Deep Dive: A Look Into Layer 2s (Part 1/3)

Key Points

• Ethereum is “all in” on L2 networks as its scaling strategy
• L2s are cheaper to use than Ethereum layer-1s (L1) and have demonstrated they are capable of higher transaction throughput
• If the “Great Migration To L2” proceeds as planned, L2s should see a boom in ecosystem growth over the coming months and years

Note: This article is the first of a 3 part series on Ethereum layer-2 (L2) networks. It discusses why L2 networks are slated to become an increasingly important part of Ethereum’s ecosystem. Part 2 and Part 3 of the series will compare and contrast top L2 projects and their tokens.

Why Does Ethereum Need L2s?

“The Merge” got Ethereum off proof-of-work (PoW) and onto proof-of-stake (PoS). ✅ The impact?

• It reduced the network’s energy consumption by ~99%. 🌿
• It introduced ETH staking whereby everyday users can help secure the network and earn rewards for doing so. 💰
• But it didn’t address one of the network’s biggest challenges: scalability.

Nor did other upgrades such as EIP-1559 or Shappella. Today, Ethereum L1 still can’t process upwards of ~2M transactions per day.

Think about it this way: New York City’s population is ~8.5M. Imagine if every NYC citizen woke up one day and decided they wanted to make a transaction on Ethereum. Less than 25% of them would actually be able to given Ethereum’s limited throughput. Womp.

That’s assuming each person only wants to make one transaction. Anyone who’s used Ethereum knows it’s easy to rack up a dozen transactions in a single day. And to make matters worse, when the network is congested, the fees associated with those transactions get really high. I’m talking Ticketmaster level fees here.

So realistically, Ethereum can only support tens of thousands or low hundreds of thousands of daily users. If it wants to achieve its goal of being the “world computer”, it will need to scale … a lot.

Enter layer-2 scaling solutions, often referred to as “rollups”. Over the coming months and years, getting users and applications off of (congested) Ethereum L1 and onto these L2 rollups is central to Ethereum’s scaling strategy.

Here’s what Ethereum’s co-founder Vitalik Buterin (aka “V-God”) had to say about this strategy:

Put more bluntly, Vitalik is asking people to “GTFO Ethereum L1” and move to L2s. Stat.

The L2 Value Proposition

The “elevator pitch” of L2 scaling goes something like this:

• Ethereum L1 can process a max of ~20 transactions per second (TPS).
• Ethereum L1 and all of its L2 rollups could (theoretically) process up to ~1,000 TPS today.
• With technical enhancements, Ethereum L1 and all of its L2 rollups could collectively support ~100,000 TPS in the future.

Whether these TPS estimates are actually do-able in production remains up for debate. But they provide useful context: Ethereum L1 is and will remain throughput constrained. And L2s are slated to deliver (pretty much) all of the scaling gains. The good news? They’re already providing a bit of scaling relief. Collectively, L2s have processed ~4X more TPS than Ethereum L1 on certain days.

They’re also already driving down the cost of making transactions. Check it out:

There are some pain points and costs associated with getting assets onto and off of an L2. But once a user is onboarded to an L2, they reap the benefits of ~90% lower transaction fees. The final (and oftentimes overlooked) piece of the L2 “elevator pitch” is that L2s inherit the security of Ethereum L1. Fraud proofs and validity proofs are the “secret sauce” that allow them to do so.

Here’s a simple way to think about the benefits of these proofs: In a nuclear scenario where an L2 network shuts down, all assets on the L2 network could still be accessed on Ethereum L1.

To use an analogy, think of L2s like escalators. If an escalator is working, people can quickly and safely go up and down floors. When an L2 is working, users will be able to quickly and securely make transactions. If an escalator breaks, people can still go up and down it - they just have to walk up and down the stairs. If an L2 breaks, users won’t be able to transact on it, but they can transact on Ethereum L1 to get their money off L2.

Given the billions of dollars that have been lost in bridge hacks, that’s a very nice perk to have.

L2 Adoption

There are 2 easy ways to assess the high level adoption of L2s today:

1) You can look at how much value has been “locked” on Ethereum L1 and moved to L2s. At the start of 2021, this number was ~$50M. Today, it stands at ~$7B. So, clearly the “Great Migration To L2” is underway.

2) You can look at how much of that value on L2s is actually being used in apps on L2. Total value locked (TVL) represents the dollar value of assets which are “locked” in smart contracts to perform different operations (e.g., lending and borrowing, swapping assets, etc.)

• Ethereum L1 currently has ~$25B in TVL.
• The biggest L2, Arbitrum, has ~$2B in TVL.
• OP is the only other L2 in the market closing in on $1B in TVL.

It took Ethereum almost 5 years to reach $1B in TVL. The bulk of these L2s launched in the past ~2 years, so they’re off to a pretty strong start.

And if things go as planned (i.e., users actually move off L1), L2s should see a boom in ecosystem growth over the coming months and years.

Next week we will be dropping Part 2 of this series: This will offer up a comparison of the top L2 projects, as well as the catalysts and challenges they are facing. Part 3 will analyze their tokens (or upcoming tokens).