enabling scalability comparable to the VISA network. Fees could be paid in ETH, DAI, RAI, and other supported tokens. This removes the need for having an additional token for gas fees.

Pros

• Very low fees that could later decrease even further.
• Fast finality: assets can be moved from Layer 1 Ethereum to zkSync in just 10 minutes.
• EVM compatibility, which makes it easier to move smart contracts to zkSync.

Cons

• zkSync requires a special wallet such as zkSync Wallet or Argent. MetaMask and other popular wallets do not yet support zkSync.

Gnosis Chain (xDAI)

Formerly known as xDAI Chain, Gnosis Chain is essentially an Ethereum-based sidechain that allows users to process transactions at higher speeds and at lower costs.

Integrations and partnerships with various projects and platforms have fueled the continued growth of the Gnosis Chain / xDAI ecosystem. Many DAO tools like DAOHaus are based on Gnosis Chain.

Gnosis Chain uses xDAI for gas payments. To get xDAI, you can lock up DAI, a stable coin, in one of the bridges. This would mint an equivalent number of xDAI on the Gnosis Chain.

Gnosis Chain also has an additional token, GNO. It is a staking token, which is used by Gnosis validators. You don't need it to use the network but you can also stake it to receive future airdrops and other incentives.

Pros

• Gnosis Chain allows tech-savvy traders to interact directly with Perpetual Protocol's architecture without having to go through proxy and relayer.
• Gas fees are paid xDAI, a stable coin, so there is no need to worry about buying an additional cryptocurrency that might lose value.

Cons

• Rather than trading right away, traders must first buy DAI and convert it into xDAI using a bridge. This adds a layer of complexity.
• Having two native tokens — xDAI and GNO — could be confusing for some users.

In this post, we reviewed the main Layer 2 scaling solutions and explored the leading projects that aim to improve Ethereum's throughput.

The best way to learn, however, is to put theory into practice and bridge some assets to a Layer 2 with Zerion — with low fees and fast transactions, this is a great way to experience Web3!    

FAQs

What is a Layer 2 blockchain?

Layer 2 is a technology that runs on top of an underlying blockchain protocol to improve its scalability and efficiency. This type of scaling solution involves offloading a portion of a blockchain protocol's transactional burden to another system, which then takes care of the majority of the network's processing and only reports back to the main blockchain to complete the process.

What is Bitcoin Layer 2?

Bitcoin Layer 2 refers to various protocols that are built on top of Layer 1 (i.e. Bitcoin) to improve the functionality of the original blockchain. Layer 2 protocols frequently employ off-chain processing elements to address the Layer 1 scaling network's speed and cost inefficiencies. Lightning Network and Liquid Network are two examples of Layer 2 platforms for Bitcoin.

What is Layer 1 in Crypto?

A Layer 1 is a new blockchain that introduces some changes to improve an earlier blockchain. Solana and BSC are examples of Layer 1 alternatives to Ethereum.

Is Chainlink a layer 2?

Chainlink is not a Layer 2 scaling solution but it is available on some Layer 2 networks. Chainlink is a decentralized oracles network built on Ethereum.

Chainlink oracles are now live on Optimistic Ethereum. With the integration, Optimism developers are able to use Chainlink's low-cost Price Feeds to build DeFi apps with minimal code changes.

Is Ethereum a layer 1 or 2?

Ethereum is an independent blockchain so it is a Layer 1 network.

Is Solana a Layer 2 Solution?

No, Solana is a Layer 1 blockchain protocol that has received a lot of interest from the cryptocurrency community and investors.

Is the lightning network a Layer 2 Solution?

The Lightning Network is a Layer 2 protocol that allows off-chain transactions on the Bitcoin blockchain.

Is PolkaDot a Layer 2 Solution?

No. Polkadot could be thought of Layer-0 protocol that aims to unify and scale multiple specialized Layer-1 blockchains.