In the cryptocurrency world, layer 2 protocols have made a massive impact. They’ve paved the way for additional features and enhanced scalability. Plus, they’ve attracted interest from investors and developers alike. These off-chain solutions are incredibly beneficial to crypto, and anyone interested in using digital currencies.
Layer 2 even acts as a viable solution for multiple crypto challenges. With interest from crypto enthusiasts only growing in layer 2, it’s crucial to get a good understanding of what it entails. By reading this guide, you’ll gain a comprehensive grasp of the concept.
What is Layer 2?
Layer 2 refers to separate blockchains built on top of the original crypto chain. Confused? Let us put it in simple terms.
Imagine the first layer (where the main crypto activities occur) as a busy highway. It has multiple lanes congested with traffic, as many cars try to get to their destination. To leave the highway, cars have to check in at the toll booth. In the same way, transactions on the crypto blockchain have to reach block confirmation. Until they do, they’re stuck in the system.
Scalability - as demand for crypto grows - is a major concern. If the blockchain can’t handle the number of transactions it receives, its reputation and functionality suffer. This makes layer 2 protocols an effective method of addressing scalability.
By building an express lane to the side of the highway, plus another dedicated toll booth, the highway moves faster. The express lane is the layer 2 protocol, which helps process the blockchain’s activities faster. Furthermore, some layer 2 solutions even have lower fees, making them more attractive to use.
Layer 2 is also a viable solution for crypto, as they share all the advantages crypto has to offer. They’re safe, secure, and anonymous to use, as they also operate in a decentralized system. They’re also faster to use than the original layer of the blockchain in many cases.
The Rise of Layer 2 Crypto
Despite being built as an additional framework on an existing blockchain, layer 2 projects can have tokens. These investment opportunities are perfect for investors looking to propel crypto development further. The tokens that represent these projects can offer unique features to their users. Let’s explore some popular layer 2 examples.
Immutable X (IMX) is a layer 2 scaling solution for NFT projects on the Ethereum blockchain. It seeks to improve scalability, liquidity, and developer experiences. Users of IMX can easily create and divide their own NFT assets on a larger scale. The IMX tokens’ distribution scheme is multi-faceted, With a total supply of 100,000,000. The supply is made up of Airdrops, Uniswap liquidity, treasury from farming, and more. Users don’t have to hold tokens to transact on the protocol, but they can receive rewards for staking their tokens.
The Lightning Network on Bitcoin supports multiple altcoins. While slightly technically different from tokens, these altcoins function through one of the most well-known layer 2 solutions. The Lightning Network also expanded to other crypto networks through its altcoins. These include Litecoin, Zcash, and Bolt. The actual Lightning Network uses Bitcoin.
Polygon (MATIC), formerly known as the Matic Network, is one of the most popular layer 2 tokens. With a market cap of over $6 billion and a total supply of $10 billion, Polygon is available on multiple exchanges. Its framework allows for interconnected chain applications, with over 37,000 running currently.
Understanding Layer 2 Protocols
Layer 2 protocols run parallel to their blockchain - remember the highway analogy earlier? Remember that Layer 2 protocols are like a separate lane to a highway. Their primary role is to address scalability and speed issues when transaction traffic builds up. There are multiple types of layer 2 protocols that each have different features and techniques.
State channels are a type of layer 2 protocol that facilitates unlimited private transactions. To open and close the channel, each party submits an on-chain transaction. Picture two cars linked together by a chain using their turn signals to merge into another lane. The Bitcoin Lightning Network is a popular example of this kind of second layer.
Rollups can process hundreds to thousands of transactions almost instantly. They do so by ‘rolling up’ or bundling transactions together. These batches of transactions are then processed off-chain. Then, the transaction data is submitted back to the first layer. Zero-knowledge Rollups on Ethereum are layer 2 scaling solutions that bundle transactions.
Maintained by smart contracts, this method disperses any delays when moving assets. Arbitrum is another example of rollup technology so fast, it reaches 40,000 transactions per second.
Sidechains are a second layer that can run independently from the blockchain. They even have their security features. This might include a unique consensus mechanism or nodes that validate transactions.
Plasma networks use smart contracts and Merkle trees. In crypto, a Merkle tree is a chain of nodes, with every ‘leaf’ encrypted with a cryptographic hash, or equation. Plasma layer 2 protocols can use the Merkle trees to create unlimited child blockchains. They also have their consensus mechanisms to generate new blocks.
