Explaining the economics of Ethereum Layer 2 solutions
The Layer 2 landscape is booming
As the name suggests, Layer 2 protocols operate on top of the base chain, seeking to resolve scalability concerns without compromising other important features such as security and decentralisation. The rising popularity of Layer 1 blockchains have led to the birth of Layer 2 solutions. This game-changing technology brought to the table mechanisms that enable off-chain processing of transactions.
If you are not familiar with the technology behind Layer 2, we suggest reading this article: 'What is Layer 2 and how does it work?'.
Ethereum has stood out as a trailblazer in the crypto space, but the ongoing network congestion became a severe obstacle. In response to this occurrence, Layer 2 solutions emerged as a way out..
Even though the tech in question is still in its early stages, there are many divergent Layer 2 protocols and most of them lie on top of the Ethereum layer, except for Bitcoin’s Lightning Network.
This article is mostly focused on Ethereum's second layers. If you want to learn more about solutions that lie on top of Bitcoin, why not read this article: 'Beyond Lightning: Bitcoin Layer 2 Mintlayer and Rootstock'.
As blockchain technology continues to witness extended real-world adoption, the focus on scalability, low transaction costs and rapid execution will drive innovations across both Layer 1 and Layer 2 blockchains. Since many base layers are promising to bring to the table significant updates and changes to the consensus mechanism, it will have a magnified impact on second layer blockchains linked to them.
Why do we need Layer 2 scaling solutions?
Since the inception of blockchain technology in 2008, many developers have worked on solving consistent limitations in scalability to match the growing user base. Such limitations have usually been detrimental due to slow transaction execution times and high transaction fees.
We are talking about the notorious blockchain trilemma or the notion that blockchains are incapable of providing decentralisation, scalability, and speed at the same time. Since blockchain networks can provide two of these at the same time, there are constant trade-offs between those three features.
Layer 2 scaling solutions were created on the premise that the scalability problem happens because the base layer has too many tasks. A blockchain network needs to fulfil three main functions – execution, data availability, and consensus.
You can think of Layer 2 solutions as resellers of block space. Simply put, they buy block space on Ethereum to make it more efficient by compressing data. Then they resell it to users and applications, along with providing a higher transaction throughput and lower gas fees.
One of the primary issues of blockchain networks is its limited transaction throughput. When it comes to the Ethereum layer, this limitation arises from the block size and block time, which are designed to provide security guarantees and decentralisation, yet at the cost of speed.
As blockchain technology continues to develop, Ethereum scaling solutions manage to enable the processing of millions of low-value transactions after validation using parallel blockchains and then transfer it to the main blockchain or mainnet ensuring integrity and immovability.
Scaling Ethereum can be done in multiple ways. State channels facilitate direct off-chain transactions among participating companies and the final state is then analysed on the main chain. A state channel is also referred to as a payment channel, in which crypto funds are deposited in a smart contract on Layer 1, and signed tickets are produced on the second layer.
On the other hand, rollups, either Zero Knowledge Rollups, known as ZK Rollups, or Optimistic Rollups, are a method that can combine multiple transactions in one mainnet operation. For example, Zero Knowledge Rollups employ validity proofs to compute transaction data off-chain and subsequently compress hundreds of transactions before posting cryptographic proofs on the Ethereum layer.
Sidechains are separate blockchains that operate independently using their own consensus mechanisms. Finally, Plasma presents a framework that enables the creation of child chains branching from the main blockchain, along with a mechanism whereby anyone can publish a fraud proof to the root contract.
All these solutions have a common goal - by ensuring that the main chain handles vital aspects of decentralisation, data availability and security, Layer 2 scaling solutions are diverting the transactional burden onto their parallel network and decongesting the main blockchain in the process.
Main benefits of Layer 2
Layer 2 scaling solutions provide several benefits for the blockchain space. Let's check them out.
Off-loading transaction data
Primarily, Layer 2 enables increased scalability by offloading numerous transactions from the main chain on the second layer. The primary objective of Layer 2 is to increase transaction throughput; Layer 1 blockchains require broad amounts of computational power to build each block of transaction data on the network. When transaction data is processed off-chain, congestion is reduced.
This means that more transactions can be processed per second, reducing network congestion and cost issues. Transaction throughput on Layer 2 is much faster when compared to transactions processed on-chain. This feature is especially important for the DeFi and NFT space where timely execution is vital.
Lower transaction fees
Secondly, a Layer 2 scaling solution improves the overall user experience by reducing gas fees. Popular blockchain networks may encompass quite high transaction fees which makes micro-transactions impractical.
