Scale or Sink: A Review of Layer 2 Scaling Solutions for Ethereum

Scalability, state channels, sidechains, rollups, Arbitrum, StarkNet, zkSync 2.0 and the blockchain trilemma.

Key takeaways

• Technological innovation is often driven by bottlenecks in the capacity of fixed-supply systems.
• In recent years, Layer 1 alternatives like Solana, Avalanche and Terra have taken off rapidly, and are building significant momentum to displace Ethereum from its lead.
• Ethereum strives to compete along all three vectors of the blockchain trilemma (scalability, security and decentralisation), whereas competing ecosystems sacrifice decentralisation to achieve scalability.
• In order to meaningfully compete, Ethereum must find a way to rapidly scale up the throughput of its system.
• Layer 2 scaling solutions are an emerging class of technical upgrades that bring activity off-chain in order to achieve higher levels of scalability. Along with sharding, they are one of the most important ways for Ethereum to achieve mass scalability.
• Arbitrum is the current leading optimistic rollup solution with over 50% of the Layer 2 Total Value Locked (TVL) and numerous integrations with 1inch, Curve, Hashflow, SushiSwap and other dApps.
• zkSync is a SNARKs-based ZK rollup solution that will be natively EVM-compatible with the release of zkEVM. It has the potential to leapfrog other Layer 2s in the scalability race and has been aptly described by the team as “the beginning of the end”.
• StarkNet is a STARKs-based ZK rollup solution that is 10 times faster than SNARKs but less natively compatible with Solidity smart contracts. It runs on a programming language called Cairo, which can be converted from Solidity code using a transpiler to syndicate EVM compatability.

Technological innovation is often driven by bottlenecks in the capacity of fixed-supply systems. As the activity of a network grows, the demand for transactions begins to outstrip available supply, congesting the network and crowding out lower value use cases.

To bring the price of transactions back to parity, the operator must implement technical upgrades to expand the system’s throughput. Thus, the capacity of the network grows — not as a linear graduation but as a series of step changes.

Source: Open Source Finance.

Ethereum’s scale or sink moment

Ethereum is reaching a pivotal moment in its history. In recent years, Layer 1 alternatives like Solana, Avalanche and Terra have taken off rapidly, and are building significant momentum to displace Ethereum from its lead.

Source: DeFi Llama.

The hotly anticipated ETH 2.0 upgrade will implement Proof of Stake (PoS) consensus to dramatically reduce energy usage and improve network security, but contrary to popular opinion, it will bring about no immediate improvements to scalability:

1. For one, the proposed increase in throughput (from 10 tps to 100,000 tps) is only theoretical and will need to be achieved through sharding — an unproven concept that splits a network into smaller partitions to increase throughput. The tech behind sharding is still unclear (the NEAR team are furthest ahead in this field), so in the interim, gas costs could in fact rise rather than fall.
2. Ethereum’s lead in the Layer 1 race has so far been preserved by its first mover advantage and the moats built up through the ecosystem’s network effects. These exist both on the side of users (in terms of the number of network participants) and on the side of developers (in terms of the available developer tooling and composability of ecosystem applications). The longer the upgrade takes, however, the weaker those network effects become. The ETH 2.0 upgrade is not only technically complex but requires coordination between multiple execution clients (on the ETH 1.0 side) and consensus clients (on the ETH 2.0 side). While the merge is due to take place in August 2022, further setbacks could buy competing ecosystems precious time in building up similar moats.

Revisiting the blockchain trilemma

The blockchain trilemma is an evaluation framework for blockchains that posits a trade-off between three contending factors: scalability, security and decentralisation.

While Ethereum is highly focused on all three, a review of today’s top Layer 1 blockchains implies a preference for scalability over decentralisation (see table below):

• The fact that more developers are building on alternative blockchains suggests that scalability (assessed as throughput in terms of the number of transactions per second as well as the cost of those transactions) may well be the primary consideration when choosing between Layer 1 alternatives.
• On the other hand, decentralisation comes into play only once a network becomes sufficiently scalable. It is less relevant on the margin because participants abandon a network only when it becomes overly centralised.

Compiled by Open Source Finance.

In other words, Ethereum is competing with other blockchains on different vectors. While it is pushing the boundaries of both decentralisation and scalability (without compromising security), other Layer 1s are sacrificing decentralisation to outcompete on scalability. In order to remain relevant, Ethereum must find a way to participate meaningfully in the scalability race.

Layer 2 scaling solutions for Ethereum

Ethereum 2.0 is known as a Layer 1 scaling solution, as it implements technical upgrades to increase the throughput of the blockchain itself. Layer 2 scaling solutions are an emerging class of technical upgrades that bring activity off-chain in order to achieve higher levels of scalability. Along with sharding, they are key to bringing Ethereum to the masses.

