Coinbase: A Comprehensive Guide to Layer 1, Layer 2, and Sidechain Solutions

Original Title: "Scaling Ethereum & crypto for a billion users"

Authors: Justin Mart & Connor Dempsey

Compiled by: Decentralized Finance Community

By the end of 2021, Ethereum had evolved to support thousands of applications from decentralized finance, NFTs, gaming, and more. The entire network processes trillions of dollars in transactions each year, with over $170 billion locked on the platform.

But as the saying goes, more money brings more problems. Ethereum's decentralized design ultimately limits the number of transactions it can handle to 15 per second. Given Ethereum's popularity far exceeds 15 transactions per second, the result is long waits and transaction fees reaching up to $200. Ultimately, this costs many users and limits the types of applications Ethereum can currently support.

If smart contract-based blockchains want to grow to support billions of users for financial and Web 3 applications, scalable solutions are needed. Fortunately, the "cavalry" has begun to arrive, with many solutions recently coming online.

Competition or Complement?

The goal is to increase the number of transactions that publicly accessible smart contract platforms can handle while maintaining sufficient decentralization. Scaling smart contract platforms through centralized solutions managed by a single entity is trivial (Visa can handle 45,000 transactions per second), but then we would be back to square one: a world owned by a few powerful centralized players.

There are two approaches to solving this problem: (1) build entirely new networks that compete with Ethereum and can handle more activity, or (2) build complementary networks that can handle Ethereum's excess capacity.

Broadly speaking, they can be categorized into the following types:

• Layer 1 blockchains (competing with Ethereum)
• Sidechains (complementing Ethereum)
• Layer 2 networks (supplementing Ethereum)

While they differ in architecture and approach, the goal is the same: to enable users to actually use the network (e.g., interact with DeFi, NFTs, etc.) without paying exorbitant fees or experiencing long wait times.

Layer 1

Ethereum is considered a Layer 1 blockchain—a standalone network that secures user funds and executes transactions in one place. Want to swap 100 USDC for DAI using a DeFi application like Uniswap? Ethereum is where it all happens.

Layer 1s that compete with Ethereum can do everything Ethereum does. Their distinction lies in the new system designs that allow for higher throughput, thus lowering transaction fees, but often at the cost of increased centralization.

In the past 10 months, new Layer 1 networks have launched, and during the same period, the total value of these networks has skyrocketed from $0 to around $75 billion. The field is currently led by Solana, Avalanche, Terra, and Binance Smart Chain, each with a growing ecosystem valued at over $10 billion.

TVL of non-Ethereum Layer 1s

All Layer 1s are competing to attract developers and users. Achieving this goal is challenging without any Ethereum tools and infrastructure (which make building and using applications easier). To bridge this gap, many Layer 1s have adopted a strategy called EVM compatibility.

EVM stands for Ethereum Virtual Machine, which is essentially the brain that executes computations to make transactions happen. By making their networks EVM-compatible, Ethereum developers can easily deploy existing Ethereum applications to new Layer 1s by copying and pasting their code. Users can also easily access EVM-compatible Layer 1s through existing wallets, simplifying migration.

Take Binance Smart Chain (BSC) as an example. By launching an EVM-compatible network and adjusting its consensus design for higher throughput and cheaper transactions, BSC saw a surge in DeFi application usage last summer, with applications similar to popular Ethereum apps like Uniswap and Curve. Avalanche, Fantom, Tron, and Celo have also taken the same approach.

In contrast, Terra and Solana currently do not support EVM compatibility.

TVL of EVM-compatible vs non-EVM-compatible Layer 1s

Interoperable Chains

In a slightly different Layer 1 storage area are blockchain ecosystems like Cosmos and Polkadot. These projects are not building new standalone blockchains but rather creating standards that allow developers to create blockchains for specific applications that can communicate with each other. For example, this could allow tokens from a gaming blockchain to be used in applications built on a separate blockchain for social networks.

Currently, chains built using the Cosmos standard have surpassed $100 billion in value and can ultimately interoperate. Meanwhile, Polkadot has recently reached a milestone in unifying its blockchain ecosystem.

In short, Ethereum's direct competitors are diverse, and there will be more in the future.

Sidechains

The distinction between sidechains and new Layer 1s is undoubtedly a blurry one. Sidechains are very similar to EVM-compatible Layer 1s, except they are specifically designed to handle Ethereum's excess capacity rather than compete with Ethereum as a whole. These ecosystems are closely tied to the Ethereum community, hosting Ethereum applications in a complementary manner.

