Due to a lack of any central authority or oversight, these platforms require the technology itself to have an innate amount of security to protect users from scams and attacks. Because of this priority in design, the immense resources require a fully functional ecosystem, which often lacks scalability. For blockchains that sacrifice scalability to achieve higher decentralization and security, Layer 2s enables greater transaction throughput, which can lead to lower fees. Layer 2 can be seen as one solution to the problem of scalability, enabling fast and scalable execution without compromising on decentralization and security.

What is layer 2?

Layer 2 refers to the asset of off-chain solutions (separate blockchains) built on top of layer 1s that reduce bottlenecks with scaling and data. Layer 2 is also an off-chain network system, a technology built on top of a blockchain network to help extend its capabilities.

Let’s think of it like a restaurant kitchen. If every order had to be made by a single person from beginning to end before the order was confirmed and delivered, It would be a very slow process that could only fulfill a few orders an hour. Layer 2s are like prep stations. There’s a station for cleaning and cutting food, a station for cooking, and another station that assembles the dishes, which can focus and do each task much more efficiently. When the time is right, a final person can match each assembled dish to the order and confirm it before it is sent to the final destination (the customer).

One core requirement for a network system or technology to be considered layer 2 is that it inherits the security of the blockchain it is built on top of. Transaction data must, in some shape or form, be verified and confirmed by the underlying blockchain network rather than a separate set of nodes.

For blockchains that sacrifice scalability to achieve higher decentralization and security, layer 2 enables greater transaction throughput, which can lead to lower fees. Layer 2 can be seen as one solution to the problem of scalability, enabling fast and scalable execution without compromising on decentralization or security. Ethereum uses this method through some features like optimistic and ZK (zero-knowledge) rollups that offload the burden of managing transactions from the mainnet, thereby enabling greater transaction inclusion and throughput (higher transaction per second). all of which make for a seamless and practical user experience. Examples of layer 2s on Ethereum include solutions like:

1. Arbitum

2. Optimism

3. Loopring and

4. ZK sync.

How Layer 2 Works

Layer 2 protocols provide a second framework where transactions can take place separately from Layer 1. This means that a decent amount of work that will be performed by the mainchain can be moved to the second layer. Layer 2 applications post the transaction data to Layer 1, where it’s secured in the blockchain ledger.

Typically, layer 2 has two parts:

1. A network that possesses transactions and

2. A smart contract on the underlying blockchain resolves any disputes and achieves consensus on the state of the layer network by cementing it to the underlying blockchain.

Layer-2 networks are where fast execution transactions and computations occur. They can vary wildly in how they achieve this throughput. A common denominator between each layer-2 environment, however, is that when looking to settle on the base chain, layer 2s must provide some cryptographic and verifiable “proof” to the blockchain on the integrity of the proposed state change, either preemptively or retroactively.

Layer 2 protocols are specially designed to integrate the underlying blockchain to improve transaction throughput. They rely on the consensus mechanism and security of the main chain. Operations on layer 2 can often be performed independently of layer 2. This is sometimes referred to as “off-chain solutions.” The mainchain/layer 1 can provide the security inherent to a blockchain, and layer 2 can provide the speed.

Most transactions on layer 2 are happening on a different chain; a connection is periodically opened to move those transactions onto the main blockchains. The connection is called a channel. The major consideration for a layer 2 solution is how transactions are validated and confirmed before going to the main chain.

The core functions of smart contracts in layer 2 are:

1. Hold and release funds transferred to layer 2.

2. Receive some kind of proof generated by layer 2, validate it, resolve disputes, and then finalize transactions.

What are Layer 2 scaling solutions and how do they work?

From using it as a transacting currency (ETH) to tapping into its immutability for record-keeping and cryptographically secured nature, Ethereum has been a catalyst for enormous growth in the blockchain industry since its introduction in 2013.

Like many other blockchains, Ethereum has reached a point where it now faces a scalability challenge. According to crypto.com, as of summer 2022, Ethereum processed an estimated 500,00 transactions per day, which translates to 30 transactions per second (TPS). In comparison, the Visa payment system can process up to 150 million transactions per day and 65,000 tps — magnitudes ahead of what Ethereum is capable of. In practice, reaching the limits of a blockchain results in network congestion (where it may take hours to process a transaction) and extremely high gas fees.

