A Primer on Layer 2 Blockchains for RIAs and Investors
As an investment advisor in an increasingly digital age, understanding the transformative potential of blockchain technologies and their myriad of applications is essential. We move beyond the familiar terrain of Bitcoin and Ethereum to a progressive innovation – Layer 2 blockchain solutions. For a recap of Layer 1 blockchains, check out the first article in this RIA series: Demystifying Blockchains
Layer 2 blockchains are secondary protocols built atop a base layer blockchain (Layer 1) such as Bitcoin or Ethereum, designed to enhance the base layer's transaction speed, scalability, and efficiency while maintaining security and decentralization. They function by offloading transactions from the congested layer 1 blockchain, thereby relieving network congestion and reducing transaction fees.
Two noteworthy examples of Layer 2 solutions are Bitcoin's Lightning Network and Ethereum's Optimistic Roll-Ups. A brief overview of each is provided below.
Lightning Network (Bitcoin): The Lightning Network, an overlay payment protocol, enables fast, low-cost, and scalable Bitcoin transactions. Transactions occur 'off-chain' via payment channels between parties, without the need to record each transaction on the blockchain. Only when the channel is opened (initial transaction) and closed (final settlement) are transactions recorded on the main Bitcoin blockchain. This method significantly enhances the Bitcoin network's transaction capacity, reducing both transaction time and cost.
Optimistic Rollups (Ethereum): Ethereum's scalability issues are tackled by Optimistic Roll Ups, a Layer 2 solution enabling more transactions per second (TPS) and lower fees. It bundles multiple transactions off-chain into a single 'rollup', periodically submitting them to the Ethereum mainnet. This solution increases the network's TPS while maintaining Ethereum's smart contract capabilities.
As registered investment advisors (RIAs), understanding Layer 2 solutions and their implications is critical for several reasons:
Enhanced Scalability: Layer 2 solutions can drastically scale transaction throughput, making networks more accommodating to large volumes of activity. This factor is crucial in the deployment of enterprise-level blockchain solutions and also extends the benefits of the underlying Layer 1 blockchain to a broader audience since Layer 2 transactions are ultimately recorded on the Layer 1 blockchain.
Reduced Transaction Costs: By processing transactions off-chain, Layer 2 solutions can significantly reduce transaction fees. Lower fees may lead to broader blockchain adoption, particularly among retail users and micro-transaction-dependent services. For specific comparisons, at the time of this article sending ETH on multiple Layer 2 chains had fees of less than 5 cents ($0.05), whereas, the same transaction on Ethereum Layer 1 costs 75 cents ($0.75); over 10x the transaction fee.
Investment Opportunities: Layer 2 projects themselves could offer promising investment opportunities, either directly via tokens associated with these projects or indirectly through businesses adopting these technologies. Similar to Layer 1 blockchains, Layer 2’s are essentially selling blockspace and generate revenue mainly through transaction fees and Max Extractable Value (MEV) that can be passed along to validator nodes and token holders. To read more about MEV, check our previous article here: MEV 101
Risk Management: Layer 2 solutions might experience unique risks, such as smart contract vulnerabilities or complex technicalities that could lead to potential pitfalls. Knowledge of these intricacies helps RIAs advise clients on managing their crypto asset portfolios effectively.
In conclusion, Layer 2 blockchains are a potent development in the blockchain ecosystem, promising scalability, reduced costs, and faster transactions. For RIAs, being conversant with this technology is an essential part of future-proofing advisory practice in a digitized and decentralized finance world. It is prudent to monitor advancements and adaptations in this space and their subsequent impact on the wider cryptocurrency market and blockchain application landscape.
This article is one in a series focused on blockchain and crypto fundamentals for RIAs and investors. Check out the Layer 1 overview: Demistifying Blockchain
