January 2022

LAYER-2 SCALING SOLUTIONS

Scalability has been a thorn in the flesh for both DApp developers and users. Most popular public blockchain networks cannot scale up transactions when network traffic increases. As an Ethereum-based application becomes popular, transaction fees on the network reach up to hundreds of dollars!

Off-chain scaling (or layer-2) solutions have emerged as a viable solution to this scaling conundrum. Layer-2 solutions run on top of the layer-1 blockchain (the base protocol), as opposed to on-chain solutions, which attempt to improve the performance of the blockchain protocol itself. They inherit the underlying blockchain’s security features and enable more throughput (or transaction processing capacity) with lower transaction fees and faster transaction confirmations.

Last month, we discussed layer-2 scalability solutions as a critical theme for 2022. In this edition, we delve deeper into our claim and investigate the specifics.

KEY INSIGHT

The blockchain trilemma revolves around three fundamental principles: security, scalability, and decentralization. In order to prioritize one of these principles, a blockchain system must sacrifice the other two to achieve execution. However, in blockchains, as in any financial infrastructure, security is always of the utmost importance. If security is treated as a constant and a non-negotiable metric, scalability and decentralization remain the only two variables to consider. This can be functionally plotted on a hyperbolic curve represented by xy = c. We have two sides of this equation –

the left-hand side (xy): where x represents scalability and y represents decentralization; whenever x increases, y decreases, in order to maintain the constant relationship; and
the right-hand side (c): where c is an arbitrary constant which represents security, technology, and other arbitrary factors that keep evolving over time but are constant at any given point of time; as technology progresses, c increases and pushes the hyperbola outwards, thereby increasing both x and y.

The above graph shows that with time, all three principles (security, scalability, and decentralization) improve as the curve moves away from the origin. Yet the nature of the graph remains hyperbolic, with scalability and decentralization following the inverse relationship.

With that context set, there are two ways to solve scalability: on-chain or off-chain solutions. Blockchain networks can achieve on-chain scalability by improving the base architecture (layer-1) via better consensus, different block parameters, or distribution techniques such as sharding. This scaling method is more complex and requires existing blockchains to “hard fork” (leave the old blockchain behind) and adopt a new paradigm. On the other hand, off-chain scalability involves technologies (referred to as layer-2 solutions) that sit “on top” of the base network layer. The rigidity of technology does not restrict these on layer-1 and hence, offers an easier solution to scalability at the cost of trust and decentralization.

Each solution has its pros and cons to consider, such as throughput, gas fees, security, decentralization, and functionality. No single layer-2 solution currently fulfills all these needs. We covered some of these layer-2 solutions in-depth in our “Let’s Talk” article here.

LAYER-2s vs LAYER-1s

While we have seen layer-1s come up with various approaches (on-chain scaling) to provide better transaction throughput, decentralization remains a crucial challenge for all the new contenders. The table below shows the extent of this challenge by comparing the validators count (and other metrics) for some of the top layer-1s.

ETH 2.0 (now called the consensus layer) has already got more than 200k+ validators with at least 6 months to go before it merges with ETH 1.0 (now execution layer). However, given the complexity, the value at risk, and the timeline for sharding to go live, Ethereum won’t achieve its full potential before sometime next year. Until then, layer-2s are perfectly placed to facilitate cheaper and faster transactions powered by the underlying security of Ethereum.

CONCLUSION

Layer-2 solutions (or off-chain solutions) are critical for scalability and will see significant adoption this year and beyond.

In the long term, we expect that layer-2s would ultimately merge with layer-1s and exist as a single composable system. This would be made possible by the advancement in technology and the consolidation of infrastructure (growth in c from the above curve). The tight coupling within the new system would abstract the distinction we currently have and provide users with a more seamless experience.

In the meantime, in a diverse layer-1 ecosystem with multiple chains thriving, it will be essential to have better cross-chain infrastructure that enables easy movement of assets and data from one chain to another. Hence, cross-chain technology will evolve simultaneously to make interoperability and composability a reality.

PROJECT HIGHLIGHT – NGRAVE

NGRAVE is a Belgium-based security-focused hardware cryptocurrency wallet developer building an end-to-end solution for safely holding and using digital assets.

“When you bring the world’s best entrepreneurs, innovators, scientists, and business experts together to solve a crucial problem in the digital assets space, you create the most secure product for millions of users and thousands of enterprises. That is what NGRAVE is all about.” After almost a year-long interaction with some of the smartest founders in the digital assets and security space, we are proud to back the NGRAVE team and lead the seed round. Read our investment thesis to know more about the project.

WOODSTOCK IN NEWS

Woodstock co-led the US$ 6mn round for NGRAVE – a crypto hardware wallet.

Pranav Sharma, our Founding Partner, recently interacted with Dataquest India and shared his insights about Web 3.0, the future of NFTs involving enterprises, and the trends we are keen on investing in.
Woodstock was the title sponsor for Cryptonite, an IIT Bombay blockchain-focused event, which saw participants from top institutes across the country from 7th Jan – 10th Jan ‘22.

Himanshu Yadav, our Founding Partner, was invited for a fireside chat with his alma mater Birla Institute of Technology and Science, Pilani. He shared his journey into the blockchain and venture capital space and views about the “Future of Web 3.0!”
Pranav Sharma featured on The Economic Times‘ CryptoTV in conversation with Miloni Bhatt – Editor, Digital Broadcast, where he shared insights on the Web3 space.

MARKET NEWS

China’s e-CNY, the mobile wallet for digital yuan (CBDC), has released a pilot version of the app in the iOS and Android stores.
Diem, Meta (Facebook)’s cryptocurrency project, is looking to sell its assets to recoup the costs borne by investors.
The Mayor of New York City received his first paycheck in Bitcoin and Ethereum to show his support for innovation.

DeFi

Bybit, a digital asset derivatives exchange, contributed US$ 134mn to BitDAO and completed the integration of Arbitrum.
1inch, a decentralized exchange aggregator, expanded to the Avalanche and Gnosis chains.
OpenSea acquired Dharma Labs, a five-year-old DeFi lending platform and wallet creator.

NFTs

Award winning musician, Eminem, is using a Bored Ape Yatch Club NFT as his Twitter profile picture. NAS joined Royal, to sell royalty rights to his songs.
Samsung to introduce NFT platform within its new smart TVs. Users can now buy NFTs from their TV sets directly.
Former first lady, Melania Trump, launched her NFT collection.