If you are one of those who have not understood Layer 2 protocols yet, here’s a quick primer: Blockchains have an inherent limit in terms of processing transactions. If there are too many transactions, it slows down the entire network. This is where Layer 2 (L2) protocols come in. You can think of them as “sub-blockchains” which are specifically designed to solve scalability issues in the main blockchain.
L2 blockchains are built on top of layer 1 blockchains like Ethereum, Solana or Avalanche, in an effort to reduce bottlenecks, constraints and other network-clogging effects.
Today, we track key trends on Layer 2s specific to Ethereum (Polygon (MATIC), Arbitrum and Optimism (OP)) to give you an idea of what to expect in the upcoming years.
1. Polygon is established; Arbitrum and Optimism are growing rapidly
In terms of number of users, Polygon has a monthly active userbase of 300–400,000. It was the first scaling solution of prominence and has built a strong product over the years. It is operating as a blockchain by itself though being an Ethereum Layer 2 is still its strong use case.
In the last six months, Arbitrum and Optimism have gained considerably in terms of new userbase.
2. Arbitrum has surpassed Ethereum on number of transactions with negligible fees.
Thanks to a growing ecosystem on Arbitrum including GMX (a DEX), more transactions were processed on Arbitrum last week compared to Ethereum. And it cost users just 2.3% of fees compared to that of Ethereum.
Surprising? This is an intended outcome with Layer 2s over time. Ethereum, the base layer, will provide security while scaling solutions will process most of the transactions.
3. Ethereum’s upgrade will likely scale L2s even more
L2s are here to stay. In spite of major upgrades to Ethereum (Shanghai upcoming), it by itself will not be capable of transactions at scale and low cost in the future. If Ethereum scales by 10x in throughput, transactions from Layer 2s will likely scale even more — and also allow room for multiple winners in the space.
Optimism has an upcoming upgrade termed ‘Bedrock’ that will make it competitive compared to Arbitrum. Polygon’s zkEVM beta launch in March is also an exciting development.
4. Layer 2s are evolving, new winners will emerge
The function and role of L2s are likely to evolve in the future. As more use cases of blockchains emerge, some of them may entirely be done on a L2 solution given restrictions in size or volume or fees.
As the technology behind the functioning of blockchains is evolving too, new launches and upgrades will continue to dictate who rules this ecosystem. Polygon, Arbitrum and Optimism seem to have an early lead, though it’s still too early.
Investment thesis: L2s have higher beta than L1s — high risk, high rewards
If you are convinced of layer 2s, we get to the key takeaway that matters: Investment. By definition, layer 2s have an higher beta than its base layer. (what’s a beta?)
When the market is good, L2s can outgrow ETH and when the market is bad, ETH will be more stable than L2 based tokens. We always advise that you park most of your crypto portfolio in BTC and ETH — say 80%. The remaining 20% can be used for strategic bets including on Layer 2s.
Today, MATIC and OP are considerable investments to research on given Arbitrum is yet to release a token.
MATIC has been one of the strongest altcoins this bear market, even outperforming BTC on some months.
OP token may see a near term spike as its Bedrock upgrade nears. Engaging on Arbitrum platform as an user might also lead to an airdrop in the future.
The other notable layer 2s on Ethereum currently are: ImmutableX (IMX) and Loopring (LRC). They are yet to gain prominence in the ecosystem.
Note: Growth in all of the above are dependent on ETH doing well in the market.