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Pantera Capital: why will Layer2 unlock the next blockchain killer app?

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In the wave of decentralization, scalability issues will continue to be addressed by a variety of complementary solutions

THE NEXT MAJOR UNLOCK

Emma Rose Bienvenu, Pantera Capital

Linch, chain Catcher

After DeFi's summer frenzy in 2020, demand for ethereum hosting protocols skyrocketed, resulting in sky-high gas charges and severe network congestion. Thankfully, 2021's "Summer of Layer 2" promises to be a solution, with the hot release of extension solutions like Optimism and Offchain Labs' Arbitrum.

Next, we discussed why Layer 2 technology is so important. We'll start with the basics of extension, then go into detail on how the new off-chain tools can help with both transaction speed and cost. Finally, we discussed what this means for the broader ecosystem and why Layer 2 will unlock the next wave of killer blockchain-based apps.

introduce

If the promise of blockchain technology is to democratize access to finance -- lowering costs by removing rent-seeking middlemen -- the great irony is that transactions on Ethereum, which hosts most DeFi protocols, remain extremely expensive for users. In distributed networks like Ethereum, each transaction requires each node to store and process: this means that as the user base grows, the network inevitably hits capacity limits. This is the cause of the notoriously high gas charges. Because congestion drives up gas prices and processing times, small transactions cannot work properly. This makes it almost impossible for computation-demanding Dapps to run directly on the increasingly crowded blockchain.

In short, Ethereum has become a victim of its own success. Over the past year, demand for processing transactions has exploded as millions of people have rushed to adopt and use DeFi protocols, NFT marketplaces, and other Dapps hosted on Ethereum. In this case, the processing power has been disappointing due to the limited computing power per node and the size of the individual blocks.

When there are more transactions competing for a limited amount of block space and computing power, gas rates will rise and volume and speed will slow. Ethereum fees rose 845% in 2021 from 2020; Average block capacity, which was around 70% in January 2020, has now risen to a sustained level of 98%.

Problems in the extension

Increasing the capacity of networks like Ethereum is particularly challenging. There are three main characteristics that define blockchain: decentralization, security, and scalability. You can choose between two of these three traits, but if you stick to the most straightforward approach, you won't have any of them. This means that making a blockchain more scalable -- that way it can process more transactions, faster and cheaper -- often weakens its security or decentralized character.

This big conundrum, often referred to as the "scalability triple paradox," has bedeviled proponents of blockchain technology since the early days of the ecosystem. In 2014, Vitalik Buterin made the memorable promise that the Ethereum community would either fix scalability issues "or die here." Thankfully, with recent scalability upgrades and the release of the breakthrough Layer 2 extension tool, success is within reach.

Broadly speaking, there are two ways to overcome the extensibility triple paradox. Layer 1, or on-chain extension, focuses on improving the blockchain itself; The focus of Layer 2, or downchain extension, is on improving the way blockchains are used.

Layer 1

In the Ethereum ecosystem, the leading Layer 1 extension proposal refers to "shards", which would split the transaction database horizontally by creating new chains or "shards" to reduce the amount of data each verifier needs to process. This allows distributed networks to process more transactions than the computing power of a single node. Ultimately, this will lower the threshold for new verifiers to join the distributed network, increase its throughput, and reduce the cost of transactions on it.

However, there are serious limitations to how Layer 1 can be extended. This extension involves challenging computer science and game theory challenges, many of which have never been solved before. Hard bifurcation of protocols is also an important basis for implementing them. As a practical matter, this requires building a strong consensus among all stakeholders around each Layer 1 upgrade. As in any complex and fragmented system, this is a daunting and time-consuming proposition.

The long-delayed hard fork upgrade plan for the beleaguered "ETH-2" ethereum shows how difficult it is to implement significant Layer 1 changes in terms of technology and community coordination.

Layer 2

The Layer 1 solution focuses on improving the performance of the core blockchain, while the Layer 2 approach focuses on improving the way blockchain is used. Its proponents argue that because distributed ledgers are volumebound by nature, they should only carry the highest value transaction data. Layer 2 moves lower-critical operations down the chain, but leaves assets and cryptocurrencies at Layer 2. It allows users to return to Layer 2 at any time to resolve disputes or reclaim their crypto assets. This anchors the operations of Layer 2 into the security of local Layer 2, freeing up valuable block space on the core blockchain. Ultimately, this allows Layer 2 to process more transactions faster and at lower cost.

There are three main types of Layer 2 solutions: state channels, side chains, and Rollups. While all three can provide a compound benefit for blockchain capacity, the Ethereum community has identified Rollups as the most promising way to scale the network. While other Layer 2 solutions can be scalable with significant compromises in terms of security or decentralization, Rollups accepts some centralization without sacrificing trust, which is a key priority for decentralization.

Rollups moves most of the computation down the chain, then periodically pushes bulk transaction data and the resulting state root onto the Layer 1 blockchain. By performing operations outside the main network but recording transaction data and/or proving at Layer 1, Rollups can benefit from the security of the core blockchain while achieving greater throughput and significantly lower costs. Broadly speaking, there are two types of Rollups: ZK-Rollups and Optimistic Rollups.

ZK Rollups moves computations to Layer 2 and periodically batches and compresses data for off-chain transactions, generating validity certificates of their integrity and publishing them to the Ethereum main net. By publishing proof of the correctness of each state transition, ZK-Rollups ensures the validity of the on-chain state and allows users to withdraw money immediately. But the calculations of these proofs are complicated and time-consuming. Even if developers are eventually able to use Solidity in conjunction with ZK Rollup technology, they currently need to rewrite smart contracts in custom programming languages. For now, ZK-Rollups is the most suitable project for implementing direct payments, such as decentralized transactions or payment platforms.

