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08 July 2022

In this issue

All about ‘Layer 2 blockchains’ || The Top Five stories this week || "Gas Fees,” explained

Hello, Financial turmoil continued to roil the crypto market this week, with Voyager Digital filing for bankruptcy after suspending trade the week before – yet another victim of the downfall of hedge fund Three Arrows Capital. Back home in India, the kicking in of the new TDS rules have reportedly led to a massive plunge in crypto transactions across exchanges. We are all trying hard, but this is just not the time for us.

But it is a great time to hunker down and learn more about the world of crypto, so you can be a better investor in the future. This week, we plan to build on our lessons on Ethereum from last week by talking about ‘Layer 2 blockchains.’ If you haven’t read last week’s issue, you can check it out here, it will help you understand this issue better.

The newsletter is put together by Giottus Crypto Platform and The News Minute’s Brand Studio. You can read all the previous issues of Cryptogram here.

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THE BIG STORY

All about ‘Layer 2 blockchains’

A quick recap of our Ethereum primer from last week: Ethereum is a blockchain network over which a platform has been built for other apps, called Decentralised Apps (DApps). Basically, Ethereum is like Android Play Store for crypto apps. The platform runs on a programming language called Solidity, and Ether is the cryptocurrency used to incentivise the use of the network. A key feature of Ethereum is “Smart Contracts” – digital contracts which are executed by the network automatically if certain conditions are met. Being a decentralised network which requires every transaction to be validated by every node of the network, a lot of computational power is needed to run the network. (That’s where all the environmental criticism for Ethereum comes from, and that is the reason why the Merge is being attempted – explained in the previous issue.) Miners help verify and process these transactions, and they are incentivised by what’s called the “gas fee.” We’ve explained gas fee in our tech explainer section below today, so we are moving on from that here.Why layer 2Just having one layer led to several issues, like the mining becoming too centralised in the hands of a few big miners, and the throughput (number of transactions processed over a period of time) becoming lower. When there are too many transactions and smart contracts waiting to be executed, miners tend to prioritize the ones that have a higher gas limit (which translates to a higher incentive to them). This leads to an inflated gas price, resulting in a transaction fee crisis – it just gets too expensive to transact on the network. But it is layer 1 which provides the very crucial security for the network to remain trustless. So what do we choose, faster transactions and lower gas fee, or better security? People were like…

Image: ethereum.org

Solution: scaling by applying Layer 2. The idea is to reduce the congestion on the main network and bring down the transaction fees by moving computation data storage off the main layer — Layer 1 — and taking it to Layer 2.Overlying a network on top of an underlying layer 1 blockchain improved scalability. It created a secondary framework where the transactions can take place on top of layer 1. This automatically led to a higher throughput and cheaper gas fees, and thus use cases of the network also expanding. While the main layer provides security, the second layer offers throughput to perform thousands of transactions every second.

