In part 1 of our L2 series, we discussed BTC off-chain scalability solutions and analyzed both Lightning Network and various bitcoin sidechains. If we look to the second largest cryptocurrency in terms of market cap, we see that Ethereum also has its fair share of off-chain scalability solutions. These solutions were largely designed in response to the network congestion Ethereum frequently experienced in 2017.
Ethereum’s programmability allows developers to design several scaling solutions that are impossible to implement on Bitcoin. In the past, that often just meant creating new smart contracts. This allowed teams to quickly secure funding, typically in the form of ERC-20 tokens, and shift their focus to building scalability protocols. Several of these protocols were launched a year or so later but saw minimal adoption. The lackluster results were a combination of dwindling interest in crypto due to the bear market, plus the inability to build traction leading up to the launch. However, in late 2019, the tides began to turn. Market reversals, increased interest, increased network utilization, and several technological developments brought layer 2 projects back on everyone’s radar.
The average cost of Ethereum transactions in USD since 2020. Source: Coinmetrics
The increased utilization of the Ethereum network, along with a 10x increase in transaction costs since January 2020, encouraged several teams to formally launch the projects they’d long been working on. Recently, we’ve seen a number of projects launch over the past few months — all fiercely competing for community attention and adoption. This article charts a map of these solutions and discusses their success so far from an investment perspective.
Off-chain scaling solutions entering an era of increased competition
Categories of Ethereum L2 Solutions
There are several flavors of Ethereum L2 projects. We categorize them into three buckets:
The first bucket includes payment scalability solutions such as Raiden, Liquidity Network, and Spankchain (based on Connext). Most of these solutions use State Channels and were inspired by Bitcoin’s Lightning Network. These projects managed to fundraise via ICOs in late 2017 or early 2018.
The second bucket is motivated by the need for more flexible scaling solutions that go beyond payment scalability. Solutions that can support arbitrary smart contract transactions and scale dapps as well as DeFi applications. One of this group’s pioneering projects was Plasma Chains — it later resulted in projects such as Loom Network, OMG network, and Matic. Due to Plasma implementation complexity, especially around data availability, a new class of general scalability solutions is gaining traction: the Rollup solutions class. Optimism/OVM pioneered this direction and it solutions like zk Rollups have followed.
The third bucket of L2 solutions runs orthogonal to the previous two groups and focuses on adding additional features, privacy in specific, that aren’t available on the Ethereum blockchain. The prominent projects in this area are Keep and Aztec.
🔹MakerDao Peg Stabilization Module a detailed discussion about an upcoming change to DAI to improve its capital inefficiency problem and improve the stability of the peg.
📌 What are mixers and “privacy coins”?A high-level explainer from Coin Center'sAndrea O’Sullivan on how privacy can be added to public blockchains either through mixers or dedicated protocols such as privacy coins.
📌 Celo DollarsThe Celo team explains the purpose of their built-in stablecoin Celo Dollar and the dynamics used to maintain the peg and allow global access to the stable asset.
Disclosure: Volt Capital and/or its partners may have exposure to some of the cryptocurrencies mentioned in this newsletter.