A typical example is the Ronin sidechain for Axie Infinity. Axie Infinity is an Ethereum-based NFT game. Because Ethereum's fees made playing the game very expensive, establishing the Ronin sidechain allowed users to transfer their NFTs and tokens from Ethereum to a low-fee environment. This made the game more affordable for more users and contributed to its popularity.

At the time of writing, users have transferred over $7.5 billion from Ethereum to Ronin to play Axie Infinity.

Polygon POS

Sidechains like Ronin are application-specific, while others are more suitable for general applications. Currently, the Polygon POS sidechain is the industry leader, with nearly $5 billion in value deployed across over 100 DeFi and gaming applications, including well-known names like Aave and Sushiswap, as well as the Uniswap clone Quickswap.

Similarly, Polygon POS does not appear to differ much from EVM-compatible Layer 1s. However, it was built as part of a framework to scale Ethereum rather than compete with it. The Polygon team believes that in the future, Ethereum will remain the dominant blockchain for high-value transactions and value storage, while everyday transactions will shift to Polygon's low-cost blockchain. (Polygon POS also maintains a special relationship with Ethereum through a process called checkpoints).

With low transaction fees, Polygon's future vision seems feasible. With the help of incentive programs, users are flocking to Polygon POS, with daily transaction volumes exceeding those of Ethereum (although spam transactions inflate this number).

Layer 2 (Rollup)

Both Layer 1s and sidechains face a significant challenge: ensuring the security of their blockchains. To do this, they must pay fees to a new batch of miners or proof-of-stake validators to verify and secure transactions, usually in the form of inflation of the underlying tokens (e.g., Polygon's $MATIC, Avalanche's $AVAX).

However, this also brings significant downsides:

• Owning the underlying tokens naturally makes the ecosystem more competitive rather than complementary to Ethereum.
• Verifying and securing transactions is a complex and challenging task, and your network will be indefinitely responsible for this task.

Wouldn't it be great if we could leverage Ethereum's security to create a scalable ecosystem? Enter Layer 2 networks, particularly "Rollup." In short, Layer 2s are independent ecosystems built on top of Ethereum, whose security relies on Ethereum.

Crucially, this means that Layer 2s do not need to have native tokens—so they are not only more complementary to Ethereum, but they are essentially part of Ethereum. Ethereum's roadmap even indicates that Ethereum 2.0 will be "Rollup-centric," paying homage to this idea.

How Rollup Works

Layer 2s are often referred to as Rollups because they "roll up" or bundle transactions together and execute them in a new environment before sending the updated transaction data back to Ethereum. Instead of letting the Ethereum network handle 1,000 Uniswap transactions individually (expensive!), it is cheaper to offload the computation on Layer 2 and submit the results back to Ethereum.

However, when the results are sent back to Ethereum, how does Ethereum know the data is correct and valid? How does Ethereum prevent anyone from posting incorrect information? These key questions distinguish between two types of Rollup: Optimistic Rollup and ZK-Rollup.

Optimistic Rollup

When submitting results to Ethereum, the "Optimistic" in Optimistic Rollup assumes they are valid. In other words, they allow Rollup operators to post any data they want (including potentially incorrect/deceptive data) and assume it is correct—undoubtedly, this is an optimistic outlook! But there are ways to combat fraud. As a check, there is a time window after any withdrawal during which anyone can check for fraud (remember, blockchains are transparent, and anyone can see what is happening). If one of the observers can mathematically prove that fraud has occurred (by submitting a fraud proof), then the Rollup will revert any fraudulent transactions, punish bad actors, and reward the observer (a clever incentive system!).

The downside is that when users move funds between Rollup and Ethereum, there is a brief delay while waiting to see if any observers detect any fraudulent activity. In some cases, this can last up to a week, but we expect these delays to decrease over time.

The key is that Optimistic Rollup is inherently tied to Ethereum and is poised to help Ethereum scale today. As many leading DeFi projects turn to leading Optimistic Rollups—Arbitrum and Optimistic Ethereum—we have already seen strong early growth.

Arbitrum and Optimistic Ethereum

Arbitrum and Optimistic Ethereum are currently the two main projects implementing Optimistic Rollup. Notably, both companies are still in early stages and maintain a level of centralized control, but both plan to decentralize over time.