Source: Blockchain Simplified

There are a lot of layer 2 scaling options available right now and they are gaining adoption very rapidly. Visit https://l2beat.com/ to track projects, their total value locked (TVL) etc. We are going to take you through the various ways layer 2 scaling is achieved on Ethereum, and some of the popular networks which are doing it.1) CHANNELSChannels allow participants to exchange their transactions off the chain any number of times, and only submit two transactions to the base layer. There are two types of channels, State Channels and Payment Channels. Upside: process thousands of transactions per second.Downside: can’t offer open participation. Participants have to be known upfront. Scaling solution is application specific. Examples:Payment Channel: Lighting Network in BTCState Channel: RAIDEN in ETH2) PLASMAPlasma leverages the use of smart contracts to enable creation of ‘child chains’, which are copies of the parent Ethereum blockchain. In this method, transactions are offloaded from the main chain to child chains. Upside: Allows fast and cheap transactions.Downside: Long waiting period to withdraw funds, cannot be used to scale general purpose smart contracts.Example: OMG3) SIDECHAINSSidechains are Ethereum-compatible independent blockchains with their own consensus model and block parameters. The interoperability, however, is made possible by using the same Ethereum Virtual Machine. Polygon (MATIC) is the most popular and used layer-2, and has Indian founders. Polygon is a stack of protocols designed to fix Ethereum’s scalability issues. The Polygon network addresses the network’s challenges by handling transactions on a separate Ethereum-compatible blockchain. It then returns transactions to the main Ethereum blockchain post-processing. This approach lowers the network load on Ethereum. In doing so, Polygon can speed up transactions and lower transaction costs. Polygon was initially a simple sidechain, but it has evolved to become a complete suite of scaling solutions for Ethereum with a strong focus on ‘ZK-Rollups.’4) ROLLUPSRollups provide scaling by bundling or rolling up sidechain transactions into a single transaction and generating a cryptographic proof, commonly referred to as ‘snark.’ This proof is submitted to the base layer for record-keeping. All transactions are handled on sidechains, while the main blockchain only stores the data.There are two types of rollups. Zero Knowledge (ZK) Rollups send batches of transactions back to Ethereum accompanied by a special type of cryptographic proof. The Ethereum network uses this so-called “validity proof” to verify the correctness of that batch’s transactions. In a ZK Rollup protocol, Ethereum only accepts a batch of transactions if that batch can be cryptographically validated. In a line: guilty until proven innocent.In an Optimistic Rollup, Ethereum assumes that a given batch of transactions is legitimate. It only rejects the batch if any participant monitoring the rollup chain submits a valid claim that the transactions are fraudulent. While ZK Rollups rely on cryptographic proofs to determine transaction integrity, Optimistic Rollups have a grace period between the time that transactions are processed on the rollup and final acceptance by the base chain.Among all the solutions, optimistic rollups are gaining more traction, as they are believed to be easier to migrate and bootstrap a new ecosystem in the layer 2 environment. The future of Ethereum will depend to a fair degree on the success of Layer 2 networks. They have become one of the primary methods to reduce gas fees. Chains such as Polygon process over 3 million transactions per day today. With Ethereum’s Merge supposed to happen by Q4 2022, layer 2 solutions can scale hand-in-hand with Ethereum.

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  THE TOP FIVE 

Stories from this week you cannot miss

1.  Ethereum scaling tool Polygon is following the Solana blockchain in bringing Web3 to smartphones with a new partnership with tech startup Nothing.2. The Central African Republic (CAR) has launched its new government-backed Sango crypto hub initiative to foster the development of the local digital asset sector.3. Lamborghini-backed GT racing team to authenticate car parts using non-fungible tokens (NFTs).4. Shiba Inu's Lead Dev Announces SHI Stablecoin Launch in 2022, Says It Will Work on Experimental Protocol.5. Ethereum Name Service domain 000.eth sells for the second-highest price ever of 300 ETH or $ 315,000 on July 3.

  EXPLAIN, PLEASE 

Demystifying the world of cryptocurrency

This week, we explain GAS FEES. In any decentralised network, processing transactions needs computational power. In the Ethereum network, ‘gas’ refers to the unit that measures the amount of computational effort required to execute a transaction. Think of it as the fuel which enables the transactions. The computational effort does not come free, so each transaction requires a fee. ‘Gas fee’ refers to the fee required to conduct a transaction on Ethereum successfully.Gas fees are paid in Ethereum's cryptocurrency, Ether (ETH). It is measured in gwei (giga wei). A wei is the smallest unit of ETH. One gwei is equal to 0.000000001 ETH. The system of “gas” was originally proposed in the Ethereum yellow paper to incentivize miners. Each time a transaction or a smart contract is executed, users need to set a gas limit for it depending on the gas price.

So, that’s it for this week’s newsletter, see you next week!If you have any questions or feedback for us, write to us at [email protected]. You can check out the previous issues here.

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