If blockchain technology is going to compete with centralized legacy financial institutions, it has to be able to scale.
Scaling refers to increasing the capacity of decentralized crypto networks to process transactions and data quickly and affordably as more people use these networks.
There are trade-offs in attempting to scale blockchains, though, and Layer 1 (L1) and Layer 2 (L2) blockchains handle these compromises in different ways.
Let me start by first explaining what L1s and L2s are.
L1s were invented to make financial transactions more transparent and trustworthy.
All L1s have their own native tokens or currencies.
You can transact on L1s without the need for a third party such as a banker to verify or permit the transaction. Instead, transactions are validated by participants in the network who run nodes.
L1s include Bitcoin, Ethereum and Solana. These blockchains are the base layers on which digital asset transactions are validated and finalized.
L1s are sometimes referred to as “settlement layers.”
These layers hold and secure a distributed ledger, which is a public record of all transactions on the network and is shared with all participants in the network.
L2s like Bitcoin’s Lightning Network or Ethereum’s Polygon (MATIC) are separate, overlaying networks that take some of the processing burden off of L1s.
L2s process transactions more quickly and cheaply than L1s.
After processing transactions, L2s report data back to L1s, where the data for these transactions are recorded on the distributed ledger.
Scalability is one dimension of the “blockchain trilemma.” All blockchain networks have to find a balance between:
The original L1, the Bitcoin network, prioritizes decentralization and security, but it can only process four to seven transactions per second (TPS). Less TPS processing ability means less ability to scale.
To put this statistic in context: A traditional, centralized financial network like Visa processes approximately 1,700 TPS. Also, newer L1 protocol Solana processes 3,000 TPS on average and does so at far lower fees than the Bitcoin network.
However, the Solana network is far less decentralized and significantly less secure than the Bitcoin network.
A middle ground between the Solana and Bitcoin networks is the Ethereum network.
Ethereum processes 15 TPS to 20 TPS and does so at high fees, but the network is far more decentralized and significantly more secure than the Solana network. However, it’s not quite as decentralized and secure as the Bitcoin network.
The main issue regarding the scalability of L1 protocols is that it’s difficult to change their original architecture.
L1 protocols are all designed with a particular consensus mechanism, which is a system that secures and verifies transactions on these networks.
The Bitcoin network is secured by a Proof of Work (PoW) consensus mechanism.
PoW requires miners to use computational power to solve cryptographic algorithms in exchange for rewards in Bitcoin.
The only way to alter the transaction capability of PoW blockchains is to increase their block size or to expand the size bundles of transactions on the network.
Allowing for bigger block sizes would make the network capable of producing more TPS, which lowers transaction fees.
However, it would also encourage centralization, because running a full node would become more expensive. Fewer people running nodes equates to a more centralized system.
The other main consensus mechanism is Proof of Stake (PoS).
The majority of new blockchains use PoS to secure their networks, as it uses far less computational power than PoS systems.
PoS allows you to stake your tokens as collateral in the network as a means to validate new blocks of transactions.
Ethereum is currently transitioning from PoW to PoS. This means that, on Ethereum, you can stake your ether tokens — Ethereum’s native currency — and receive rewards in ether for helping to secure the network.
Sharding is the most popular scaling solution on PoS blockchains.
A shard is a portion of an overall database that processes a small part of network activity.
Each shard has its own nodes, but these nodes don’t have to process all the data on the entire blockchain — each shard only has to process portions of overall datasets before reporting finalized transactions back to the mainchain.
Sharding exponentially increases the TPS rate of a blockchain, because shards process transactions in smaller chunks instead of making the mainchain process all transactions sequentially.
L2 technology doesn’t alter L1s; it only reports to them.
The goal of L2s is to improve the scalability and efficiency of L1s by increasing the TPS rate.
L2s are designed to handle processing for L1s before delivering transactional data back to them.
For example, Bitcoin’s Lightning Network is an L2 solution that remedies Bitcoin’s slow TPS rate and relatively high transaction costs.
The Lightning Network uses smart contracts that enable speedy and nearly free transactions without creating on-blockchain transactions for individual payments.
Data from the smart contracts is then reported back to the L1 Bitcoin network for final settlement.
This allows for an exponentially larger number of transactions to occur simultaneously, while still relying on the security of the Bitcoin network.
Polygon MATIC is a L2 solution for Ethereum. Polygon MATIC uses the PoS consensus mechanism, which helps to reduce transactional fees while increasing the TPS rate.
Most blockchain developers claim that L2 solutions are the best way forward, especially for networks as large as Bitcoin and Ethereum. It’s dangerous to tamper with the underlying architecture of L1 blockchains that process tens of billions of dollars worth of transactions daily.
Bitcoin developers have already gone through what has been termed a “blocksize war,” in which the size of Bitcoin’s blocks was decided in a vote among developers, which means that the TPS rate on the main Bitcoin network likely will not change any time soon.
Now, the cheapest and quickest way to transact in bitcoin — the currency, not the network — is to use the Lightning Network.
Ethereum is in the process of transitioning from a PoW to a PoS blockchain in a process known in the crypto space as “the merge.”
In theory, this shift should increase the network’s TPS rate and reduce transaction fees.
However, the date for the unveiling of this new version of Ethereum — often called Ethereum 2.0 — continues to be pushed back.
For now, the cheapest and quickest way to transact in ether is to use an Ethereum L2 network like Polygon (MATIC).
Roughly only 2% of the global population uses blockchain networks to transact in digital assets, while approximately 62% of the world is banked.
If blockchain technology is going to continue to cut into the market share of traditional financial institutions, it has to be able to scale.
The different L1 and L2 solutions will help it do so.
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