Multi-chain, side chain and Layer 2, which one is the future of Ethereum expansion solution?

As of the end of 2021, Ethereum has grown to support thousands of applications from decentralized finance, NFT, games, and more. The entire network settles trillions of dollars in transactions each year, and more than $170 billion is locked on the platform. But at the same time, problems also arise.

Ethereum's decentralized design ultimately limits the number of transactions it can handle to 15 per second. Since Ethereum's popularity far exceeds 15 transactions per second, this leads to transaction congestion on Ethereum and high gas fees. Ultimately, this also discourages many users and limits the types of applications that Ethereum can currently handle.

If blockchains based on smart contracts want to grow into financial and Web 3 applications with billions of users, scalable solutions are needed. Fortunately, many Ethereum solutions have already appeared on the market. This article will conduct an in-depth analysis and discussion of the Ethereum solutions currently on the market.

Source: Coinbase

By Justin Mart and Connor Dempsey

Compiled by: Chen Yiwanfeng

Competition or complementarity?

The goal of the Ethereum solution is to increase the number of transactions that a publicly accessible smart contract platform can handle while maintaining sufficient decentralization. Remember, scaling a smart contract platform through a centralized solution managed by a single entity is trivial (Visa can handle 45,000 transactions per second), but we are immediately back to where we started: a world owned by a few powerful centralized players.

There are two ways to solve this problem:

1. Build a new network to compete with Ethereum that can handle more activity;

2. Build complementary networks that can handle Ethereum’s excess capacity.

Broadly speaking, they fall into several categories:

1. Layer 1 blockchain (competing with Ethereum);

2. Sidechain (partially complementary to Ethereum);

3.Layer 2 network (completely complementary to Ethereum).

While each architecture and approach is different, the goal is the same: to allow users to actually use the network (e.g., interact with DeFi, NFTs, etc.) without paying exorbitant fees or experiencing long wait times.

Layer 1

Ethereum is considered a Layer 1 blockchain, an independent network that protects user funds and performs transactions in one place. For example, in Ethereum, a user can use a DeFi application such as Uniswap to exchange 100 USDC for DAI.

Competing Layer 1s can do everything Ethereum does, but in an entirely new network. The difference is that new system designs can achieve higher throughput, resulting in lower transaction fees, but usually at the cost of increased centralization.

Over the past 10 months, new Layer 1s have come online in droves. During the same period, the total value of these networks has surged from $0 to around $75 billion. The field is currently led by Solana, Avalanche, Terra, and Binance Smart Chain, each of which has a growing ecosystem valued at over $10 billion.

Non-Ethereum Layer 1 led by TVL

All Layer 1s are competing to attract developers and users. It is difficult to easily build and use applications without any of Ethereum's tools and infrastructure. To bridge this gap, many Layer 1s have adopted a strategy called EVM compatibility.

EVM stands for Ethereum Virtual Machine, which is essentially the brains that performs computations to make transactions happen. By making their network compatible with the EVM, Ethereum developers can easily deploy their existing Ethereum applications to the new Layer 1 by essentially copying and pasting their code. Users can also easily access the EVM-compatible Layer 1 using their existing wallets, making migration simple.

Take BSC as an example. By launching an EVM-compatible network and adjusting the consensus design to achieve higher throughput and cheaper transactions, BSC saw a surge in usage of dozens of DeFi applications last summer, all of which are similar to popular Ethereum applications such as Uniswap and Curve. Avalanche, Fantom, Tron, and Celo have also taken the same approach.

In contrast, Terra and Solana currently do not support EVM compatibility.

EVM-compatible and non-EVM-compatible Layer 1 TVL

Interoperability Chain

Typically, Layer 1 represents blockchain ecosystems such as Cosmos and Polkadot. Rather than building new independent blockchains, these projects build standards that allow developers to create application-specific blockchains that can communicate with each other. For example, this could allow tokens from a gaming blockchain to be used in an application built on a separate blockchain for a social network.

Currently, there is over $100 billion on chains built using the Cosmos standard that will eventually become interoperable. Meanwhile, Polkadot recently reached a milestone that will similarly unify its blockchain ecosystem. In short, there is now a diverse landscape of direct Ethereum competitors, and there will be more to come.

Sidechain

The distinction between sidechains and new Layer 1s is admittedly a fuzzy one. Sidechains are very similar to EVM-compatible Layer 1s, except that they are specifically designed to handle Ethereum’s excess capacity rather than competing with Ethereum as a whole. These ecosystems are closely integrated with the Ethereum community and host Ethereum applications in a complementary way.

