What is a Layer 2?
There are lots of terms and acronyms you may need to understand when you begin trading cryptocurrency for the first time. Some are relatively self-explanatory, such as cryptocurrency wallets, but others can be a little more difficult to work out without background knowledge.
For most people, one of those is “Layer 2.” So, what exactly is a Layer 2, why are they important to cryptocurrency networks, and what the heck happened to Layer 1? Here’s our beginner’s guide.
What is a Layer 2?
A Layer 2 is a secondary framework or protocol (hence the name) built on top of an existing blockchain system. They are typically designed to solve certain problems with a blockchain’s original implementation, such as transaction speeds or scaling issues that larger cryptocurrency networks are often forced to deal with. They are sometimes referred to as “off-chain” scaling solutions.
With a Layer 2 protocol in place, blockchain transactions can take place separately, away from the Layer 1 protocol (the main chain) so that it is not affected. And because they are separate entities, added as a second layer, they have some big advantages, like negating the need to make any structural changes to the Layer 1 chain that could cause disruption or impose security risks.
Examples of a Layer 2
Some of the best-known Layer 2 protocols include the Bitcoin Lightning Network (LN) and Ethereum Plasma. These are part of the Bitcoin and Ethereum networks, respectively, and despite being closely linked, they operate independently, with their own nodes (computer networks) and software. However, the biggest Layer 2 platforms by market cap are currently Polygon and Loopring — both of which operate on the Ethereum blockchain.
Both LN and Plasma were built to address the scalability issues of the original Bitcoin and Ethereum networks, which began to struggle as they became significantly bigger and greater numbers of people wanted to buy and trade cryptocurrency tokens.
When these Layer 2 protocols are used, transactions can take place without having to be recorded on the main chain. But as far as the user (or cryptocurrency trader) is concerned, there is no noticeable difference in the way their transactions are carried out.
Not every cryptocurrency network has a Layer 2. In fact, they tend to be implemented only by those that really need them. However, given that they effectively solve a number of problems that exist within larger networks, they are likely to become increasingly popular.
Why is a Layer 2 necessary?
We’ve already touched upon one of the biggest reasons why a Layer 2 is necessary for larger cryptocurrency blockchains. But it’s not just better scalability that they offer. Because Layer 2 protocols are separate entities, they are substantially more flexible than the Layer 1. Changes, adjustments, and even experimentation can take place without the risk of disrupting the main chain.
This allows cryptocurrency networks to regularly tweak and improve their processes for a better end user experience. Many of these improvements wouldn’t be possible — or very rare — without a Layer 2 that protects the main chain and ensures it can continue to operate as normal.
Some Layer 2 protocols were built to address other shortcomings in early blockchain technologies. For example, dYdX promises a more powerful exchange experience for trading, while zkSync and ZKSpace add NFT minting and NFT marketplaces. Adding features like these to a Layer 1 comes with substantial risk. There is a chance that a simple coding error or bug could be disastrous. It’s a lot simpler and safer to make these changes and improvements with a Layer 2 and leave the Layer 1 as it is.
A Layer 2 makes trading more affordable
A Layer 2 can also make trading significantly more affordable on larger cryptocurrency networks. When a great number of transactions are taking place and a blockchain is pushed to its limit, the average gas (transaction) fee can skyrocket as miners prioritize traders who are willing to pay significantly higher gas fees. At one point in 2017, the average cost of a Bitcoin transaction reached $50.
With a Layer 2, you still have to pay transaction fees — and they still fluctuate over time, depending on the volume of transactions taking place. But because the network is less susceptible to being overwhelmed, bigger traders making large transactions are less likely to be offering higher fees that push up the average price.
In fact, thanks to Layer 2 protocols, it’s actually possible to make some trades for free. A Layer 2 allows a direct channel between two cryptocurrency traders to be opened up. You’ll need to pay a fee to open that channel (and eventually another when you want to close it), but while it’s live, the same two traders can make as many transactions as they like without having to pay again.
Layer 2 disadvantages
It should be noted that Layer 2 protocols aren’t completely perfect. Although they solve a number of problems that need to be solved, there are disadvantages that come with adding a second layer to a primary blockchain. One downside is that it can make things more complicated.
For instance, certain decentralized applications (or “dApps”) built to work with a Layer 2 may not be able to communicate effectively — or at all — with the Layer 1. This could make some transactions between certain parties difficult, unreliable, or even impossible.
Another downside is that a Layer 2 can reduce the liquidity in the primary blockchain. Since some liquidity is necessary to facilitate transactions, it has to come from somewhere — and it is usually taken from the original liquidity pool. That’s usually not a problem if the transaction is carefully managed and liquidity is shared appropriately, but it can be detrimental to the network if not.
Finally, there are the security risks. A Layer 2 must be protected just as well as a Layer 1. Think of it like adding another door to your home; you need that door to be just as secure as any other entry point, otherwise your home becomes vulnerable. And because a Layer 2 tends to be operated by a significantly smaller number of nodes, it could be more easily controlled than a Layer 1.
If you like to be particularly careful with your cryptocurrency transactions, then, using the Layer 1 blockchain is the safest way to trade.
Layer 2 in a nutshell
We know that’s a lot of information to take in, so let’s simplify it: A Layer 2 is a secondary blockchain protocol that allows transactions to take place away from the main chain. In addition to solving scalability issues, it allows for cheaper transaction fees, and greater network flexibility. But, like most technologies, it also has its downsides, which users should be mindful of.
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