CoinEx Research Institute: Things You Need to Know about Ethereum Layer 2 Solution

Recently, the soaring price of Ethereum and the popular DeFi ecosystem have pushed the transaction fee of the Ethereum network to a new historical high. The expansion of Ethereum, especially the Layer 2 solution, has been increasingly discussed. Demands for Layer 2 used as a soltion to the congestion of the Ethereum network will rise as a result.

The expansion plan of Ethereum is divided into two basic categories. One is to split the work tasks of the Ethereum network to nodes, which is the sharding to be implemented by ETH2. The other type is to allow users to put most of their transactions in the Layer 2 protocol under the Ethereum chain, and submit them to the Ethereum network through packaged and aggregated transactions. The Layer 2 expansion plan is subdivided into roughly four categories, namely State channels, Sidechains, Rollups, and Plasma.

In the table are expansion solutions with their respective technology, advantages, and disadvantages, for your convenience of comparison and understanding. But still, it may be difficult at first glance. Here is an example.

In the crypto world, there is a popular bank called Ethereum. It has only one business hall that can only process dozens of transactions per second. That leads to an imparity clause: transactions with higher fees are processed first. As a result, during busy hours, tens of thousands of people come to this bank for business, leaving the business hall in serious congestion and pushing up the transaction fee. In response to this problem, various banks aiming to surpass Ethereum have come into being. They claim they can handle thousands or even millions of transactions at the same time, but few are willing to transfer assets to these banks because of their weak ecosystem without such common services as finance, utility, and shopping. (Many projects, which advertise themselves as the alternative to Ethereum and claim to boast tens of thousands of TPS, actually have a much weaker ecosystem with insufficient users, compared with that of Ethereum.)

Aware of the serious congestion, the Ethereum bank has put forward the ETH2.0 plan, intending to expand the one business hall into the 1,024 that are connected to each other. By doing so, business processing capabilities can be greatly improved. However, considering the size of the ambitious plan, it is split into three phases of construction. The first phase was just launched at the end of 2020, and the entire plan will not be completed even by 2022. (ETH2.0 is a way of Layer 1 expansion. Work is distributed to different nodes through sharding. Phase 0 was launched at the end of 2020. However, it is said that the final phase 2 is technically difficult, so whether it can be completed by the end of 2022 remains a question.)

A Chinese say goes that the distant water cannot save the nearby fire. Under this circumstance, people have made countless suggestions for the Ethereum bank. Among them is a “state channel” plan: for services like broadband service payment, users don’t need to pay at the business hall frequently but just deposit a sum of money in advance into a joint account with the service provider. Instead of lining up at the business hall to cash the check every time, the service provider only needs to ask the user to void the previous check and write a new one with the aggregated amount. In the end, the service provider hands over the latest check to the bank to process multiple charges at once, thereby saving the transaction fee paid to the business hall. Yet this plan also comes with risks: users need to sign checks frequently, or the checks may be stolen. (The state channel is a general expansion scheme for locking assets to smart contracts. It has good privacy and immediacy, but this scheme can only be applied to certain situations. Moreover, smart contract multi-signature participants need to verify transactions online at the same time and update the verification multiple times. Frequent transaction verification means high transaction fees. There is also a risk of attack from multi-signature participant agents.)

Here comes another scheme called “side chain” where users can deposit money from the Ethereum bank into an account similar to “Alipay” in exchange for their corresponding internal points. The points can be directly used in daily consumption scenarios, and settled in the internal system of such companies and withdrawn to the bank when necessary. Ideal as this idea may sound, such project development teams are still in their infancy in the crypto world, with only a few members and corporate asset value less than the funds deposited by users. Although such programs claim to strengthen financial security by various means, there are still risks of asset security. (The side chain is independent of and runs parallel to the Ethereum main chain. The side chain greatly reduces the calculation pressure on the main network, and thus saves the cost and development time. However, the side chain operates independently, and the security is completely separated from the Ethereum main chain. Most sidechains have only a few validators and a weak consensus mechanism, which is prone to asset security issues.)

Plasma was created as a solution to the security issue of the side chain. In this scheme, anyone can create a special account in the Ethereum bank based on their business needs. This type of accounts is open and transparent, and regularly summarizes the internal settlement results with the bank. The transfer of funds in the account requires a seven-day publicity period. Any user who finds abnormalities in the transfer of funds can file a report. If the report succeeds, the submitter can get a reward, and the transfer will also be canceled. For example, a game company opens such an account, and users’ assets deposited in it will be directly exchanged for the corresponding game tokens to enjoy a fast and smooth game experience. But the disadvantage of this scheme lies in its long withdrawal time and a risk of fraudulent accounts due to the untransparent internal transaction records. (Plasma is another side chain that uses smart contracts and Merkel trees to attach to the main chain to establish countless sub-chains. While ensuring the security of both sub-chains and the Ethereum main chain, it increases the interaction and communication between sub-chains. In this way, Plasma solves security issues, relieving the congestion on the main chain in the meantime. Since it adopts a “fraud proof”, in order to ensure the security of assets, there is a lockup period for assets withdrawn from the side chain to the Ethereum main chain, which is generally seven to fourteen days. Such a lockup period is not friendly to users of small-value assets and high-value transactions.)

The solutions abovementioned have been discussed for several years, but none of them have been widely adopted by the outside world. As Ethereum gets increasingly congested due to various applications, Rollups, another improved expansion solution, has emerged. Compared with the previous solution Plasma, all the offline transaction records of Rollups will be collected and packaged by the operator/coordinator and then compressed, by various means, and submitted to the business hall. In this case, users can audit the public account book of the business hall to see if there is false data.

According to different data audit methods, Rollups has evolved Optimsitic Rollups and ZK Rollups. The data submitted by Optimsitic Rollups to the business hall is not audited, so a 7-day buffer period is reserved like in Plasma. The advantage is that its internal settlement system is the same general accounting standard as the bank which can be connected to various applications of merchants. The data submitted by ZK Rollups to the business hall is audited, but at present ZK Rollups only supports functions such as transfers and transactions. (Optimistic Rollups are compatible with EVM. There is no proof of transaction submitted in advance, and everyone can submit a fraud proof. It boasts flexible general computing, storage on the data chain, and good user experience. But like Plasma, it has a long transaction waiting time, and network throughput is less than that of other solutions. There are also security concerns. ZK Rollups is a two-tier network solution that aggregates multiple transactions into a single transaction, using SNARK or STARK zero-knowledge proof algorithm as a proof of validity. Compared with Optimistic Rollup, ZK Rollup is faster and more decentralized, has lower transaction fees, better throughput and scalability, and does not require a fraud proof.)

At present, there are some Rollups projects under development in the segment of Layer 2, and those with a stronger ecosystem will acquire more liquidity from Layer 1 in the future. Below is the ecosystem panorama of expansion plans, sorted by the media.

Although the Layer 2 projects, especially Rollups, are still in their infancy, there is still one or two years before Ethereum 2.0 comes to reality, leaving a window period for Layer 2. The Ethereum development community has also taken Rollups as the core of expansion, and DeFi leaders including Synthetix, Uniswap, and AAVE plan to adopt the Rollups solution. The founder Vitalik believes that “Rollup is a powerful and novel two-tier expansion paradigm, which is expected to become the cornerstone of Ethereum’s short-term (or long-term) expansion. The Ethereum community has shown a strong interest in Rollup, because unlike previous attempts to expand at the second layer, they can support common EVM codes, making existing applications easy to migrate.” After the successful deployment of the Layer 2 of the Ethereum network, other public chains need to challenge Ethereum in respects other than TPS.