Blockchain War 2.0 The Rise and Outburst of Layer2

Author: Yue Xiaoyu

The smoke of the Layer1 public chain battle has not yet dissipated, and now the horn of the Layer2 second-layer network battle has been sounded.

This article will explore the history and development of the public chain war, analyze the public chain track in depth, and explore possible future development directions.

Review of the Layer1 Public Chain Battle

At the beginning, the blockchain industry only had one chain, Bitcoin. Bitcoin is a pure digital currency mainly used for payment, and can be called the era of digital currency public chains. After the emergence of Ethereum, the blockchain industry entered the era of smart contract public chains.

Ethereum is a world computer platform that builds different applications and products on this platform through “smart contracts”, extending blockchain technology to various scenarios in the real world.

Currently, Ethereum has the richest ecosystem, but it also has its own problems: due to the performance limitations of Ethereum itself, there are network congestion and high fees. This has given opportunities for other public chains to survive, leading to the public chain battle.

Starting in February 2021, ETH’s TVL ratio plummeted, and the BNB chain suddenly emerged. With the help of the BNB chain, other public chains such as Polygon, Solana, Tron, and Avalanche also squeezed ETH’s dominance.

During this period, many new public chains claiming to be “Ethereum killers” emerged.

Why did the public chain battle erupt in 2021?

Mainly because 2021 was a bull market, Ethereum gas fees remained high, the DeFi wealth effect was booming, the story and concept of NFTs successfully gained attention, and the huge demand gave new public chains the opportunity to catch up. The first to seize this opportunity was BSC (later renamed BNB Chain).

BNB Chain took over the overflow demand of Ethereum by being compatible with EVM, and empowered the BNB chain ecosystem through the use of BNB tokens to participate in project launches. In February 2021, the explosion of the BNB chain DeFi ecosystem and the BNB market formed a mutually reinforcing effect.

Similarly, public chains such as Polygon, Fantom, Harmony, and Avalanche also adopted various incentive mechanisms to promote their development.

The most representative one is Solana. Solana adopts a “light technology, heavy ecosystem” strategy to achieve overtaking on the curve. Solana chose a relatively centralized technical solution, which greatly reduced the difficulty of technical implementation and enabled rapid deployment to meet demand.

In order to promote ecosystem prosperity, the Solana team and its investors have taken a series of incentive measures to encourage users to experience their platform, such as introducing liquidity mining, providing subsidies to developers, hosting hackathons, and providing donation funds, etc.

In summary, the logic behind the public chain explosion in 2021 can be summarized as follows:

  • The prosperity of DeFi has caused high gas fees and congestion on the Ethereum network, and this situation has continued into 2021. The alternating prosperity of NFT and GameFi continues to demand scalability from public chains.

  • During the bull market, the huge demand for various applications allows technically grounded and well-funded public chains to take the lead and attract various applications to join their ecosystems, such as BNB backed by the world’s largest exchange, Binance.

  • Different public chains have different resource backgrounds, and even with the same “EVM compatibility + cross-chain bridge + ecosystem incentives” formula, their specific strategies vary. BNB and Solana empower their platforms with native tokens, while Polygon integrates top Ethereum DeFi protocols.

  • EVM compatibility allows for faster access to Ethereum achievements, including forked protocols and developers.

Counterexamples are Cosmos and Polkadot, which did not benefit much from the bull market in 2021. First, the technical difficulty and slow implementation of their public chains hindered their progress. Second, their compatibility with Ethereum was not good enough, requiring the establishment of additional cross-chain bridges to connect with Ethereum.

However, by 2022, with the collapse of Luna, Three Arrows, and FTX, the entire industry entered a bear market, and the public chain war came to a standstill.

FTX’s scandal, especially, has affected Solana, which was heavily manipulated by FTX, causing capital and developers to flee from Solana. This also signifies that other new public chains wanting to surpass Ethereum through high performance have gone bankrupt.

Even new public chains like Aptos and Sui, which were launched later and based on the Move language, have fallen into silence after a brief hype. These new public chains have become “empty cities” that have not brought new growth to the entire industry.

The Rise of Layer2

Brave warriors have risen to challenge the old king, but the old king still stands strong and even grows during each challenge.

Facing the challenges from competitors, Ethereum did not sit idly by and has been solving its performance issues through various means.

Currently, there are two paths for Ethereum’s scalability:

The first is to scale at the Ethereum blockchain layer itself by implementing sharding, which essentially partitions the database for storage and querying.

This solution is developing relatively slowly, as Ethereum has a long-term roadmap that expects to achieve sharding goals in 5 to 10 years.

The second path is to scale on top of the Ethereum blockchain, known as Layer2 scaling solutions, which is similar to building a flyover on a narrow road.

One important characteristic of Layer2 is that it locks assets in smart contracts on the Ethereum mainnet and conducts transactions and computations off-chain.

This solution has developed rapidly.

Currently, the main L2 scaling solutions are:

1. Sidechains

(1) Definition: Independent blockchains that run parallel to the Ethereum mainnet and operate independently. Sidechains are more like L1 compatible with EVM.

