Ethereum Layer 2 Solutions Make DeFi Functional: Here’s How
Jhe decentralized finance (DeFi) industry has grown significantly over the past two years. The total value locked (TVL) in the ecosystem peaked at over $250 billion at the end of 2021, catalyzed by an ever-growing range of decentralized applications (dApps).
Ethereum has been one of the major players in the market since its genesis and remains in a dominant position to this day. The network is even designed to lay the groundwork for Web3 and the Metaverse. But there is a catch; Ethereum has a major scaling problem.
Rate limits and the ever-increasing cost of transactions cripple the user experience and hinder widespread adoption. Ethereum’s inability to scale has galvanized mass migration to competing Layer 1 platforms, such as Binance Smart Chain, Polkadot, and Solana. While these so-called “eth killers” have proven popular, Ethereum still dominates 54% of the DeFi market, with $111 billion in TVL. This is mainly due to the higher levels of security and decentralization offered by the network.
To allow native Ethereum dApps to scale and serve more users, many developers are harnessing the power of “Layer 2” blockchain solutions.
Layer 2 protocols come in many forms, but generally speaking, they are separate blockchains designed to sit “on top” of Ethereum and offload transaction volume from the main chain. This dramatically increases capacity, minimizes latency, and reduces fees, making DeFi business on Ethereum viable again.
There are several strategies available for scaling Ethereum, each with their own advantages and disadvantages.
The Ethereum Scale Race
Optimistic rollups work by leveraging smart contracts to transmit transaction data from the main Ethereum chain to a Layer 2 network. The protocol bundles multiple transactions into larger batches and then submits verification of the entire collection to the main chain via a single transaction. This significantly reduces traffic on the underlying network, improving latency and transaction costs.
Unlike their siblings, ZK Rollups, Optimistic Rollups do not perform checks on every proof submitted. To save computational power, optimistic rollups assume that all transactions are valid, except when a given proof is disputed. Only then are cryptographic confirmations executed, which always ensures security while minimizing resource expenditure. One particular benefit of this form of rollups is that they are inherently compatible with Ethereum Virtual Machine (EVM) and Solidity, making them an obvious choice for scaling Ethereum.
There are even platforms that leverage both Optimistic and ZK stacks. ZK rollups are also capable of validating data off the underlying blockchain, but unlike the Optimistic variety, they offer more comprehensive finality and security at the cost of additional resources. By leveraging multiple types of rollups, networks can be incredibly flexible in when and how they reach consensus, using more or less network latency as needed in a given situation.
Other key developments are also important, such as the ability to move value in and out of the network in minutes by leveraging on- and off-ramps backed by pools of liquidity. This ensures funds are not “locked” to the network – a common problem with L2 solutions.
Then there are processes like “hybrid compute,” which allow Ethereum developers to run code off-chain through web-scale frameworks like AWS Lambda. This allows developers to run more sophisticated algorithms such as machine learning models that are too complex or otherwise too expensive to run on-chain.
Finally, there are sidechains, which act as additional blockchains that can process data “on top” of the underlying network. This removes much of the traffic from the first layer, and multiple side chains can work in tandem for open scaling. All information on these other layers is secured using the aggregation technology we have described, which means that these transactions remain secure and reliable.
Ultimately, with many of these solutions pointing in the same direction, the race to scale Ethereum is likely to have multiple winners. Combining increased speeds and reduced costs with improved interoperability through connecting these protocols will drive greater inclusion and liquidity in the space. This will incentivize developers and users alike, providing a pathway to realize the true vision – and functionality – of DeFi.
About the Author
Alan Chiu is the CEO of Enya.ai and Boba Network. Alan also serves on the Stanford Graduate School of Business Alumni Council and volunteers as Co-Chair of Stanford Angels and Entrepreneurs, a Stanford alumni club with more than 2,000 active members in the startup ecosystem. .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.