Ethereum, the second-most-valuable cryptocurrency blockchain after bitcoin, has been hailed for its programmable smart contracts and greater flexibility. But it faces challenges in scaling up: Transaction speeds are slow and costs high.
Layer 2 networks that sit on top of Ethereum are designed to address these challenges. Ethereum co-founder Vitalik Buterin has said that the future of Ethereum will depend on Layer 2 networks for scaling, even after Ethereum moves to a faster, more environmentally friendly system known as proof of stake.
This intense competition to "win Ethereum" boils down to this question: Will developers and users flock to the most advanced technology, or will they just go with what works when they need it? Convenience often wins, unless the technology is so much better or some other incentive drives them to try something new.
Scaling Ethereum is still its biggest problem. The company that can solve this will be in the driver’s seat to power a range of services on Ethereum, including decentralized finance, NFTs, gaming and more. Because Ethereum is the largest smart-contract protocol and is popular with developers, whoever becomes the dominant Layer 2 on Ethereum could end up handling a sizable portion of crypto transactions. The debate over which option will prevail is as fierce as any in crypto.
Layer 2 networks are still relatively small compared to other Layer 1 blockchains — the primary ledger and protocol associated with a specific token, like bitcoin or litecoin. "That will change over time" as more users shift to Layer 2 applications, said Haseeb Qureshi, managing partner at Dragonfly Capital.
A key Layer 2 strategy is the rollup, or bundling of transactions off the main chain for faster processing. The two main approaches are optimistic rollups and zero knowledge, or ZK, rollups. Both approaches reduce congestion on the Ethereum blockchain, speed transactions and lower costs.
Optimistic rollups are live. Arbitrum is the largest player with $2.9 billion in total value locked, or deposited, in the network. Crypto entities using Arbitrum include decentralized exchanges SushiSwap and Uniswap and NFT project Treasure.
Optimistic rollups validate and execute transactions and send them to Ethereum, and only run a computation fraud proof if a transaction is challenged — thus the moniker "optimistic." These transactions can be challenged after they’re sent back to the Ethereum chain for up to seven days.
ZK rollups, on the other hand, always run an advanced cryptographic proof called "zero knowledge" and then submit it back to Ethereum. ZK is designed to be foolproof since transactions are all verified and thus can’t be challenged. The newer technology is still just emerging in the wild.
But the technology is much better, and sure to improve, supporters say. "It’s really hard to do" zero-knowledge proofs, said Qureshi, whose firm invested in Matter Labs, a ZK rollup startup. “Only in the last year and a half have they come up with ways that were thought to be theoretically impossible.”
Optimistic supporters like Steven Goldfeder, CEO of Offchain Labs, which created Arbitrum, says ZK rollups are "orders of magnitude" more expensive than optimistic ones, because of the intensive calculations required. Some ZK systems that have launched are not including the costs of the proofs that they run off-chain for customers, which obscures their true costs, he said.
"We think optimistic systems are more practical and much cheaper to operate than ZK systems," said Ed Felten, co-founder of Offchain Labs.
ZK supporters say optimistic rollups take too long to be fully completed, since they can be challenged up to seven days after they are executed. This means that someone seeking to get their ETH tokens out of a Layer 2 such as Arbitrum to the Ethereum network would have to wait seven days. That’s not viable in crypto, where people want fast access to capital, Qureshi said. One week is "worse than a wire transfer," he said.
There are several services, however, that will pay users instantly, minus a small fee, and take on the risk of being challenged. And this type of challenge is rare and actually hasn’t happened yet, due to the financial penalties for posting a rollup that is wrong or making an unsuccessful challenge to a correct rollup, Felten said.
Even though there is a delay with withdrawing funds to Ethereum, these optimistic transactions actually have already been fully verified on Layer 2. The reason for the delay is Ethereum doesn’t see the transactions and has not validated those transactions yet.
Firms like Andreessen Horowitz are betting on ZK rollups as the future, and NFT-focused Immutable X uses StarkWare’s ZK rollup technology. But the best technology doesn’t necessarily win.
Even Arbitrum’s Goldfeder admits that ZK rollups are technologically impressive and doesn’t rule out supporting ZK rollups in the future.
But he says it’s unfair to compare optimistic rollups in their current state to ZK rollups in the future, since optimistic technology will improve in the future as well.
This isn’t the first time Ethereum has pushed for an off-chain scaling solution: Plasma was a previous effort that didn’t work out. But Buterin and others believe a new system based on rollups will work, even if it takes years to become mainstream.
Both technologies will coexist for a while, said Jake Brukhman, founder and CEO at CoinFund, which has made some Layer 2 investments. Over the longer term, ZK rollups have a technology advantage, he said. Meanwhile, he said, other Layer 1 blockchains could eventually be an even bigger threat in terms of speed, scalability and security.
That’s part of what’s at stake as Layer 2 networks develop: If Ethereum can’t scale to handle the demand for transactions, it could drive developers to other blockchains. And the software industry has proven that developers are key to winning.