Layer-2 scaling solution intends to solve blockchain’s scalability issue by processing transactions on third-party networks instead of the Ethereum mainnet (Layer-1). In doing so, it not only lightens the workload on the mainnet but also maintains the main security and decentralization standards of the underlying Ethereum blockchain.

Types of Scaling Solutions:

There are a multitude of layer-2 scaling solutions out there or being developed today. We would be discussing them broadly.

1. Transaction Execution

2. Data Availability

Transaction Execution: Transaction Execution strategies deal with how transactions are run, where they are run, what the trust environment is, and what the security and decentralization environments are.

Data Availability: Data Availability strategies deal with whether or not the layer2 solution makes its transaction data available in the layer 1 chain or not.

Examples of Layer-2 Scaling Solutions:

1. State Channels: State Channels were the first widespread scaling blockchains. State channels are used when two or more users want to do a bunch of transactions in a trusted environment without paying transaction fees for an on-chain transaction every time. State channels utilize multi-signature contracts to enable participants to transact quickly and freely off-chain, then settle finally with the mainnet. This minimizes network congestion, fees, and delays.

Exploring a Simple Example:

An on-chain two-player game like chess. Let’s say Peter and Angela want to put down 1ETH each to play a game of chess on-chain, and the winner takes all. Let’s say Peter and Angela also trust each other not to be malicious but want to make sure the loser isn’t sore about losing and pays up the money. A smart contract would be designed such that each move they make is recorded on-chain, and at the end of the game, the state of the chess board can be verified by the contract, and the price is paid out automatically to the winner. If each transaction were to happen, This would quickly become an expensive endeavor since each move would cost Peter or Angela gas fees. This is a kind of use case that channels can help solve.

State channels allow participants to transact off-chain and settle with the mainnet. This enables high transaction throughput and minimizes congestion and fees. Whenever you are designing a smart contract, make sure you design a smart contract that allows the opening and closing of a channel. When you first open a channel, it sets the initial state of the chessboard in the contract. Every subsequent move is played off-chain. But Peter and Angela sign each move with their wallet (private key), but don’t post that on-chain as a transaction.

They keep recording each signature of each move, and at the end of the game, they submit all the signatures in a single transaction back on-chain. This would be the closure of the channel. This approach is not without its challenges as well. The core assumption under which state channels are useful is that participants in the state channels trust each other to perform these transactions off-chain.

Example of State Channels:

i. Celer X Network

ii. Raiden Network

iii. Lightning Network

B. Payment channels: A payment channel enables the off-chain transfer of on-chain tokens between two or more users by pre-funding liquidity into a channel. Peter and Angela create a payment by locking up collective funds in a smart contract and agreeing (through cryptographic signatures) how much each has access to. For example, if both locked up $50 of funds for a total of $100, they would most likely agree that each gets to use $50 in the payment channel.

Once the payment channel is set up, Peter and Angela are free to transact off-chain via signed messages without submitting transactions to the underlying blockchain. Peter can pay Angela at zero cost and lightning-fast latencies. When communicating over the two-way payment channel, Peter and Angela’s transactions aren’t posted onto the underlying blockchain; it’s only when they mutually decide to close the channel that the results are transmitted to and settled on the blockchain.

The result of this system is that Peter and Angela only need to pay for two on-chain transactions to open and close the payment channel. While the payment channel is open, millions of transfers can be made at zero cost and sub-second speeds directly peer-to-peer. This is a classical example of scalability.

C. Sidechains: A sidechain is an independent EVM-compatible blockchain that runs in parallel to a main blockchain and as a channel to Layer 1. A side chain has its validators and consensus methods of adding blocks. Sidechains accumulate transactions quickly and cheaply and summarize them for the main chain via a bridge or channel. Sidechain uses a separate consensus mechanism and is not secured by layer 1, so it is not technically considered layer 2. You can think of sidechains as mini-Ethereum blockchains. Sidechains come with all the benefits of an EVM, such as writing smart contracts in Solidity and interacting with the chain using the WEB3 API. Sidechains have drawbacks, such as the fact that they can be more centralized. Examples of sidechains are gnosis chain (formerly known as XDai) and Polygon POS.