(2) Disadvantages: Weak security (few nodes in general)

(3) Representative player: Polygon

2. State Channels

(1) Definition: State channels allow users to make multiple off-chain transactions and only submit two transactions to the Ethereum network, one when the channel is opened and one when the channel is closed;

(2) Disadvantages: It takes time to establish channels and monitor malicious behavior; funds are locked during the channel’s validity period;

(3) Representative players: Bitcoin’s Lightning Network, Ethereum’s Raiden Network;

3. Rollups

(1) Definition: Computation is moved off-chain, and summary data is returned on-chain. It can be compared to an exam where only the results and key steps are written on the paper, and the calculation process is written on a draft paper. Therefore, only data summaries are transmitted on L1, which reduces the burden of storage and computation on L1.

(2) Current situation: According to the technology, it can be divided into two factions, ZK Rollup and Optimistic Rollup. ZK Rollup ensures security through zero-knowledge proof cryptographic algorithms, while Optimistic Rollup relies on punishment mechanisms to ensure security (economic game theory). Once validator nodes behave maliciously, they will pay a heavy price.

Among them, ZK Rollup has poor universality, while Optimistic Rollup has better universality. Developers can migrate their code from Ethereum to Layer 2 with less effort, so Optimistic Rollup is currently developing well.

However, ZK Rollup relies on mathematics to guarantee data correctness, so it is more reliable. Even though ZK technology is developing slowly now, it is considered more promising in the long term.

Therefore, it can be said that in the short term, Optimistic is optimistic, and in the long term, ZK (Zero-Knowledge) is favored by the market.

The outbreak of Layer2

Among various L2 solutions, Layer2 Rollup is currently developing rapidly. In this article, Layer2 refers specifically to Layer2 Rollup.

The story of L2 is very good. Since it is compatible with Ethereum’s EVM, it not only inherits the security, users, and ecosystem of the Ethereum mainnet but also effectively improves performance and reduces users’ transaction fees, truly solving the problem.

On the other hand, the business model of Layer2 is also clear and mature, essentially a transaction fee commission model.

When users use Layer2, the gas fees they pay are split into four parts:

The first split is the execution fee of Layer2 and the security fee given to Layer1, with the security fee accounting for the majority;

Then, based on EIP1559, the security fee of Layer1 is further split into base fees and miner fees, with the base fees being burned to achieve Ethereum deflation and the miner fees given to validators of various Ethereum nodes.

Various business models, in simple terms, can be described by the formula: Profit = Revenue – Expenses.

In L2, the GAS fees users pay to L2 = Revenue, and the GAS fees L2 pays to Ethereum = Expenses. Therefore, L2 can be seen as a business that earns the difference in transaction fees.

Even in a bear market, when the blockchain industry is quiet, speculators interact with many newly launched projects that have not yet issued tokens in order to obtain airdrops. This provides a large amount of transaction fees to L2, allowing them to make significant profits.

With more and more Layer 2 chains emerging, the liquidity of funds becomes fragmented. So which chain should users choose?

The throne is yet to be determined, so L2 players are competing for the throne of the new king.

The four major players in L2 are Optimism, Arbitrum, zkSync, and Starknet.

Among them, Optimism and Arbitrum belong to Optimistic Rollup, while zkSync and Starknet belong to ZK Rollup.

Although it is said that Optimistic Rollup is optimistic in the short term and ZK (Zero-Knowledge) in the long term, the ZK-based L2 has technical advantages. However, Optimism and Arbitrum, which are part of the Optimistic Rollup family, have a first-mover advantage. They are also paying attention to the development of ZK technology and may transition to ZK technology when the time is right.

Therefore, it cannot be said that Optimism and Arbitrum have completely lost their competitiveness. They are still strong competitors to the ZK-based Layer 2 networks.

The New Narrative of Layer 2

As the Layer 2 battle intensifies, all Layer 2 solutions are starting to become homogeneous. So how can they differentiate themselves?

The best narrative is: selling water to gold miners.

When people flock to gold mining in the hopes of getting rich, most of them won’t make money. But those who sell water on the gold mining journey will definitely make money and can be considered a safe and profitable venture.

Since the Layer 2 model is effective and profitable, many projects want to launch their own Layer 2 blockchains. So why not provide them with tools?

Therefore, the Optimism team has introduced OP Stack, which simplifies the process of launching chains and enables interoperability among different chains.

From the structure of OP Stack, it is actually a set of open-source software components that allow anyone to build their own Layer 2 blockchain on Ethereum using Optimistic Rollups.

All L2 chains developed based on OP Stack share the bridge, security, communication layer, governance layer, and upgrade iteration with the OP mainnet.

OP Stack consists of four main components:

(1) Mainnet: The OP mainnet is a cheap and fast Layer 2 network compatible with the Ethereum Virtual Machine (EVM);

(2) Contracts: Smart contracts that implement the core logic and functionality of OP Stack;

(3) Services: Services that provide data availability, synchronization, and communication between Layer 1 and Layer 2.

