Ethereum Layer 1 vs Layer 2

In the cryptoverse, Layer 1 (L1) refers to actual blockchains and their associated technologies such as Bitcoin, Ethereum, Solana, Polkadot, Cardano, Avalanche, etc. These Layer 1 blockchain’s typically consist of a globally distributed and synchronized network of computers that maintain a copy of transaction history, validate and record new transactions, and through those processes secure the network from invalid transactions. In contrast, Layer 2 (L2) technologies operate external to the L1 blockchain in an asynchronous fashion the majority of the time, but routinely synchronize with the L1 blockchain for final transaction settlement. Therefore, the L1 blockchain remains the final settlement layer of L2 transactions.

Ethereum’s Evolution

As the popularity of the ETH blockchain increased the past few years, so did the number of daily transactions. According to etherscan.io, daily transactions on the ETH blockchain in March 2019 stayed below 650,000 daily transactions. Fast forward to March 2022 and daily transactions have nearly doubled and are from between 1.1 to 1.2 million daily transactions. Or, an average YoY growth in daily transactions of over 35%. The growth of transactions settled on the Ethereum blockchain is depicted in the following figure.

During the same time period the number of unique Ethereum wallet addresses experienced an even greater increase, climbing from around 58 million unique addresses in March 2019 to over 192 million in March 2022. Although more than one wallet can be held by a single person or entity, that is over 300% more wallets transacting on the blockchain!

Transaction Times

Although the Ethereum blockchain experienced a steady increase in daily transactions from an ever-growing number of wallet addresses the past few years, the average block time remained steady at about 13 seconds per block as shown in the following figure.

At first glance it may appear that transaction settlement time experienced by the end user is unchanged. But, what happens to the ever-increasing daily transactions when block times remain steady? They join a queue. And, the transactions willing to pay the highest gas fee are selected first by miners securing the network. From a user’s perspective this typically translates to longer wait times to see a transaction actually complete, unless one is willing to pay a high gas fee.

Transaction Fees

On the gas fee side of the equation, we will take a look at the max gas fee limit since gas fees are composed of a tip that miners receive and base network fee that nobody receives because it is burned. The miner’s tip, also called the Max Priority Fee Per Gas, has steadily stair stepped in an upward direction over the past two years from ~$33.50 (10 million GWEI) to ~$100 (30 million GWEI). So, while ethereum block times have not changed, the total fees and the actual transaction time from user submission to final settlement both increased. At the time of this writing, average gas fees to execute an exchange on Uniswap was $41.40, a sale on Opensea was $45.40, and a USDT transfer was $12.14. Those transactions correlate to a DEX swap, NFT purchase, and wire transfer, respectively.

Ethereum Layer 1 Improvements

Two big changes on the horizon for the Ethereum blockchain itself in 2022 include transition to Proof of Stake take via The Merge, and the introduction of Shards.

Proof of Stake and The Merge

Ethereum Mainnet is currently secured using a Proof-of-Work (PoW) consensus mechanism and one big drawback of PoW, according to the ethereum.org website, is that “ Ethereum on proof-of-work consumes 73.2 TWh annually, the energy equivalent of a medium-sized country like Austria.” However, the Beacon chain has been live since December 2020 as a proving ground for Ethereum Proof-of-Stake (PoS) functionality. The Beacon chain has been using PoS, but does not support smart contract functionality crucial to support DeFi applications that run on ETH. The Merge, formerly called The Docking, is the name given to the merge of the current Ethereum Mainnet into the Beacon chain which will combine smart contract functionality with Proof-of-Stake, respectively, while retaining the state and full history of the current Ethereum mainnet chain. The transition to PoS promises to lower the ETH network’s energy consumption by 99.95%, and will marry PoS with smart contract functionality in a seamless fashion.

The Merge image courtesy of ethereum.org

In terms of network security, PoS will require validator nodes to stake a minimum of 32 ETH or $111,854 USD at the time of writing, and “Stake slashings, ejections, and other penalties, coordinated by the beacon chain, will exist to prevent other acts of bad behavior. Validators will also be responsible for flagging these incidents.” Ethereum developer documentation, found at ethereum.org, elaborates further about how a 51% attack is less probable due to random node committee assignments responsible for attesting (validating) transactions, and a separate random assignment of the single validator node that creates each new block on the blockchain.

