What is a Layer 2 Protocol in Crypto?

Remember when having 16 gigabytes of storage on your smartphone was an incredible amount? Just as your smartphone technology has adapted to today’s demands, so have many of the world’s leading cryptocurrencies.

Why Layer 2 Is Necessary

A few years ago, blockchains were more than capable of handling traffic on their respective networks. The number of users has grown exponentially since then. As more and more people use cryptocurrencies today, these networks are bogged down in traffic. Traffic on some of these blockchains results in high fees and slow processing times.

To alleviate congestion, the developers have created secondary blockchains that work in conjunction with the main blockchain. This technology is known as Layer 2 protocol. They have virtually no capacity limits, increase transaction speeds, reduce fees, and make Layer 1 blockchains more efficient.

Processing transactions quickly and cheaply is known as scaling. Bitcoin and Ethereum have become some of the most notorious layer 1 blockchains that don’t scale well. Bitcoin can only process around 5-7 transactions per second, and Ethereum processes around twice that amount.

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Layer 1 vs Layer 2: A Real World Comparison

Imagine transactions on a blockchain as pieces of mail. Carriers that deliver mail only by automobile would be similar to a layer 1 blockchain that does not scale efficiently (Bitcoin or Ethereum.)

Some carriers use airplanes to transport mail. They are capable of efficiently transporting large amounts of mail and parcels over long distances. These mail-carrying planes are the equivalent of Layer 2 protocols. Mail always arrives at the same place, although much faster and more cost-effectively.

Similarly, Layer 2 protocols can transport more transactions and then “deliver” them to the Layer 1 blockchain at a later date. The end result is still the same, but the mode of transport is just a little different.
Rollups, Sidechains and Channels

There are different methods that Layer 2 solutions use to interact with the Layer 1 blockchain they support. Rollups, sidechains, and channels are all examples of Layer 2 methodologies. Each has advantages and disadvantages. The important thing to remember is that they all achieve the same goal; increase transaction speeds and reduce fees for Layer 1.

Rollups aggregate multiple transactions into one and deposit them on the Layer 1 blockchain at a later date. They are really a second layer above the layer 1 blockchain. One of the most well-known rollups for Ethereum is loopback.

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Unlike rollups, sidechains are completely separate blockchains that connect and relay transactions to the Layer 1 network concurrently rather than on hold. Think of a side chain as a bridge connecting the two blockchains. For example, Polygon is a high-level sidechain that helps scale Ethereum.

Channels track multiple payments between two users, much like rollups. Unlike rollups, however, channels only record two transactions on the Layer 1 blockchain. If the same dollar were sent 20 times between two people, rollups would have 20 transactions. With channels, only the final amount that each user owns is added to Layer 1. The Lightning Network is considered a Layer 2 solution and is the most popular scaling option for Bitcoin.

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The Blockchain Trilemma

So why doesn’t all Layer 1 blockchains need a Layer 2 solution? The answer lies in understanding some limitations of building a blockchain.

Scaling is one of the three defining characteristics that make up a blockchain. The other two are decentralization and security. These three characteristics have become known as the “Blockchain Trilemma,” a term coined by Ethereum founder Vitalik Buterin. We talk about a trilemma because there is no blockchain that does not compromise at least one of these three facets. Currently, no cryptocurrency is able to achieve maximum scalability, security, and decentralization.

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In other words, cryptocurrencies choose two of these three characteristics to focus on, to the detriment of the third.

A look at the top 10 cryptocurrencies by market cap today reveals that some are scalable and secure, some are secure and decentralized, and some are decentralized and scalable. The important thing to note is that none are able to reach a maximum of all three. There is always a compromise.

Cryptocurrencies like Cardano, Avalanche, or Solana are layer 1s that have made a name for themselves by capitalizing on the scaling problem of Bitcoin and Ethereum. The aforementioned cryptocurrencies can process thousands of transactions per second, but they sacrifice decentralization or security. In contrast, Bitcoin and Ethereum are two of the most secure and decentralized cryptocurrencies.

Layer 2 for the long haul

In March 2022, Bitcoin and Ethereum accounted for more than half of the total cryptocurrency market capitalization. These blockchains support large numbers of users and challenge ecosystems. Other Layer 1s (Cardano, Avalanche, Solana, etc.) have started grabbing more market share, but they lack some of the inherent decentralization and security that makes Bitcoin and Ethereum so unique.

For users who value these features, Layer 2 promotes the usefulness of these blockchains that would otherwise be expensive and slow.

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What is a Layer 2 Protocol in Crypto?


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