We previously invested in StarkWare, which is now a leading pioneer of ZK-Rollups technology. In mid-2020, Starkware set up 1.3 million accounts on Ethereum using StarkEx and set the initial balance for each account within 12 hours, Demonstrated the power of StarkEx, its ZK-Rollups scalability engine that supports decentralized transactions. If this behavior were run directly on the main network, the process would consume the entire ethereum network capacity for 4.5 days. StarkEx ran the entire process in just 12 hours at a staggering average cost of $0.003 per transaction and 2.5 percent of Ethereum's capacity.

Unlike ZK-Rollups, Optimistic Rollups assumes that the transaction is valid and only runs proof of fraud if there is a challenge. Optimistic Rollups relies on parties to validate the data submitted by Layer 2 -- and challenge the incorrect state -- to maintain the integrity of the transformation. While computationally efficient, this forces users to wait for a challenging period before they can access their funds. Still, the scalability benefits of Optimistic Rollups are huge, reducing Ethereum gas costs by 10,000+% and increasing throughput by up to 200 times.

By using Optimistic Rollup technology, Projects such as Arbitrum can easily integrate existing DApps and support the execution of arbitrary EVM codes at the sub-chain level, while making minimal changes to the underlying smart contracts. Since its launch in August 2021, more than 250 development teams have begun to develop on Arbitrum. This project was selected by Reddit to launch its own Layer 2 Rollup, Aave, Balancer, Band Protocol, Coinbase Wallet, Chainlink, Curve, DAI Stablecoin, Etherscan, DODO, MetaMask, Shapeshift, Sushiswap and Uniswap has been on-line or will be integrated with Arbitrum technology.

The ability and promise of Optimistic and ZK-Rollups is to give users the option to revert to Layer 1 to reclaim their assets or resolve disputes by anchoring transactions in local Layer 1 security. They created game theory incentives for users and operators to act honestly. This makes them an important catalyst for creating secure and scalable networks on which users can conduct transactions without trusting central intermediaries or their counterparties. In short, the promise of blockchains and cryptocurrencies is obvious. With the recent launch of the highly anticipated Layer 2 extension project, this promise is now easier than ever to fulfill.

What does it mean to address scalability

In order for blockchain-based protocols to replicate and eventually replace the backbone of traditional finance, they need to match or exceed the performance of their infrastructure. Without the help of Layer 2, the Ethereum main network can only handle 15-20 transactions (TPS) per second. The bitcoin main chain can only handle seven transactions. By comparison, VisaNet's payment network processes about 1,700 TPS on average and Nasdaq processes about 500-1,000TPS. With the introduction of Layer 2, this gap will narrow or disappear. Rollups alone is expected to increase TPS on Ethereum to between 1,000 and 4,000TPS.

Other Layer 2 solutions such as state channels and side chains will increase the capacity of the ecosystem, as will highly scalable Ethereum alternatives like Polkadot. Taken together, these tools will make it possible to create blockchain-based point-of-sale payment systems that offer instant money transfers for quick checkout and guaranteed settlement, with throughput comparable to the Visa network.

In the short term, the benefits of higher transaction speeds and lower costs will be felt most strongly in DeFi. Applications that migrate to Layer 2 will provide lower transaction fees and lower minimum transaction sizes and pass on their significant cost-saving status to users. This will drive DeFi's overall transaction volume, attracting retail users who have previously been reluctant to trade directly on Ethereum, leaving centralized exchanges or using less secure alternatives such as Binance Smart Chain.

For example, allow dYdX's Starkware integration, provide users with a higher threshold for maximum leverage, lower penalties for clearing, and cross-profit trading features.

The DeFi protocol itself will also be improved. Apps like Perpetual Protocol and dYdX allow users to long or short cryptocurrency assets using margin and leverage; When the value of the posted collateral falls below a specified threshold, the collateral is automatically liquidated. This clearing mechanism is suboptimal when transactions take a few minutes to process, but it works more efficiently and precisely in a scale-up ecosystem of near-instantaneous transactions. This significantly improves the capital efficiency of the DeFi protocol. For example, allowing dYdX's Starkware integration to provide users with higher maximum leverage thresholds, lower clearing penalties, and cross-margin trading capabilities.

More broadly, the emergence of high-throughput, nearly free, and instant transactions will enable blockchain-based protocols to rival or surpass user experiences on traditional web browsers. Historically, one reason attempts to build a decentralized Facebook, World of Warcraft, Visa, or SecondLife have largely stalled in their establishment is that public blockchains lack the capacity to handle applications that require hundreds or thousands of calculations per second.

Applications that used to be too slow or computation-intensive to run on the core blockchain will become viable with extensibility tools that increase throughput by 50-1,000 times. This will mark an unprecedented expansion in the size and scope of the addressable market for blockchain-based projects, unlocking the next generation of decentralized social media, virtual worlds, micropayment platforms, gaming ecosystems, and more.

conclusion

For blockchain-based systems to realize their vision of a transparent, secure, censorship resistant, and privacy-protecting financial infrastructure, expanding the ecosystem's capabilities will need to become an iterative, enduring project. For now, Layer 2 solutions can provide powerful, flexible, composite tools. Over time, the best way to extend Layer 1 is probably to increase its efficiency as a data availability engine to optimize Layer 1's ability to run Layer 2 on top of it. In the true trend of decentralization, the issue of scaling is being and will continue to be addressed by a variety of complementary solutions.

For now, Layer 2 is leading the way toward a scalable, stackable blockchain ecosystem, and we can't wait to see the wave of innovation they unleash.