(4) Tools: Tools that facilitate the development, testing, deployment, monitoring, and debugging of blockchain based on the OP Stack.

The Optimism team has adopted a three-step strategy: OP→OP Stack→Superchain, and is currently in the second step.

OP Mainnet is the first instance of OP Stack, and Base/Mantle/opBNB is an OP Stack instance developed by cryptocurrency exchanges Coinbase/Bybit/Binance.

Projects such as WorldCoin, co-founded by OpenAI, DeBank, a Web3 data platform, and Gitcoin, an open-source platform, will also develop L2 based on OP Stack.

These L2s developed based on OP Stack, together with OP Mainnet, will constitute a multi-chain interoperable system, which the OP team refers to as the Superchain.

We can see that many star projects have already emerged based on OP Stack, giving them a first-mover advantage.

OP’s competitor, zkSync, also subsequently launched ZK Stack, which can help other projects issue L2 based on zero-knowledge proof technology. However, the biggest problem is that zkSync itself has not yet been fully established, and its ecosystem is very scarce compared to Optimism’s.

Therefore, OP Stack is currently in a leading position, but the competition has become intense.

In fact, one-click chain deployment is not a new concept. As early as 2018, Cosmos had already been building an interconnected ecosystem of thousands of chains. However, this ecosystem is not interoperable with the Ethereum ecosystem and is a completely different technical architecture and closed ecosystem.

If Ethereum develops very slowly and cannot solve the issues of performance and fees, Ethereum’s leading position will be significantly weakened by revolutionaries like Cosmos, and the market may form a situation of one superpower and multiple strong players.

But reality does not depend on “ifs”. Cosmos was originally called the Ethereum killer, but now, OP Stack based on the Ethereum ecosystem has become the Cosmos killer.

In 2022, DYDX, a leading decentralized derivatives protocol on Ethereum, announced that it would launch an application chain on Cosmos for performance reasons.

Because the Layer1 public chain built on Cosmos is not interoperable with the Ethereum ecosystem, it will lose the existing users and ecosystem advantages of Ethereum. DYDX’s decision has been questioned by the community.

In 2023, if DYDX has another chance, I believe it will not choose to launch on Cosmos, but will choose to launch a Layer2 on OP.

The Future of Layer2

In the medium to short term, the Cancun upgrade of Ethereum in 2023 is crucial for Layer2.

The most important part of the Cancun upgrade is the EIP-4844 upgrade, which allows Layer2 to not send data to Ethereum but to the Ethereum Blob Zone (to use an analogy, it’s like developing a new zone in urban planning), greatly reducing the expenses of L2.

As anyone in business knows, when expenses decrease, profits increase. If the Cancun upgrade is completed and Layer2 does not reduce fees, theoretically, gross profits can easily double.

However, Layer2 is currently in a state of homogeneous competition, so theoretically, fees will also be reduced. If one platform does not reduce fees, others will compete by doing so to seize market share.

The main trends of Layer2 in the future are as follows:

(1) Increase in revenue (activity): Mainly by encouraging various projects within its own ecosystem and incentivizing users to increase their activity through airdrops.

(2) Increase in revenue (average order value): Mainly in the direction of MEV (Maximal Extractable Value), which involves reordering user-submitted transactions to obtain additional profits. For example, if you submit a large transaction, which would normally cause price fluctuations, the orderer can profit from executing the transaction first.

(3) Decrease in expenses (self): Embrace the upgrade of the underlying protocol and use cheaper data layers, among other strategies.

(4) Decrease in expenses (collaboration): Collaborate with other Layer2 solutions to share L2 gateways and orderers, thereby reducing gas fees.

Some may wonder whether Layer2 will abandon Ethereum or challenge its position once it becomes larger.

It’s like a physical store that grows bigger, even becomes a nationwide chain, and no longer wants to pay rent to a shopping mall like Wanda. Is it possible for the store to completely abandon Wanda and build its own malls?

Although it is possible, such a transition is extremely difficult.

As Ethereum takes on the security of transaction settlement, the larger it becomes, the deeper the moat of security it provides. Ethereum will become more secure, and Layer2 will increasingly rely on it.

The rapid development of Layer2 actually further solidifies the position of Ethereum.

If Layer2 wants to break away from Ethereum, it will face the risk of decreased security in the short term. Only Layer2 solutions that are already large in scale would have the desire to leave Ethereum. If they are already so big, they would be hesitant to migrate because the risks would be very high, while the potential rewards may not be as great.

Therefore, unless the rewards far outweigh the risks and costs, there would be no scenario where Layer2 chooses to leave Ethereum.

Layer2 and Ethereum can be said to thrive or decline together. They have generated synergistic effects and are spiraling upward in their development.

Currently, the biggest problem for Layer2 is the lack of a rich ecosystem and star projects. However, as the infrastructure matures, it is also preparing for the influx of users in the next bull market.

When the market falls silent and speculators exit, builders continue to work diligently. Eventually, the accumulation of technology and products will lead to a new bull market explosion.

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