Users can execute transactions and interact with smart contracts at a fraction of the cost compared to traditional on-chain executions. Allowing users to pay lower transaction fees expands the adoption and enhances user experience.
More privacy and security
Finally, Layer 2 improves privacy and lays down additional security guarantees. Processing transactions off the main blockchain means that sensitive transaction data can remain private. This is especially important within the space of a decentralised economy where users interact with smart contracts and manage confidential financial data.
Are there any drawbacks?
Even though they are quite beneficial, Layer 2 solutions encompass several issues as opposed to building on the first layer. As Layer 2 scaling solutions flourish, it is important to assess their implications for Ethereum Layer 1.
The primary concern is related to the diminishing of Ethereum’s composability or interoperability.
When creating an isolated ecosystem on the second layer, transactions could get restricted to the separate protocol; this could negatively impact the blockchain’s interoperability due to the inability of decentralised applications (Dapps) to interact on different layers.
The second potential drawback is the concern that it could diminish the liquidity of the main chain. In other words, when Dapps create separate layers, liquidity could be spread thinly.
Additionally, when multiple layers are situated on top of the Ethereum blockchain, the base layer and divergent Dapps could require a bigger number of bridges to transfer transaction data. This means that additional accounts would be needed, and this might be detrimental from a user’s point of view.
Layer 2 as a business model
In the past, the Ethereum blockchain faced congestion problems. It is a typical problem encountered by blockchain networks – there is too much demand and not enough supply. When that happens, transaction fees go up as well. At some point, it becomes unaffordable for users to send a transaction, and scalability fails accordingly.
A part of the crypto community refers to the Ethereum network as the ‘New York City’ of the crypto space. That is not a bad comparison at all, but the fact that the network cannot support so many users on its main chain remains. That is why Ethereum needed to scale on Layer 2.
One of the main constituents of the Layer 2 business model is the use of Layer 2 smart contracts. Such smart contracts have been specifically designed to improve the performance of ordinary smart contract technology, giving them more speed and cost efficiency.
Additionally, the Rollup technology on Ethereum has been growing in user adoption and developer focus. Some think of it as the bleeding edge of the Web3 movement.
The smartphone example
The demand for more space has been the case for other important computing innovations in history as well. Just look at smartphones which have improved a lot over the last few years. In other words, most of the value we get from our smartphones comes from its applications.
When apps on smartphones improved, more users were drawn to them which in return gave manufacturers more money to invest into the base layer of the smartphones’ infrastructure. As you can see, there is a feedback loop between the development of the infrastructure and the applications. The economy is as simple as that.
It is the same with Ethereum. With applications improving, more users want to use Ethereum. More users mean scalability issues, and the demand is pushing developers to re-invest back into the infrastructure to support enhanced apps and expand the user base.
What is value flow within the crypto ecosystem?
With the increasing notability of crypto assets, investors need a firm understanding of how value circulates within the digital ecosystem. Ethereum, as the main layer for decentralised finance (DeFi), is approaching an important milestone called the ‘broadband moment’.
The broadband moment demonstrates a solution of throughput barriers by utilising Layer 2 scaling solutions which pave the way for a more efficient infrastructure capable of supporting a higher demand. When it comes to Ethereum, many think that specifically, Layer 2s will enable Ethereum to usher in its broadband moment.
The economy behind Layer 2 solutions
Aside from the innovative technology, the viability of Layer 2 solutions is also made of their economic model. Profits in Layer 2 scaling solutions typically derive from the transaction fee spread, which presents the difference between gas fees collected on the second layer and the transaction costs that happen on the base layer.
Layer 2 solutions are made of two components – the intrinsic value and the monetary premium. The second layer’s intrinsic value stems from the total gas fee spread that is generated by the blockchain network which should be returned to token holders. Other than that, Layer 2 tokens don’t have a specific value accrual system.
On the other hand, the monetary premium component stems from the features of sustainability and sovereignty. Since Layer 2 scaling solutions make a positive spread, they are considered sustainable. As for sovereignty, second layers rely on the Ethereum blockchain for data availability and settlement. In these terms, they are not sovereign, along with the fact that they pay Ethereum for these services.
Sovereignty may be possible to obtain through Layer 2’s ability to configure self-standing architectures. By attaining independence from the base layer, Layer 2 could become sovereign ecosystems with a separate monetary policy and governance mechanisms.
However, it is not as easy as it sounds. Layer 2 architectures may face trade-offs – while sovereignty comes along with several monetary benefits, it could have security implications.
We have discussed several times how traditional economic principles can be applied within the crypto space. Before introducing the main economic principles of Layer 2, you can learn more by reading this article: 'How do popular theories in economics shape crypto?'.