ETH Sharding

Sometime in 2023, the introduction of sharding is planned for Ethereum to improve scalability and overall storage capacity while aiming to facilitate greater decentralization of the Ethereum network. If your background is in computer engineering/science, think of a blockchain as a process, and sharding of a blockchain would be akin to multithreaded processing. Ethereum nodes will eventually support the storage and validation of a single shard, and a total of 64 shards will collectively contribute new blocks to the main ETH Beacon blockchain in the future. This is in contrast to the current architecture that requires each miner to store the entire blockchain and simultaneously compete with all other miners to be the first to mine the next block.

Since less storage space and lower computation power will be required from each PoS validator node to participate in the ETH network, the number of global validators should increase and result in a more decentralized Ethereum network!

The Ethereum organization’s stated vision is for validator computing requirements to drop so much that basic personal computers will be able to participate as PoS validator nodes.

Ethereum Layer 2 Improvements

Similar to aforementioned Ethereum L1 improvements, Ethereum Layer 2 technologies aim to improve transaction times and transaction fees, but in two different ways - Rollups, and State Channels.

Rollups

In simple terms, an L2 rollup bundles transactions off-chain then routinely writes the transactions, or a representation of those transactions, to the L1 blockchain. The figure below illustrates how the Polygon Hermez Layer 2 network aggregates transactions on its network into a batch, then sends the batch and a validity proof to the ETH chain.

The figure to the right illustrates how the Polygon Hermez Layer 2 network aggregates transactions on its network into a batch, then sends the batch and a validity proof to the ETH chain.

By moving a Decentralized App’s (DApp’s) transactions from the main ETH chain to a Layer 2 solution, the Layer 1 chain experiences less network congestion - a significant contributor to Ethereum's slower transaction times and increased gas fees over the past few years. There are two main types of rollups: Zero Knowledge Rollups (ZK-Rollups) and Optimistic Rollups. Various pros and cons exist for both, including the potential for slower transaction times if an optimistic rollup is contested as fraudulent which triggers fraud checking computations. This is a good place to start for more details on the differences between ZK-Rollups and Optimistic rollups: https://ethereum.org/en/developers/docs/scaling/#rollups

State Channels

At a high level, state channels are a mechanism for conducting transactions off-chain, meaning the transactions are executed in a separate environment that does not record every transaction to the main Ethereum blockchain. Instead, a state channel is opened by first recording the starting state and the channel's participants to the Layer 1 blockchain via a smart contract. Then, any number of transactions can occur off-chain over any duration of time. Once a final state is reached and agreed upon by all channel participants, the final state is recorded on the Layer 1 blockchain.

By taking a snapshot in time of a state channel, typically referred to as its current state, and anchoring that snapshot to the layer 1 chain, a state channel benefits from the L1 chain's secure and decentralized network while simultaneously reducing layer 1 network congestion.

One use case would be a state channel failure event. If there is a failure within the state channel, the channel could recover by rolling back to the last state anchored to the L1 blockchain.

In the case of Ethereum, the use of this Layer 2 technology means that the vast majority of state channel transactions avoid ETH gas fees, reduce Ethereum network traffic, and transaction data does not have to be public as it would be if all transactions occurred directly on the Ethereum blockchain.

Since state channels essentially incur an entry and exit fee when writing the starting state and final state to the layer 1 blockchain, state channels provide the greatest value when a large volume of intermediate/layer 2 transactions occur off-chain. Introduction of new participants to a state channel also requires updating the initial smart contract, so a static pool of state channel participants also results in less layer 1 blockchain fees required by the channel.

Concluding Thoughts

With Ethereum's rise in popularity, crypto degens have experienced a burgeoning ecosystem marked by a plethora of DeFi services, NFTs and a broad array of related projects. Unfortunately, the increased utilization of the Ethereum mainnet also led to network congestion and ever-increasing gas fees. Especially the past couple of years.

Various highly anticipated Layer 1 improvements have been in work for years and will be rolled out to the Ethereum mainnet in 2022 and 2023. This includes the transition to Proof of Stake, and the introduction of Shard chains.

Simultaneous efforts are also underway to mature Layer 2 scaling solutions in the form of Rollups and State Channels. There are two main types of rollups - Optimistic rollups and Zero Knowledge rollups. And, for State Channels there are general State Channels and Payment Channels. The latter of which is tailored towards facilitating financial transactions such as token coin or token exchanges. The figure below captures a subset of ongoing Layer 2 projects.

There are a number of concurrent Layer 1 and Layer 2 Ethereum scaling solutions that will rollout over the next couple of years that are characterized by well-funded projects and substantial software development efforts. It's an exciting time to participate in the Ethereum ecosystem!

Ethereum’s Blockhain Improvements