It is estimated that once mature, Optimistic Rollups can increase scalability by 10-100 times. Even in their early stages, DeFi applications on Arbitrum and Optimism have already accumulated billions in network value.

Optimistic has deployed over $300 million in TVL across seven DeFi applications, with the most notable being Uniswap, Synthetix, and 1inch.

Arbitrum goes further, investing about $2.5 billion in TVL across over 60 applications, including familiar DeFi protocols like Curve, Sushiswap, and Balancer.

Arbitrum has also been chosen as the scaling solution for Reddit, as they anticipate their long-awaited efforts to mark community points for the social media platform's 500 million active users.

ZK-Rollup

Optimistic Rollup assumes transactions are valid and provides space for others to prove fraud, while ZK-Rollup actually proves to the Ethereum network that transactions are valid.

As they bundle transaction results, they submit what is known as a validity proof to Ethereum smart contracts. As the name suggests, validity proofs allow the Ethereum network to verify whether transactions are valid, making it impossible for relayers to deceive the system. This eliminates the need for fraud proofs, so transferring funds between Ethereum and ZK-Rollup is an instant operation.

While instant settlement and no withdrawal times sound great, ZK-Rollup is not without trade-offs. First, generating validity proofs requires significant computation, necessitating high-performance machines to make them work. Second, the complexity surrounding validity proofs makes supporting EVM compatibility more difficult, thereby limiting the types of smart contracts that can be deployed to ZK-Rollup. Thus, Optimistic Rollup entered the market first and is better equipped to address Ethereum's current scaling issues, but in the long run, ZK-Rollup may become the better technical solution.

Adoption of ZK-Rollup

The situation with ZK-Rollup is quite deep, with multiple teams working on implementations in both development and production. Some notable companies include Starkware, Matter Labs, Hermez, and Aztec. Today, ZK-Rollup primarily supports relatively simple applications like payments or exchanges. For example, the derivatives exchange dYdX uses Starkware's (StarkEx) ZK-Rollup solution, supporting nearly 5 million transactions weekly and over $1 billion in TVL.

However, what is truly commendable is ZK-Rollup solutions that are fully EVM-compatible, thus able to support popular general applications (like a full suite of DeFi applications) without the withdrawal delays of Optimistic Rollup. Major players in this space include MatterLab's zkSync 2.0, Starkware's Starknet, Polygon Hermez's zkEVM, and Polygon Miden, all of which are currently working towards mainnet launches. (Meanwhile, Aztec focuses on applying zk proofs to privacy).

Many industry insiders (including Vitalik) are considering combining ZK-Rollup with Ethereum 2.0 as a long-term solution for scaling Ethereum, primarily because they can fundamentally handle hundreds of thousands of transactions per second without compromising security or decentralization. The upcoming fully EVM-compatible ZK-Rollup will be one of the key issues to watch in Ethereum's development.

A Fragmented World

In the long run, if smart contract platforms want to scale to billions of users, these scalable solutions are necessary. However, in the short term, these solutions may pose significant challenges for users and crypto operators. Navigating from Ethereum to these networks requires using cross-chain bridges, which can be complex and carry potential risks for users. For example, some cross-chain bridges have already become targets for attacks.

More importantly, a multi-chain world breaks composability and liquidity. Consider that Sushiswap is currently implemented on Ethereum, Binance Smart Chain, Avalanche, Polygon, and Arbitrum. Sushiswap's liquidity was once concentrated on one network (Ethereum) and is now distributed across five different networks.

Ethereum applications have always benefited from composability—e.g., Sushiswap on Ethereum can plug and play with other Ethereum applications like Aave or Compound. As applications expand to new networks, applications implemented on Layer 1/sidechains/Layer 2 can no longer compose with applications implemented on another layer, limiting availability and posing challenges for users and developers.

An Uncertain Future

Will new Layer 1s like Avalanche or Solana continue to grow and compete with Ethereum? Will blockchain ecosystems like Cosmos or Polkadot surge? Will sidechains continue to operate harmoniously with Ethereum, taking on its excess capacity? Or will Rollups combined with Ethereum 2.0 prevail? No one can say for sure.

While the future is uncertain, we should take comfort in the fact that so many smart teams are dedicated to solving the most challenging problems faced by open, permissionless networks. Just as broadband ultimately helped the internet support many revolutionary applications, we believe we will eventually view these successful scaling solutions in the same light.