What does Layer 2 mean for the crypto world?

Author: Rex |W3.Hitchhiker

Revision: Aaron |W3.Hitchhiker

As early as a year ago, Ethereum faced issues of network congestion and high gas fees, and the concept of Layer 2 was frequently mentioned. At that time, L2 felt more like a defensive measure for Ethereum to compete with other public chains in the market. However, now the topic of L2 is becoming increasingly popular, and its significance in the entire crypto world seems to go beyond just being Ethereum's "defensive mechanism."

The Impossible Triangle and Monolithic Blockchains

First, let's trace back to the issue of the blockchain's impossible triangle.

The impossible triangle problem of blockchain points out that due to technical limitations, you can only enhance two of the three attributes of a blockchain at the same time, sacrificing one attribute.

The three main attributes (and their technical points) are:

1. Decentralization: Number of network nodes; whether there is a central node;

2. Security: Difficulty of attacking the network;

3. Scalability: The system's data throughput and TPS.

Moreover, achieving these three attributes requires corresponding underlying components, which are:

1. Consensus: Provides security and defines the authenticity of stored data.

2. Execution: Converts the old state into a new state, a process that needs to be completed through computation. (Block N updates to N+1)

3. Data Availability: Ensures the authenticity of referenced data (all data constituting block N) through the main chain.

BTC, at its inception, chose a sufficient level of decentralization due to the trust risks posed by centralized institutions, while also needing enough security as a financial payment system, thus having to sacrifice scalability. Subsequently, most public chains opted for the POW mechanism (like ETH), aiming for sufficient decentralization and security, which resulted in poor scalability, making the widespread adoption of blockchain a persistent challenge.

In fact, we have been constrained by the impossible triangle primarily because most blockchains attempt to accomplish consensus, execution, and data availability simultaneously on L1 (the main chain), leading to the current predicament.

To ensure security and decentralization, we reduced the supply of block space and lowered the hardware requirements for nodes, allowing everyone to participate in the network as nodes, but this also extended transaction times, resulting in poor scalability.

However, if we reduce the number of nodes, although we eliminate a bunch of computers performing redundant calculations, it also means we can only trust a few nodes, weakening the level of decentralization.

In summary, over the past decade, to ensure the centralization and security of blockchain, we have reached the limits of its scalability.

A blockchain that is responsible for consensus, execution, and data availability simultaneously is referred to as a monolithic blockchain, and it seems that the path of monolithic blockchains has come to an end.

Rollups Solutions and Modular Blockchains

Now, let's shift our thinking: what if we let those responsible for consensus focus solely on doing consensus well, while those executing transactions specialize in improving transaction efficiency, allowing everyone to collaborate? Could this solve the "impossible triangle" dilemma of monolithic blockchains?

Let's take Ethereum L2's Rollups solution as an example.

L2 creates an off-chain transaction execution environment independent of Ethereum L1 and updates L1's state after processing transactions. Additionally, Rollups can increase the transaction speed of the execution layer by two orders of magnitude while reducing transaction costs by one order of magnitude (with room for further optimization), all without bearing the costs of maintaining consensus and data availability.

Specifically, Rollups compress batches of transactions and periodically publish a single state root update to the Ethereum mainnet, which contains the results of many transactions that occurred on the Rollups layer.

Rollups' L2 does not need to focus on consensus and data availability; it only needs to concentrate on improving transaction efficiency. Since the Rollup network only requires a minimal number of nodes (or even just one node) to be active at any time, its maintenance costs are very low. However, there is no need to worry about security and decentralization issues, as Rollups are tightly linked to Ethereum L1 in an encrypted manner, with Ethereum L1 responsible for security and decentralization.

We call this architecture a modular blockchain.

In simple terms, a modular blockchain means breaking down the three underlying components of consensus, execution, and data availability that the current L1 main chain is responsible for simultaneously, allowing each layer to focus solely on improving the efficiency of its own work, thus achieving division of labor and forming a modular structure.

In fact, we have similar operational models in real life. For example, the commonly used Alipay and WeChat act as platforms like L2, responsible for executing transactions, while the settlement and security of cash on our bank cards are actually handled by the systems of commercial banks, which are akin to L1.

The modular form can significantly enhance our transaction efficiency.

Ethereum's Modularity

We have outlined the first step of Ethereum's modularity—Rollups. Next, let's look at the other two steps—POS and Sharding.

Through the PoS mechanism, Ethereum no longer requires specific computers to ensure network security. Now, theoretically, any computer can be used to maintain network security.

Currently, Ethereum's PoS beacon chain has reduced the economic cost of running a validating node to 32 ETH and one computer, increasing the potential total number of blockchain validators. Although the cost of 32 ETH is still relatively high, it is an order of magnitude lower than the minimum viable cost of POW mining (which starts at several million dollars).

Moreover, decentralized staking pools or third-party projects like Lido and Rocketpool allow users to pool any amount of ETH for staking, making the 32 ETH requirement no longer a rigid condition, thereby increasing the number of potential validators and simultaneously enhancing the decentralization of the Ethereum network.

Additionally, after transitioning to PoS, the scenario where 10 million ETH need to be staked for security is indeed achievable—staking 10 million ETH with each validator staking 32 ETH would mean there are 312,500 validators in the network.

Once ETH completes its transition to PoS, the entire network will have a modular security resource pool (validator pool), forming a powerful consensus layer (potentially worth $40 billion), and sufficient decentralization to evolve into an infrastructure providing a consensus layer.