There are currently four main types of Layer 2 scaling solutions, of which rollups are expected to provide the best improvements in terms of throughput and speed (and therefore where most of the developer activity is currently aggregated). These are:

1. channels: where groups of users deposit or lock up a balance on Ethereum to open a payment channel, which allows them to transact off-chain. Only when the channel is closed is the net transaction amount published on-chain. Channels have high throughput and low costs, but can be subject to long exit times and require third party security guarantees.
2. custodial sidechains: sidechains are faster and cheaper blockchains that run parallel to the main blockchain to relieve throughput on the network. Users lock up value on Ethereum and the same amount is credited to their wallet on the sidechain. Sidechains rely on their own consensus mechanism and security guarantees, and are generally considered to be less secure.
3. plasma sidechains: plasma uses sidechains to assist the main network with verification, leveraging its security guarantees.
4. rollups: rollups aggregate bundles of transactions and settle them off-chain, then publish a reduced amount of data to represent them on-chain. There are two types of rollups currently in play:

• Zero-knowledge (ZK) rollups represent multiple off-chain transactions as a single succinct proof. A validator can infer the validity of these transactions from the validity of the resulting proof.
• Optimistic rollups take an optimistic view of the world by assuming transactions are correct unless proven otherwise by honest validators. They tradeoff scalability for usability by being Ethereum Virtual Machine (EVM) compatible — meaning existing Ethereum smart contracts and applications can run without modification on its network.

Source: Decentral Park Capital.

In most cases, Layer 2 blockchains bifurcate consensus and computation / storage to achieve scalability. Rather than having a single blockchain (i.e. Ethereum) perform every function, Layer 2s move Ethereum toward a modular structure, outsourcing computation and storage to dramatically increase throughput.

Layer 2 chains, and in particular rollups, will directly benefit Ethereum because they leverage the consensus resources of the main Ethereum blockchain. As new dApps are deployed onto Layer 2 and activity at this layer grows, value accrues back to Ethereum, feeding a virtuous cycle for the Ethereum ecosystem.

Emerging Layer 2 winners

Rollups are furthest ahead in the Layer 2 race in terms of achieving the desired increase in throughput. Let’s look at some of the emerging winners in this space.

Arbitrum

Optimistic rollups are far more widely used today than ZK rollups due to their EVM compatibility and friendliness for developers. Their optimistic nature also avoids the need to produce complex cryptographic proofs, which can be computationally expensive.

Arbitrum is the current leading optimistic rollup solution with $2.8 billion in Total Value Locked (TVL), representing over 50% of the Layer 2 ecosystem. Numerous DeFi protocols like 1inch, Curve, Hashflow and SushiSwap have already integrated with Arbitrum, and its ecosystem currently counts integrations with around 150 different projects.

Source: Eigen Network (Medium).

zkSync

zkSync is a ZK rollup solution in development by Matter Labs since 2019. To say that ZK rollups will become successful understates their significance both in the context of blockchains and the wider computer science space.

Two teams are building at the bleeding edge of this technology: StarkNet and zkSync. zkSync runs on SNARKs technology, which is slower than STARKs (discussed below) but more natively EVM-compatible, meaning Solidity smart contracts can be run directly using its compiler.

zkSync 2.0 has just been launched on public testnet, which brings to the table zkEVM — a turing complete, EVM-compatible ZK rollup capable of general computation. Once released, this technology has the potential to leapfrog others in the Layer 2 race. The team aptly describes zkSync 2.0 as “the beginning of the end”.

Angle, Ramp, 1inch, The Graph, Argent, Aragon and many other dApps are beginning to actively migrate to Layer 2 via zkSync. zkSync last raised a $50 million Series B round from Andressen Horowitz and Consensys in November 2021.

Source: zkSync Daily (Twitter).

StarkNet

StarkNet is Starkware’s ZK rollup solution that has been in development since 2018. StarkNet uses STARKs technology, which is 10 times faster than SNARKs (the previous iteration of ZK rollups).

It runs on a newly developed, Turing complete programming language known as Cairo, which is capable of deploying smart contracts on StarkNet. Cairo is not natively compatible with Ethereum smart contracts, but the team behind the project (StarkWare) is developing a Solidity to Cairo transpiler known as Warp, to syndicate EVM compatability.

A small but growing ecosystem of applications is now building on the StarkNet platform, including ZKX (decentralised derivatives exchange), Immutable X (feeless blockchain for gaming NFTs) and Briq (a composable NFT project). Argent has also developed the first wallet solution, Argent X, for interacting with tokens and dApps in the StarkNet ecosystem.

StarkNet last raised a $50 million Series C round from Sequoia and Paradigm. They are rumored to be raising another $100 million at $6 billion valuation.

Note: Some of the projects mentioned in this article are part of the portfolio of Fabric Ventures, with which the author of this article is affliliated.

This article was originally published on Open Source Finance.