Substitutes and complements
Think of any product in the market – it has its complements and substitutes. A substitute refers to another product you might decide to buy if the first option is too expensive. For example, you buy chicken instead of beef; therefore, chicken is a substitute product for beef.
On the other hand, a complement is a product you buy together with another product. For example, when you buy a car, you also buy gas.
If all other conditions on the market are equal, the basic interplay between a complement and the base product goes like this – demand for a certain product increases when the prices of its complements decrease. For instance, hotels in a certain destination will most likely go up if the price of flights decreases.
Let’s go back to layers – if Layer 2 scaling solutions are complements, that means that they continuously drive down costs to enable better user experiences.
In most cases, Layer 2 keeps an average of 23.5% of all transaction fees running through apps that underline their execution, and Ethereum validators get the remaining 76.5% of user transaction fees that are paid on the second layer.
Therefore, Layer 2 is a complement product to Layer 1 since it serves as an execution layer of the crypto tech stack. It achieves this by batching transaction data, compressing it, and anchoring proofs of data to the Ethereum layer, ensuring final settlement.
Moore's Law and blockchain technology
Complements may become commoditized. If that is the case, we may expect to encounter Layer 2 margins compress over time as other competitors enter the market and Moore’s Law continues to function.
The term coined by Gordon Moore, the co-founder of Intel Corporation, predicts the exponential growth of computational power over time. Originally, the law stated that the number of transistors on microchips, which are the backbone of electronic devices, shall double approximately every two years while the production costs remain the same or decrease.
One of the economic impacts of Moore’s Law is that computing devices continue to demonstrate exponential growth in computing power and overall complexity while generating a comparable reduction in cost to the manufacturer and the producers.
The crypto space is not immune to the effects of Moore’s Law. In other words, the constant doubling of computing power underpins the expansion of blockchains, enabling them to support higher throughput and broader data sets. The growth itself leads the way for the emergence of more secure cryptographic methods and encryption techniques.
Additionally, Moore’s Law drives blockchain technology towards energy efficiency, and holds the potential to diminish the negative environmental impact of blockchains while maintaining stability.
While there are particular challenges that come along with the effects of Moore’s Law, the increasing storage capacity is able to empower blockchains to accommodate complex smart contracts.
Layer 2 network effects
The theory of network effects assumed an important role within the crypto space in the light of determining the success of a particular blockchain network. Similar to Bitcoin which has enjoyed network effects due to being the primary value store within the crypto ecosystem, the Ethereum ecosystem has been building its network effects through its potential to store value.
Network effects can be defined as the changes in decision variables of a particular economic agent which are based on choices of other agents which use similar goods or services. They can be further divided into application effects, system effects and user effects as well as direct or indirect network effects.
For example, application effects refer to the increase in utility gained through compatibility with other applications, and horizontal direct network effects present a type of effect that arise from the additional utility gained through a bigger number of network participants.
In its simplest form, application effects and user effects demonstrate increases in network interconnectivity through additional nodes or block producers. In contrast, indirect network effects stem from the benefits presented by complementary goods and services.
We have discussed earlier in the text how Layer 2 assumed the role of complements concerning the main chain, and how Moore's Law applies in relation to the feedback loop and developments of technology.
Let’s lay down a quick example from the DeFi space. If you take a look at popular decentralised exchanges (DEXs), you can see how increased user activity and participation contribute to the overall value system.
As more users join these exchanges, the liquidity providers increase which ends up in narrower bid-ask spreads, deeper order books, and most importantly – more favourable prices for crypto trading. When trading improves, it attracts additional users and liquidity providers.
This may sound overwhelming, but if you think of main benefits delivered by Layer 2, you might conclude that perks such as higher transactions per second, lower gas fees and assurance that all transactions, once completed, are irreversibly recorded on the mainnet, can be associated with the theory of network effects and the expanding of the Ethereum community.
The future of Layer 2
Given that blockchains are going through a rising real-world adoption, technological developments will continue to focus on fast transactions, low fees and scalability. It is vital to understand the role economic models play within the crypto ecosystem.
Divergent approaches to crypto-economics are starting to settle into distinct layers of a crypto-economic stack – Layer 1 as the base network protocol and Layer 2 referring to mechanism capacities provided by blockchain platforms.
The future of Layer 2 is not set in stone, but it is on the path of becoming a vital component of crypto space. Research is constantly being conducted to improve both the scalability and security of Layer 2 mechanisms, along with novel Layer 2 technologies which aim to combine the advantages of Zero Knowledge Rollups and Optimistic Rollups.
In line with all economic theories we have presented so far, the growing adoption of blockchain is proportional to the increased demand for scalable solutions.