Benefits of Layer 2 Protocols
One of the most pressing cryptocurrency challenges is the blockchain trilemma, coined by Ethereum co-founder Vitalik Buterin. The trilemma describes how difficult it is to balance all three of the most important and desirable crypto aspects.
- and security.
When two aspects are fulfilled, one left aside can suffer.
Many traditional solutions jeopardize one of the aspects, causing a bigger problem. Using layer 2 protocols, blockchains can satisfy all three aspects. Many layer 2 crypto protocols come with the added benefits of increased transaction speed and lower fees. Different layer 2 projects can also offer higher liquidity for certain digital assets, new investment opportunities, and convenience.
Use Cases for Layer 2 Protocols
We’ve discussed layer 2 protocols that enhance the performance of existing cryptocurrencies, but there are multiple other uses.
Layer 2 protocols can enhance in-game transactions, reducing both cost and waiting time. With many games being developed in collaboration with blockchain tech, this is a major use case. Some Web 3 gaming projects even serve as investments, as they offer crypto rewards to players.
The Immutable X is a great example of how layer 2 protocols can make minting, trading, and transacting NFTs easy. This makes the NFT market more accessible to a wider audience.
Seamless, secure, and speedy crypto transactions for daily payments are possible with layer 2. Investors can make mall-value transactions of just a few dollars using layer 2 protocols like the Lightning Network. This makes buying most products or services incredibly convenient, from anywhere that accepts crypto.
Investors can participate on DeFi platforms with advanced speed, security, and liquidity with layer 2 protocols. In many instances, fees for lending, borrowing, or transacting are even reduced.
Challenges and Considerations
Layer 2 protocols have challenges to consider before use. They’re still in development, and despite offering many benefits, can also have limitations. One major challenge is interoperability. This describes the ability of computer systems to connect and function together.
Layer 2 protocols have different types and functions, and they might not work compatibly with each other, reducing their interoperability. This limitation might hinder future progress in crypto.
Another is security and potential vulnerability to cyber attacks. Think of the highway metaphor once again, and the cyber attack as a sinkhole. Many layer 2 protocols don’t have their own, separate security measures. If the security of one blockchain layer is compromised, so can the other layers.
Lastly, layer 2 protocols are a complex addition to blockchains. Integrating them can offer great advantages, but they’re also complicated and time-consuming. Developers have to carefully implement adding another layer while maintaining the blockchain’s performance simultaneously.
Investing in Layer 2 Crypto
Thinking of investing in layer 2 crypto projects? There’s untold potential in layer 2 protocols, but before you invest, consider these helpful tips.
- Assess their goal: Most layer 2 projects have a specific goal (or set of goals) in mind. For example, the Lightning Network on Bitcoin opened up two-way speedy transactions for a quickly-growing community. Review whether the project’s goals align with your interests.
- Review its infrastructure: Get to know the ins and outs of the layer 2 protocol’s technology. What type of layer 2 is it? What kind of consensus mechanism and security measures does it have? How does it interact with the underlying blockchain?
- Reputation and community: The crypto world has a thriving, eager community. Use this to your advantage to understand sentiments on potential layer 2 investments. Ensure the project has a reputable history, an experienced team, and a strong user base.
- Regulatory compliance: While cryptocurrency is largely decentralized, many countries have separate crypto regulations. In the U.S., the CFTC regulates and oversees cryptocurrency. Check how the layer 2 protocol complies with the regulations in its home country. This is crucial to long-term success and continued development.
- Risk management: Use risk management strategies to protect your investment against volatility. Remember that the crypto market can experience quick price fluctuations. The risks of traditional blockchain investments also apply to layer 2 protocols.
Layer 2 crypto protocols are an amazing investment opportunity for crypto enthusiasts. The second layer of blockchain technology is propelling the crypto market further into mainstream adoption. They provide a viable solution to the infamous blockchain trilemma. They also offer traders unique practical benefits in various industries, from gaming to everyday use.
You’ve taken a great step in getting to know the inner workings of layer 2 protocols and how they impact crypto. Before going further, take care to consider the points above when searching for projects to invest in. Explore layer 2 resources and reading materials developed by professionals, like blockchain developers or crypto analysts.
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