D. Rollups: A rollup is a specific layer 2 solution that executes hundreds of transactions outside of layer 1, rolls them up into a single piece of compressed data, and then posts the data back to the mainnet for anyone to review and dispute if deemed suspicious. Rollups don’t only utilize the security of Ethereum but can also reduce gas fees by up to 10–100x. Rollups help with deposits, withdrawals, and verifying proofs.

There are subtle variations in the way rollups are done, such as: 1. Optimistic rollups 2. Zero-Knowledge Rollups

1. Optimistic Rollups: In Optimistic Rollups, batches of transaction data are posted to the main chain and presumed to be valid by default but can be challenged by other users.

Anyone can challenge them by submitting a claim, also known as fraud-proof, to prove that a batch committed to the chain contained invalid state transactions. If the fraud proof is valid, these invalid state transactions would be rolled back. If nobody challenges the transaction, it will be committed to the mainchain. To give users enough time to challenge transactions, there is a long wait time between a transaction being posted and it being committed on the main chain, typically a few days but as long as a week. During this period, you cannot withdraw your funds from the main chain.

What’s stopping bad actors from spamming the network with fraud-proof verifications? And where does the money come from for layer 1 to verify transactions if challenged? This is what happens:

First, there are three players in the space:

1. Asserter: The prosper is attempting to post proof of transactions on the main chain, thereby asserting their validity.

2. Challenger: The user is trying to prove that the proof posted by the asserter is fraudulent.

3. Verifier: A smart contract on the main chain that verifies the proof and checks its validity.

An asserter has to provide a bond to propose a block of transactions, usually in the form of some ETH. A challenger also has to be provided with a bond (usually ETH) to make a challenge. The verifier will verify the transaction(s) on the main chain.

If the assertor is found to be fraudulent, they lose some of their bond. The verifier gets some of the asserter’s bond for processing the verification, and the challenger gets another portion of the asserter’s bond as a reward for finding the fraud.

If the assertor is found to be fraudulent, the challenger loses some of their bond. The verifier gets some of the challenger’s bond for processing the verification as before, and this time the asserter gets some of the challenger’s bond as a reward for their trouble. Several examples of rollups include Arbitum, Optimism, and Boba.

1. Zero-Knowledge Rollups: ZK stands for “zero knowledge,” and it’s a method by which one party (the prover) can prove to another party (the verifier) that a given statement is true, while the prover avoids conveying any additional information apart from the fact that the statement is indeed true.

ZK rollups generate cryptographic proofs to validate the authenticity of transactions. These proofs (posted to layer 1) are validity proofs, SNARK (succinct non-interactive argument of knowledge), or STARKS (scalable transparent argument of knowledge).

In the ZK rollup, no individuals are doing the verification. Instead, everyone who proposes a new set of rolled-up transactions to be added to the main chain constructs a zero-knowledge proof for it. This can be automatically verified by the smart contract that controls adding transactions to the main chain. Therefore, in contrast to optimistic rollups, ZK rollups do not have the challenger role, and every proof posted on the mainchain is verified at the time of posting. Examples of ZK rollups are dyDX, Loopring, and ZKsync.

1. Plasma Chains: Plasma is a framework for building scalable, layer 2 applications. Plasma uses a lot of the above ideas in its application. The building blocks of plasma are off-chain executions, state commitment, and entry/exit to the main chain. A plasma is a separate child blockchain that is anchored to the main Ethereum chain. Plasma chains use various fraud proofs to arbitrate disputes, just like optimistic rollups. Plasma chains have their own consensus algorithm and create blocks of transactions. At fixed intervals, a compressed representation of each block is committed to a smart contract on Ethereum. The implementation of plasma gives the ability for hundreds of sidechain transactions to be processed offline with only a single hash of the sidechain block being added to the Ethereum blockchain.

Plasma chains only interact with the main chain to commit their state or facilitate entry and exit.

Most implementations of plasma are on an entirely different blockchain; they must facilitate entering and exiting the chain, which is facilitated by smart contracts. An example of a plasma chain is a polygon.

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