Sharding technology allows for the redistribution of security across more shard chains, rather than concentrating the entire system's security on a single chain. Having 300,000 validators protect a monolithic blockchain is an inefficient allocation of resources. However, if these validators are distributed across multiple shard chains (the first phase will launch 64 shard chains),

Ethereum L1 can create the scale of 18 monolithic Ethereums by allocating about 4,500 validators to each shard chain. (Initially implementing 64 shard chains does not mean we have increased Ethereum's capacity by 64 times; rather, the number of Ethereum chains we have increases by 64 times, but the capacity of each chain will be 1/3 of the current capacity, so the overall size will increase by about 18 times.)

After the transition to PoS, the beacon chain acts as the dispatcher of system resources, randomly sampling to assign each validator to a specific shard chain, where they will be responsible for validation work; moreover, all validators will be randomly reassigned in order at each epoch (approximately every 6 minutes). Overall, sharding maximizes the available block space in L1!

The beauty of modular design lies in the fact that the optimization of each module amplifies the optimization of other modules (synergy).

By increasing the decentralization of the network through PoS, the number of shards on Ethereum increases;

Increasing more shards on Ethereum L1 can raise the number of Rollups on L2 by an order of magnitude;

The growth in the scale of Rollups will bring about new feasible types of on-chain transactions, ultimately increasing the total fees paid by Rollups to L1;

The more net transaction activity that occurs on Rollups, the higher the total fees paid when purchasing L1 block space, leading to a gas war between L2s, which will increase the demand for computational resources, while not increasing additional inflation (more validating nodes are added, but the price of ETH will rise due to burning and deflation), the network will add more computational resources.

These computational resources can be used to create more shards, and more shards mean faster transaction speeds. (Ethereum aims to implement 64 shard chains in the first phase, but its ultimate goal is to increase to 1,024 shard chains. According to Moore's Law, and as home computer CPUs become increasingly powerful, the number and capacity of shards will increase.)

The combination of sharding and Rollups turns computational resources into assets for the network, rather than liabilities.

The Economic Sustainability of Modular Blockchains

After modularization, Ethereum not only possesses technical feasibility but also economic feasibility that aligns with common sense.

The crypto-economic system compensates the providers of network security (POW miners or POS validators) using transaction fees and the issuance of new coins.

The more transaction fees a blockchain network can collect, the fewer new coins it needs to issue, resulting in a lower overall inflation rate for the network, ultimately making the coin more valuable.

We can compare the inflation and fee consumption of Polygon, Solana, and ETH:

Polygon's PoS network collects about $50,000 to $100,000 in transaction fees daily, which amounts to $18 million to $36 million annually; meanwhile, Polygon is distributing over $400 million in annual inflation rewards;

Solana's PoS network collects about $100,000 in transaction fees daily, which totals around $36 million annually; however, Solana is issuing a staggering $4 billion in annual inflation rewards;

In comparison, ETH under the POW mechanism collects transaction fees in the range of $60 million daily, amounting to approximately $22 billion annually; at the same time, ETH's annual inflation reward is about $20 billion. (Currently, Ethereum produces a block approximately every 15 seconds, with each block rewarding 2 ETH, resulting in a daily inflation of about 11,500 ETH, or 4.2 million ETH annually.)

Moreover, after transitioning to PoS, the inflation rate is lower, with an expected annual inflation of around 570,000 to 1 million ETH. Comparatively, it can be seen that in the long run, Ethereum's economic sustainability capability is enhanced after modularization, making it more competitive in the market.

Future Predictions for Layer 2

The Rollup approach, which separates the execution transaction environment from the mainnet, divides ETH into a consensus module (on-chain) and a transaction module (off-chain), creating immense imaginative space for the market. Thus, based on the premise that Rollups are currently the ideal network solution, we make predictions about future market trends:

2022 will be the year of L2, with numerous teams starting to create their own L2s to expand market scale. L2 networks do not need to worry about the enormous maintenance costs of the consensus/security layer; what they need to do is pay gas fees to Ethereum L1 for storage proofs and data, thereby ensuring their own security, allowing them to focus all their attention on improving their execution/computation processes.

Secondly, the off-chain environment is very conducive to rapid iterative updates using Rollups, allowing new technologies and cost-efficiency optimizations to be deployed more quickly. Furthermore, Rollup-style L2s have legitimacy compared to many projects claiming to be ETH sidechains; they also possess the security and decentralization brought by Ethereum compared to many EVM public chains, so the L2 market has immense potential.

As the market progresses further, some L1 sidechains or established public chains may find themselves lacking competitiveness and will have to abandon their costly consensus and data availability layers, transforming into Ethereum's L2, lightening their load and focusing on managing their ecosystems, leading to a rebound in their token prices (by transforming into L2 networks on Ethereum).

They can not only retain their native tokens, communities, applications, etc., but also benefit from the entire Ethereum ecosystem without worrying about the consensus/security layer.

Furthermore, there will definitely be major web2 internet companies entering the space, as the operational model of Rollups is very familiar to them from the web2 era. They will quickly transition into the Web3 era using this model and focus on building their excellent applications without worrying about security and decentralization.

In the next four years, the next cycle will witness a "public chain" battle, with topics such as technology, capital, users, and culture being discussed repeatedly. However, the protagonists will no longer be L1s but L2s; there will certainly be a thriving ecosystem of top-tier Rollup L2s, with valuations rising to the hundreds of billions; subsequently, capital will elevate the valuations of all L2s to around tens of billions.

Finally, Ethereum will gradually evolve into a cloud-based blockchain infrastructure, providing a robust consensus layer built with significant economic costs that has stood the test of time (through two bull and bear cycles), offering security and decentralization. All Rollups will pay for expensive block packaging fees to complete on-chain settlements, leading to a gradual acceptance of Ethereum as the first public, neutral global settlement network in history.