If you’ve spent time in the cryptosphere recently, you might have heard some excitement around “Layer 2 protocols.” Supporters believe they can fill in some of the industry’s biggest gaps and become the next big thing in crypto. And of course, they’re even more excited about the specific cryptocurrencies associated with these layers, and the potential for their values to appreciate.
So what exactly are Layer 2 protocols? Let’s demystify them by exploring how blockchain layers work.
What are blockchain layers?
Blockchain layers are ecosystems that enable third parties to improve the way blockchains work.
One way to think of this is through the analogy of a smartphone. On a big picture level, smartphones can be broken down into several layers. The first is the physical phone itself (i.e., the hardware, including the screen and buttons). The second layer is the software, or operating system, which is usually designed and updated by a single team or company. The third layer is the apps. These run on the operating system from the second layer, and can be designed by the company itself, or by third-party companies.
In the same vein, blockchains are often stacks of applications, or layers, with each providing a function that aims to make the blockchain faster and easier to use.
How do blockchain layers work? Are they necessary?
Blockchain layers start with the foundational layer: Layer 0. Layer 1 is built on top of Layer 0, Layer 2 is built on top of Layer 1, and so on. As mentioned earlier, blockchain layers work as an ecosystem. Each layer is designed to support and enhance the function of the one below it.
Layers were built to solve some of the key challenges blockchains face. One of the most prominent challenges is that some blockchains may be impractical for daily use due to their complexity.
For example, one complaint about Bitcoin is that the settlement time for each transaction on the blockchain can be slow. Also, the fees that it charges for each transaction can be significant, which means it may not make sense to pay for small, everyday items with bitcoin.
To address these issues, crypto developers created the Lightning Network, a Layer 2 network built on the Bitcoin blockchain. The Lightning Network keeps track of bitcoin transactions on a separate, faster, and more efficient ledger, and then transposes these records over to the Bitcoin blockchain in batches. This allows users to transact in bitcoin with lower settlement times and fees.
In addition to making blockchains more practical, layers are also used to tackle interoperability issues. Interoperability refers to how different blockchains send each other information. For example, you and your friend may have smartphones made by different manufacturers, but you can still send and receive texts from each other. Layers can make it possible for this same function to exist between different blockchains.
Finally, layers can also enhance the crypto industry by allowing developers to optimize their area of expertise. In the smartphone analogy above, the app developers don’t have to worry about manufacturing the hardware, and vice versa. Instead, they can each focus on what they do best. In the same way, layers enable niches of the crypto industry to create the best products they can.
Types of blockchain layers
Broadly speaking, there are 2 major layer types.
These layers typically either host the actual blockchain, or allow users to build blockchains using its infrastructure. In the smartphone analogy from above, they represent the hardware.
Mining, transaction settlements, and rules for consensus mechanisms all take place in this layer. Some of the most well-known examples include the Bitcoin and Ethereum blockchains, which host the 2 largest cryptocurrencies by market cap, bitcoin ($BTC) and ethereum ($ETH).
As mentioned in the Lightning Network example earlier, one challenge blockchains on this layer face is scalability. Some run on consensus mechanisms that optimize decentralization and security, but this may make them slower than practical for certain use cases.
Layers built on base layers
These layers aim to improve the speed, scalability, practicality, usability, and interoperability of the base layer they’re built on.
The Layer 2 protocols mentioned earlier fall under this category. They’ve been generating excitement recently because supporters hope they can make crypto more user-friendly, which could then make its products and services more accessible to the general public.
Examples of Layer 2 protocols include the Lightning Network and Ethereum rollups.
What to consider when exploring cryptocurrencies from different layers
Most blockchain projects have their own token, regardless of which layer they run on. Those who believe in the project might buy the token in hopes that it will appreciate in value.
Before you jump in, however, be sure to research the project thoroughly. Just because a project can be associated with a specific layer and has intentions to improve the blockchain ecosystem doesn’t make it a safe buy. These tokens are cryptocurrencies, which means there’s potential for the project to be a scam, or for its value to drop to zero.
In general, remember that crypto is highly volatile, and may be more susceptible to market manipulation than securities. Crypto holders do not benefit from the same regulatory protections applicable to registered securities, and the future regulatory environment for crypto is currently uncertain. Crypto is also not insured by the Federal Deposit Insurance Corporation or the Securities Investor Protection Corporation, meaning you should only buy crypto with an amount you're willing to lose.