The Difference Between Layer 1 and Layer 2 in Crypto

Authored by Makara
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Makara

Published November 5, 20215 mins
Makara - 1200x1200 Layer 1 and Layer 2 Crypto

If you’ve been involved in crypto very long, you’ve probably seen the term “layer 1.” This summer, smaller layer 1 coins were industry darlings, often seeing enormous growth—and offering plenty of opportunity. You may have even taken advantage of that opportunity by investing in one of Makara’s baskets. But what, exactly, are they? And how does layer 1 differ from layer 2?

The difference between layer 1 and layer 2 is kind of like the difference between your phone’s operating system and its apps. The OS determines the phone’s capabilities, and the apps use those capabilities to do cool things. So in crypto, layer 1 is a base-level blockchain like Bitcoin or Ethereum. Most layer 1 networks have their own layer 1 coins—in this case, Bitcoin and Ether. Currently, Ethereum is used for so many different things that it can get congested, leading to annoyingly high transaction fees. That’s part of the reason for the rise of lesser-known layer 1 blockchains like Cardano, Solana, and Terra. These alternatives have their own basic abilities and priorities that make them better suited to different types of layer 2 applications. (For instance, Solana prioritizes transaction speed over the decentralization of Ethereum.)

Those layer 2 apps are what people use to buy and sell NFTs, to invest via the decentralized finance network, or to just, you know, play games. They often have their own tokens, which, as we mentioned before, can be good investments. But the most important thing about layer 2 is what it allows layer 1 to do: increase scale without sacrificing too much security and decentralization.

Scale is the holy grail for blockchains. The more transactions a blockchain can handle (and the more efficient and cheap those transactions are), the more appealing it is—and the closer it gets to replacing traditional payment systems. As long as Visa can handle hundreds of times more transactions per second than a blockchain like Bitcoin or Ethereum, crypto will have a very hard time becoming the central hub for global finance that it deserves to be. But with the help of layer 2 apps and systems that offer different ways for blockchain developers to achieve that scale, it’s no longer an impossible dream. Here’s what has to happen. 

How to Improve Layer 1

To say you want to fix a base blockchain is like saying you want to fix traffic on I-95. You can’t just paint new lane lines or increase the speed limit. You’re better off tearing it all down and rebuilding an all-new system of electric cable cars. It’s not easy. 

With a blockchain, one way to increase transaction speed and capacity is to change how the network reaches consensus—how it goes about deciding what transactions to record. Right now, the proof-of-work process used in big networks like Bitcoin and Ethereum is decentralized and secure, but also really costly and slow. But this will change for Ethereum when it finishes upgrading to Ethereum 2 next year. At that point, consensus will be reached through proof of stake. Instead of needing computational power to write a new block, miners will need collateral currency. (If they cheat, they lose their money.) It uses much less energy and moves much more quickly, while still being incredibly secure. 

Another way to speed things up is to create a system in which responsibilities are broken up. This is called “sharding.” Instead of having each of its nodes authenticate every single translation, a blockchain that uses sharding can spread the responsibilities around, lightening the load for each node, and increasing speeds across the network. (ETH2 will institute sharding too.)

Both options sound good, right? Unfortunately, these upgrades can take years to complete. In the meantime, layer 2 fixes can be made far faster.

What Layer 2 Can Do

The beauty of layer 2 is that it can add functions to layer 1—and even relieve layer 1 of some of its burden by having transactions redirected toward it.

There are a lot of ways to do this, all completed by third parties like Bitcoin’s Lightning Network or Ethereum’s Raiden. One is to effectively build other, smaller blockchains that are connected to the layer 1 network. These baby blockchains can have their own rules for how consensus is reached and blocks are made—and they often prioritize speed and scale. They oversee a whole bunch of transactions, then batch them together and send them to be confirmed and logged by the grateful layer 1.

For a network like Ethereum, baby blockchains still aren’t enough, since they can handle only transactions and not additional apps. The solution is something called rollups, which can be used to create essentially parallel universes capable of handling everything Ethereum can. In order to perform these functions for the blockchain without getting bogged down themselves, rollups keep some transaction data on layer 1, which allows layer 1 to handle security while the rollup focuses on speed. The biggest limitation for rollups is the amount of data that layer 1 can hold. So if layer 1 can be built to reliably hold more data, layer 2 can ensure that people can still access all of it in a timely way.

Both layer 1 and layer 2 upgrades are essential to building a faster, cheaper future of crypto—without sacrificing security. Together, they can move crypto even closer to having the scale needed to finally replace the old global financial system. What makes all this even more exciting is that both layer 1 and layer 2 can be working on improvements at the same time. One doesn’t get stuck waiting for the other. What this means is that the crypto world is about to get a whole lot better in a whole lot of ways.