In this week’s episode of Opto Sessions, Larry Cermak highlights the transformative potential of L2 blockchains. This technology can greatly increase the scale and reliability of blockchains, with key ramifications for investors who are exposed to or considering entering the space.
Layer-two (L2) blockchains are “very close to a breakthrough in terms of usability”, as Larry Cermak, CEO of digital asset information service The Block, told this week’s episode of Opto Sessions: they could be “a huge narrative for the next two to four years”.
Cryptocurrencies operate off blockchains: distributed databases or ledgers that can make any form of data ‘immutable’, or unable to be changed. As a result, they are an incredibly reliable store of information, which is what enables blockchains to function as a store of value.
Their use is not limited to cryptocurrencies; hundreds exist for non-crypto purposes, and individual blockchains, such as Ethereum, can be geared towards a wide array of use cases.
Adoption of blockchain technology, especially cryptocurrencies, is reaching a point that strains the capacity of traditional, ‘layer-one’ (L1) blockchains. L2 solutions are protocols operating over L1 blockchains that offer a raft of benefits, chiefly in terms of scalability, but also with regard to privacy and other areas.
“A huge narrative for the next two to four years.”
Types of L2 blockchain
There are four principal classes of L2 blockchain: state channels, sidechains, optimistic rollups, and zero knowledge (ZK) rollups.
Normally, blockchain transactions require changes to be broadcast to the entire network. State channels allow two or more users to conduct off-chain transactions, reducing the load on the network, and thereby massively increasing scalability. The reduced load also lowers the transaction fees incurred by using the network.
Sidechains are separate blockchains stemming from a main blockchain, enabling the transfer of assets between chains. They reduce the load on the main chain, and as such, like state channels, improve scalability.
Built specifically for Ethereum, optimistic rollups enable contracts to be executed off-chain instead of being broadcast to the entire network. Again, this reduces the load on the blockchain, improving its scalability and cutting transaction fees. They assume that transactions are valid (hence ‘optimistic’), unless challenged within a seven-day time period.
Optimistic rollups account for the majority of L2 blockchains, with Optimism and Arbitrum being two of the most prominent examples.
ZK rollups allow users to verify transactions without revealing any sensitive information, thereby improving security and privacy on the blockchain.
Advantages of L2
Scalability and reliability
L2s ultimately offer the potential for blockchain to be accessible to more people in a more reliable format. As outlined above, most of them work by reducing the workload of the main chain, thereby increasing the number of transactions it can handle.
This also improves the reliability of the blockchain. Blockchains are currently plagued by liveness failures — essentially, instances where the chain stops producing or finalising new blocks — which periodically cause outages or delays in networks.
“That's something that is very unappealing for someone that wants to use de-fi [decentralised finance] on top of these blockchains,” says Cermak. “You really don't want liveness failures, you don't want the blockchain to go down and your position to be liquidated because you had no way to prevent it.”
By taking a large number of the transactions off the main chain, L2 blockchains can reduce liveness failures and improve reliability.
L2 blockchains also have more revenue-generating potential than L1s, according to Cermak.
“Ultimately, most of the L1s only make revenue from the fees themselves.” When it comes to ‘low-fee, high-throughput’, “the fees are so low that the revenue ends up not being super meaningful… None of the blockchains are generating significant revenue outside of Ethereum, and Bitcoin to some extent.”
However, L2 blockchains can charge sequencer revenue for sequencing transactions on top of the first layer, which can translate into significant revenue streams.
“When you look at certain L2s, including Optimism and Arbitrum… and some ZK ones… they are actually generating decent amounts of revenue.”
Revenue alone is not the whole story, though. Because of the unpredictable regulatory environment for de-fi assets, many blockchain providers are hesitant to link revenue too closely to the performance of the token.
“There’s a lot of nuance there. Revenue by itself is not enough: what actually ends up moving the needle is how the revenue ends up being distributed, where the revenue actually ends up going. Is the system actually decentralised enough for this to be meaningful?”
Among the L2 rollups that are on the horizon, Cermak is personally most excited by Starknet, a ZK rollup that bundles numerous Ethereum transactions into single transactions on the main chain. However, he’s also watching how they all compete against each another.
“There's some nuance between their approaches. But ultimately… what's most important is that they're finally going to be usable by normal people. That's going to allow an order of magnitude of more use cases to be built on top.”
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