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Layer 2 & Ethereum 2.0 – Do They Solve Ethereum’s Scalability Issues?
Layer 2 technologies

This article deals with the ongoing scaling constraints of processed transactions on the Ethereum blockchain and its mainnet (Layer 1). The increased adoption of DeFi applications and the growing NFT environment are not the only strong drivers for the processed traffic on the network. For now Ethereum is in the pole position of protocols that are enabling smart contracts and bringing up new use cases.

There are different projects in the ecosystem attempting to bring  potential scaling solutions for the Ethereum mainnet. This blogpost will describe the reasons for the constraints as its consequences, alongside a deep dive into Ethereum 2.0 and Layer 2 Technologies as some of the potential scaling solutions.

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Why is scaling on Ethereum mainnet (Layer 1) an issue?

The high demand and traffic on Ethereum is a strong indicator for the ongoing and progressing adoption of DLT related use cases. For instance the total value locked in DeFi applications on Ethereum increased by more than 850% in 2021 after an even bigger growth rate in the year before of nearly 2850%. At the same time, the number of wallets holding NFTs has increased by 700% in the same period.

Those positive developments and high demand for use cases bring with it downsides. In its current state, the Proof-of-Work (PoW) consensus of Ethereum allows a throughput of approximately 15-30 transactions per second. As a consequence, users are confronted with a congested queue of transactions and long waiting times until their transactions are successfully processed. 

In addition to long waiting times, users need to pay expensive gas fees for transaction execution. Those are part of Ethereum’s regulation mechanism to control the traffic and incentivise miners to validate transactions. 

High gas fees make earning opportunities for interested investors difficult / unattractive, and actually exclude a high number of potential investors. This implication dilutes further adoption, making it a threat to Ethereum itself as users might switch to other protocols offering better conditions and higher investment opportunities.

What potential solutions exist?

There are different projects working on an organic solution by further developing and improving the current Ethereum mainnet (e.g. Consensus Layer). Additionally, other projects trying to offer solutions for distributing and processing the workload outside the mainnet (e.g. Layer 2 Technologies).

Ethereum 2.0

The term “Ethereum 2.0” or “Consensus Layer” stands for the further development of the current Ethereum mainnet. The Ethereum foundation agreed on some fundamental changes to take place on the network in order to tackle the weaknesses alongside enabling further adoption of the blockchain.

The plan involves three steps:

  1. In a first step, it was planned to change the consensus mechanism from PoW to Proof-of-Stake (PoS) by developing the “Beacon chain” 
  2. In a second step, both chains are planned to merge to maintain continuity and data protection
  3. As a last step, sharding should be introduced
Description of Rollout Plan for Ethereum 2.0

Change of Consensus from PoW to PoS

In December 2020, the new Beacon chain was launched on the Ethereum network. As a consensus mechanism, the Beacon chain is using the less energy consuming PoS mechanism.

Instead of solving difficult mathematical problems, stakers (aka validators of PoS chains) have to deposit a specific amount of Ether (ETH) to run a node and validate transactions of the network to be able to participate in the creation of new blocks. Honest stakers that are validating transactions correctly will get rewarded accordingly, whereas malicious behavior of other stakers can be fined by losing their deposited Ether. Our recently published blog post provides more information about staking.

Merge

As the term “Merge” indicates, it is not planned that the current mainnet gets offline once the Beacon chain takes over. Instead, the old PoW mainnet and new Beacon chain will be merged into one more robust, scalable, and sustainable system. The PoW chain will ensure that smart contracts will run on the PoS chain while keeping  the full history and transaction data available.

Sharding

Sharding will be the final step of the Ethereum transformation and is the crucial part to scale the Ethereum network. The idea is that the blockchain will no longer process transactions only on one single chain, instead, it will introduce 64 new chains, more accurately referred to as “shards”.

The traffic on the blockchain will be distributed over these 64 chains drastically empowering the scalability. The nodes on the Ethereum network will be distributed to validate transactions of each shard. 

The implementation of sharding is expected to take place in 2023. Initially it was planned to be introduced before the merge, however, due to successful developments of other layer 2 scaling solutions the Ethereum foundation decided to focus on the merge first.

What Layer 2 Technologies exist and what is their value proposition?

Before diving into the different approaches, we would like to clarify the terms layer 1 and layer 2.

The Ethereum mainnet in its current state and after the upgrade represents the first layer of the Ethereum network. 

However, there are projects and other solutions that work outside of the mainnet (layer 2 technologies) and are based on different technologies to exchange transactional data or even tokens with the mainnet.

Sidechains

A sidechain is a separate blockchain running its own consensus mechanism to secure its transaction processing. They often use a more central mechanism in order to process faster transactions. 

If it is compatible with the Ethereum Virtual Machine (EVM-compatible), meaning it supports Ethereum’s token standards and Solidity as a coding language, it can easily exchange assets and data with the Ethereum mainnet. 

This can be achieved via Atomic-Swaps. This acts as a bridge between both chains and ensures that the asset of interest will be removed from one chain and simultaneously created on the other one.

It is an established technology that allows users to develop the same type of complex applications as on the mainnet. On the other hand, a less decentralized consensus mechanism makes it more prone to fraudulent attacks.

Rollups

Rollups process transactions outside the Ethereum mainnet but interact with it afterwards therefore, posting transaction data on layer 1. Since the mainnet receives and stores the transaction data, it ensures the secure storage on layer 1. Three general characteristics of rollups are:

  • Inheriting the security properties of layer 1 while executing the transaction execution outside the mainnet
  • Proof-of-transactions or transaction data is on layer 1
  • Rollup smart contract in layer 1 that can enforce correct transaction execution on layer 2 by using the transaction data of layer 1

Rollups users allow users to  benefit from low transaction fees while benefiting from the high security and decentralization standards of the mainnet. 

There are different types of rollups, but most of them are fully EVM and Solidity compatible allowing the same functionality range as on Ethereum layer one. 

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Conclusion

As we can see, there are different solutions that contribute to Ethereum’s scalability issues. A strong driver to  Ethereum’ success is the interlocking of its entire ecosystem.

Ethereum is permissionless, every party that wants to participate in it and supports the corresponding standards to be compatible, can interact with Ethereum. Hence the solution to its scalability issues will probably be a combination of existing layer 2 technologies which are experiencing high usage, and the upgrade to Ethereum 2.0. Using interoperability and the strong network to deliver a common solution.

Time will also be a deciding factor of the future success and adoption of the Ethereum network. In the past, the Ethereum foundation had to postpone the implementation of the upgrade a couple of times. Technical difficulties and delays are understandable for such a complex undertaking, but Ethereum competitors will be taking advantage of such delays.

The question is therefore not about which solution can solve Ethereum’s scaling problem, but whether the solution can be delivered in a timely manner, preventing competitors from capitalizing on delays by shifting the traffic from Ethereum to another protocol.

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