Axie Infinity’s Ronin sidechain is a great example of this. Axie Infinity is an NFT game originally built on Ethereum. Since Ethereum’s high gas fees make it very expensive to play the game, the Ronin sidechain is designed to allow users to transfer their NFTs and tokens from Ethereum to a low gas fee environment. This makes the game affordable to more users and has driven its popularity.

At the time of writing, users have transferred over $7.5 billion from Ethereum to the Ronin sidechain to play Axey Infinity.

Polygon POS

Sidechains like Ronin are application-specific, while others are for more general applications. Currently, Polygon’s proof-of-stake (POS) sidechain is the industry leader, with nearly $5 billion in value and more than 100 DeFi and gaming applications deployed, including Aave and Sushiswap, as well as a Uniswap clone called Quickswap.

Likewise, Polygon POS does not really look any different than EVM-compatible Layer 1. However, it is built as part of a framework to extend Ethereum rather than compete with it. The Polygon team sees a future where Ethereum remains the dominant blockchain for high-value transactions and value storage, while everyday transactions move to Polygon’s low-cost blockchain. (Polygon POS also maintains a special relationship with Ethereum through a process called checkpoints).

With transaction fees of less than a penny, Polygon’s vision for the future looked plausible. With the help of an incentive program, users flocked to Polygon POS, with daily transaction volume exceeding that of Ethereum (although this included a lot of spam transactions).

Layer 2 (Rollups)

An obvious challenge for both Layer 1 and sidechains is to secure their blockchains. To do this, they must pay fees to a new group of miners or stake validators to verify and secure transactions, usually in the form of inflation of the underlying token, such as $MATIC for Polygon or $AVAX for Avalanche.

However, this also comes with significant disadvantages:

1. Having a basic token makes the ecological network more competitive, rather than complementary to Ethereum;

2. Verifying and protecting transactions is a complex and challenging task that the ecosystem will be responsible for indefinitely.

Wouldn’t it be great if we could borrow the security of Ethereum to create a scalable ecosystem?

So, let’s move on to Layer 2 networks.

In short, Layer 2 is an independent ecosystem that sits on top of Ethereum and relies on Ethereum for its security. Crucially, Layer 2 does not need to have a native token, so they are not only more complementary to Ethereum, but are essentially part of Ethereum. The Ethereum roadmap even pays homage to this idea by indicating that Ethereum 2.0 will be "centered around Rollups."

How Rollups Work

Layer 2 is often called Rollups because they “roll up” or bundle transactions together and execute them in a new environment before sending the updated transaction data back to Ethereum. Rather than having the Ethereum network process 1,000 Uniswap transactions alone, the computation is offloaded on Layer 2 Rollups before submitting the results back to Ethereum.

However, when the results are published back to Ethereum, how does Ethereum know that the data is correct and valid? How does Ethereum prevent anyone from publishing incorrect information? These key questions distinguish two types of Rollups: Optimistic Rollups and Zero-Knowledge Rollups (ZK-Rollups).

Optimistic Rollups

When submitting results to Ethereum, Optimistic Rollups "optimistically" assume that they are valid. In other words, they let the operators of the Rollups publish any data they want (including potentially incorrect/fraudulent data) and assume that it is correct, which is undoubtedly an optimistic outlook.

But there are ways to combat fraud. As a check and balance, there is a window of time after any withdrawal where anyone can point out fraud (remember, the blockchain is transparent and anyone can see what is going on). If one of these observers can mathematically prove that fraud occurred (by submitting a fraud proof), Rollups will revert any fraudulent transactions and punish the bad actor and reward the observer.

The downside is that there will be a short delay when you transfer funds between Rollups and Ethereum, waiting to see if the watchers detect any fraud. In some cases, this can be up to a week, but these delays are expected to decrease over time.

The key is that Optimistic Rollups are intrinsically tied to Ethereum and are poised to help Ethereum scale today. As a result, we’ve seen strong early growth as many leading DeFi projects turn to leading Optimistic Rollups, such as Arbitrum and Optimistic Ethereum.

Arbitrum and Optimistic Ethereum

Arbitrum and Optimistic Ethereum are the two main projects implementing Optimistic Rollups today. It is worth noting that both companies are still in the early stages, both maintain a level of centralized control, but both plan to decentralize over time.

