A Guide to Layer 2 Blockchains.
Dive into the world of Layer 2 blockchain protocols with our guide. Learn about Bitcoin Lightning Network, Polygon, Arbitrum, and Optimism, and how they're combating blockchain congestion.
GM,
In this email today we’ll be focusing on Layer 2 blockchains and explain why they are needed and what the top ones are!
Why do we need Layer 2 Blockchains?
As the popularity of cryptocurrencies like Bitcoin and Ethereum grows, the networks are becoming increasingly congested with transactions, resulting in high fees and slow transaction speeds. This can make usability worse and hurt the long-term adoption of Crypto, DeFi, and NFTs.
To combat this, there has been an influx of layer 2 blockchains. These protocols are designed to enhance the processing capacity of a blockchain (Layer 1) while reducing transaction fees. They work independently of the main chain but still utilize the underlying Layer 1 blockchain for security, opening up new avenues for high-speed, low-cost transactions.
We'll be focusing on four big layer 2 blockchain protocols:
Bitcoin Lightning Network (Bitcoin)
Polygon (Ethereum)
Arbitrum (Ethereum)
Optimism (Ethereum)
If you want to read the full in depth guide on Layer 2 Blockchains, check out This Article on Medium
Bitcoin Scalability Issues
Bitcoin’s scalability issues primarily stem from its 1MB block size limit and 10-minute block time, which caps the transaction throughput at approximately 7 transactions per second (TPS). This limitation results in slower transaction times and higher fees when the network is congested.
This has become more of an issue recently since the rise of Bitcoin Inscriptions and Ordinals. Inscriptions have sent bitcoin block fullness to levels that were previously only seen at the top of bull markets and we are just barely off the bottom of the market.
Bitcoin Lightning Network
The Bitcoin Lightning Network addresses the issue of block fullness and high transaction fees in Bitcoin by enabling fast, low-fee transactions through off-chain payment channels between parties.
How to think of it: You go to a local store regularly and wish to pay in Bitcoin. You can either make a small transaction each time, pay high fees, and possibly wait a few hours for the transaction to be completed. Or you can use the Lightning Network and open up a payment channel with the store. Each purchase from the store is recorded in the channel, instantaneously, and with very cheap transaction fees. Then when the channel gets closed after many visits, it gets recorded on the main Bitcoin blockchain.
Dramatically reducing the fees you need to pay on the Bitcoin Blockchain.
Ethereum Scalability Issues
Similar to Bitcoin, Ethereum also struggles with scalability issues. Its design allows for complex smart contracts but at the cost of limiting the network to around 15–30 TPS. This often results in network congestion and high transaction fees (gas fees), particularly during periods of high demand.
Solution 1: PoS Sidechains - Polygon
Proof of Stake (PoS) sidechains present a potential solution. As a Layer 2 approach, PoS sidechains validate transactions based on the number of tokens a person holds and is willing to “stake” as collateral.
Polygon is a Layer 2 scaling solution for Ethereum that uses side chains for off-chain computation while ensuring asset security.
While PoS Ethereum can process ~30 TPS, Polygon can execute ~7,000 TPS, significantly improving the scalability of the Ethereum Blockchain. Significantly improves the scalability of the Ethereum Blockchain.
Polygon’s native token is MATIC which is used for governance and for securing the Polygon Blockchain. The total amount of tokens that will ever be in circulation is 10 Billion, with 9.2 Billion $MATIC currently in circulation.
There are multiple portfolio’s on Velvet.Capital with MATIC Exposure:
Top 10 - Weighted by Market Cap & Equally Weighted
Yield By Venus
Safe and Secure
Value Plays
BigCap Altcoin
Solution 2: Optimistic Rollups
Optimistic Rollups are Layer 2 solutions that help scale Ethereum by handling most computation off-chain and submitting a computation summary to Ethereum. This reduces the computational load on the Ethereum network, allowing for more transactions per second.
There are three components of an optimistic rollup: A Smart Contract on Ethereum, a Sequencer, and a set of Validators.
Smart Contract: governs interactions between the Layer 2 and Ethereum blockchain.
Sequencer: Collects, orders, and executes transactions on the Layer 2 Blockchain.
Validators: comprising a group of nodes that monitor the Layer 2 Blockchain and submit fraud proofs.
Users on a Layer 2 Blockchain can transact freely with low transaction fees and high speeds, without having to wait for the transaction to be validated on the Layer 1 Ethereum Blockchain.
Arbitrum
Arbitrum is a Layer 2 solution that significantly enhances the capabilities of Ethereum’s smart contracts. It bolsters transaction speed, and overall scalability, and adds extra privacy features. The platform allows developers to run unmodified Ethereum Virtual Machine (EVM) contracts and Ethereum transactions on a secondary layer while still leveraging the security of Ethereum’s Layer 1.
Arbitrum utilizes Optimistic Rollups to record transactions submitted on Ethereum’s main chain and execute them on a Layer 2 sidechain. This strategy allows for accurate results while also reducing Ethereum’s storage and computational burdens.
Arbitrum’s native token is ARB which is an ERC-20 governance token that allows its holders to participate in the Arbitrum DAO’s on-chain governance protocol. The $ARB token is minted by a smart contract that lives on Arbitrum One, a Layer 2 Arbitrum rollup chain.
Supply of $ARB is capped at 10 Billion, with 1.275 $ARB in circulation so far. Arbitrum has a market cap of $1.4B, making it the 36th largest Cryptocurrency.
Optimism
Optimism, like Arbitrum, is a Layer 2 solution designed to improve the scalability of Ethereum. It achieves this by executing transactions off-chain and posting the data to Ethereum’s main chain, thereby reducing congestion on the Ethereum network. Optimism uses a technology known as Optimistic Rollups, which are Layer 2 solutions that execute transactions off-chain but commit the data to the Ethereum main chain.
The OP token is used for the Governance of the Token House and Citizens House. Token House governs technical decisions related to Optimism, whereas the Citizens House is for funding other projects in the space.
The OP Token has a total supply of 4.2 Billion OP and there is currently 664 Million OP in circulation. Optimism currently has a market cap of $911 Million making it the 51st-ranked cryptocurrency by market cap.
After reading this email, if you want to read the full in depth guide on Layer 2 Blockchains, check out This Article on Medium
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