Layer 2 Networks In Crypto Explained: What Are They and Their Value Proposition in Decentralized Finance (DeFi)
Decentralized Finance (DeFi) is one of the novel innovations in crypto that is gradually defining the future of finance. This growing niche accounts for 4.9% of the total crypto market cap, with over $53 billion currently locked in DeFi protocols.
Despite the enormous growth, DeFi faces multiple challenges, with scaling as one of the main shortcomings. Projects built on the Ethereum blockchain are hard to scale due to the network’s slow transaction speed, leading to congestion problems and high transaction costs for DeFi users.
The scalability challenge has forced crypto innovators to develop solutions to enable more growth within the crypto ecosystem. One of the popular solutions includes Layer 2 chains built on top of Layer 1 chains such as Ethereum – a trend that is likely to be a highlight in 2021.
The Layer 1 Scalability Problem
Layer 1 blockchains are the base of today’s decentralized ecosystems. These chains are designed to settle every transaction on the network, which means that all transactional data is recorded and stored on-chain. While Layer 1 chains may have fostered crypto innovations for the past decade, a paradigm shift to Layer 2 solutions seems inevitable, at least until Ethereum 2.0 launches.
So, what are the shortcomings of Layer 1 chains? For starters, these legacy blockchain architectures are slow and costly. In addition, the applications built on them are pretty complex for the average crypto user to navigate, especially in DeFi. The complex nature of the DeFi ecosystem built on Ethereum is one of the major hindrances to its adoption.
Layer 2 Scalability Solutions
Crypto innovators and developers are now coming up with Layer 2 scaling solutions to enable the mainstream adoption of cryptocurrencies. Layer 2 solutions are frameworks built on the main blockchain networks (Layer 1), such as Bitcoin and Ethereum. At its current state, the Ethereum blockchain can handle around 30 transactions per second (tps), which is relatively slow and costly. Layer 2 solutions change this narrative by leveraging Layer 1 infrastructures for security while they handle the transactions.
Some prominent Layer 2 solutions include Celer Network, a layer-2 scaling platform built to enable fast, easy and secure transactions for smart contracts and payment transactions. This Layer 2 environment allows developers to build scalable decentralised applications by leveraging off-chain scaling techniques and incentive-aligned tokenomics. The platform is powered by Rollup technology and Generalized State Channel network designs.
Notably, Celer has made significant progress in the Layer 2 scaling space since the project was launched in 2018. The network’s latest scaling solution is dubbed Layer2.Finance and seeks to onboard the masses onto DeFi. Layer2.Finance acts as a ‘public transportation system’ by providing a cheaper means to access existing DeFi services. This platform lowers the transaction costs by almost 100x, allowing both big and small accounts to participate in the DeFi market.
One exciting feature about Celer’s Layer2.Finance solution is the platform’s ability to scale existing DeFi protocols without chain migration – DeFi users can move their funds from Ethereum’s Layer 1 applications without breaking composability or experiencing liquidity fragmentation. The platform currently supports three DeFi protocols built on Ethereum: Curve, Aave and Compound. In future, Celer Network plans to feature more protocols, including Uniswap, Sushiswap, Alpha Finance and 1inch, amongst others.
Following the breakdown of the value proposition of Layer 2 networks, one thing is evident; they are here to complement existing Layer 1 chains such as Ethereum. What happens when Ethereum solves its scalability and security issues with the upcoming launch of Eth2? This will likely threaten the existence of Layer 2 solutions, given that Eth2 promises an estimated 100,000 transactions per second.
Ethereum’s 2.0 launch is one of the most awaited events by the crypto community, although it has been in the works for some years. The debut of Eth2 will mark Ethereum’s shift from a proof-of-work (PoW) consensus algorithm to a proof-of-stake (PoS). In doing so, the platform will enhance its speed, efficacy and scalability. This is because the PoS consensus requires less energy to keep a blockchain network running and secure.
While the launch of Eth2 may be a promising event, it is still uncertain when the network will officially migrate to a PoS consensus. The full roll-out is designed to occur in three phases (0, 1, 2), with the first one having rolled out in December 2020. The other phases are scheduled for 2021 to 2022 when the Ethereum dev team expects to pioneer phase 2. Meanwhile, Layer 2 solutions will continue to provide cheaper and faster solutions to the DeFi market.
Crypto is a fast-paced environment where innovations happen daily – Layer 2 solutions are an excellent example of this innovative nature. These upcoming platforms will enable more people to become early DeFi adopters, creating room to scale the future of finance. However, the road is still murky and will require Layer 2 innovators to build long-term solutions for the platforms to survive.