It is estimated that once mature, Optimistic's Rollups can increase scalability by 10-100 times. Even in the early days, DeFi applications on Arbitrum and Optimism have accumulated billions in network value.

Optimism is early on its adoption curve, with over $300M TVL deployed across 7 DeFi applications, most notably Uniswap, Synthetix, and 1inch.

Arbitrum goes even further, with a TVL of around $2.5 billion across more than 60 applications (including familiar DeFi protocols like Curve, Sushiswap, and Balancer).

Arbitrum has also been selected as Reddit’s preferred scaling solution for their long-awaited effort to tokenize Community Points for the social media platform’s 500 million monthly active users.

ZK-Rollups

Optimistic Rollups always assume that transactions are valid and provide room for others to prove fraud, ZK-Rollups actually prove to the Ethereum network that the transaction is valid.

As the results of the bundled transactions are presented, they submit what is known as a validity proof to the Ethereum smart contract. As the name implies, the validity proof lets the Ethereum network verify that the transaction is valid, making it impossible for relayers to cheat the system. This eliminates the need for a fraud proof window, so transferring funds between Ethereum and ZK-Rollups is effectively instantaneous.

While instant settlement and zero withdrawal times sound great, ZK-Rollups are not without tradeoffs. First, generating validity proofs is computationally intensive, so high-performance machines are needed to make them work. Second, the complexity surrounding validity proofs makes it more difficult to support EVM compatibility, limiting the types of smart contracts that can be deployed to ZK-Rollups. As a result, Optimistic Rollups came to market first and are more capable of solving Ethereum’s scaling issues today, but ZK-Rollups may become a better technical solution in the long run.

ZK-Rollups Adoption

The ZK-Rollups situation is deep, with multiple teams and implementations in work and production. Some notable players include Starkware, Matter Labs, Hermez, and Aztec. Today, ZK-Rollups mainly support relatively simple applications such as payments or exchanges (due to current limitations on the types of applications that ZK-Rollups can support). For example, derivatives exchange dYdX uses Starkware (StarkEx)’s ZK-Rollups solution to support nearly 5 million trades per week and over $1 billion in TVL.

However, what really deserves praise is the ZK-Rollups solution, which is fully compatible with the EVM and is therefore able to support popular general-purpose applications (such as the full suite of DeFi applications) without the exit delays of Optimistic Rollups. The main players in this field are MatterLab's zkSync 2.0, Starkware's Starknet, Polygon Hermez's zkEVM, and Polygon Miden, all of which are currently working on mainnet launches.

Many in the industry (including Vitalik) are considering ZK-Rollups in conjunction with Ethereum 2.0 as a long-term solution for scaling Ethereum, primarily due to their ability to fundamentally handle hundreds of thousands of transactions per second without compromising security or decentralization. As the process of scaling Ethereum continues to move forward, the upcoming fully EVM-compatible ZK-Rollups will be one of the key issues to watch.

A fragmented world

In the long term, these scaling solutions are necessary if smart contract platforms are to scale to billions of users. However, in the short term, these solutions may present significant challenges for users and crypto operators. Navigating from Ethereum to these networks requires the use of cross-chain bridges, which are complex for users and carry potential risks. For example, several cross-chain bridges have been the target of attacks worth more than $100 million.

More importantly, the fragmentation of the multi-chain world breaks composability and liquidity. Considering that Sushiswap is currently implemented on Ethereum, BSC, Avalanche, Polygon, and Arbitrum. Sushiswap's liquidity was once concentrated on one network (Ethereum), and now it is distributed among five different networks.

Ethereum applications have long benefited from composability, where Sushiswap on Ethereum plugs and plays with other Ethereum applications such as Aave or Compound. As applications expand to new networks, applications implemented on Layer 1/sidechain/Layer 2 are no longer composable with applications implemented on another layer, limiting usability and creating challenges for users and developers.

Uncertain future

Will new Layer 1s like Avalanche or Solana continue to grow to compete with Ethereum? Will blockchain ecosystems like Cosmos or Polkadot proliferate? Will sidechains continue to operate in harmony with Ethereum, taking on its excess capacity? Or will Rollups combined with Ethereum 2.0 win out? No one can say for sure.

While the future is uncertain, take solace in the fact that everyone can count on so many smart teams working to solve the most challenging problems facing the open, permissionless web. Just as broadband eventually helped the internet power a host of revolutionary applications like YouTube and Uber, we believe we will eventually view these winning scaling solutions in the same light.