You’re already familiar with Layer-1 technology, even if you’re unfamiliar with the term. Layer-1 is the base blockchain technology that runs all cryptos. Now, Juan Villaverde, editor of Weiss Crypto Portfolio, wants you to get in on Layer-2 solutions.
Layer-2 is a parallel secondary framework or protocol built on top of an existing blockchain system to provide updates or solutions.
Last Sunday, we released a video interview with Juan, diving into detail about the different Layer-2 solutions. If you haven’t had a chance to watch this informative video, you can find it here.
Chris Coney: Hi there, everyone, and welcome to this week's edition of the Weiss Sunday Special with me, your host, Chris Coney. My guest analyst today is Juan Villaverde, and the macroeconomic topic we're going to be discussing today is Layer-2 (L2) scaling and the macroeconomic impact.
So, Juan, can you start us off here with this topic? Can you give us a brief summary of what we mean by Layer-2 scaling, and what are the potential macroeconomic impacts for the crypto space?
Juan Villaverde: Okay. So, by Layer-2 scaling, we mean essentially, even though there are many technologies, they all try to do the same thing: push transactions off the main blockchain.
Now, there are many ways to accomplish this. One of the most famous ways is the Bitcoin Lightning Network, which many people may have heard of by now, and I believe it is the first major Layer-2 solution to come to market, which was in early 2018. You can correct me if I'm wrong there, but I think the big hype about Lightning was Q1 2018 or Q2. I remember following the chart there, and the whole point there is basically you and I, Chris, can do a lot of transactions using Bitcoin (BTC, Tech/Adoption Grade “A-”) without writing those transactions on the main Bitcoin blockchain. The only thing we're going to use the blockchain for is a summary of our transactions.
So, a classic example is a bar tab. You go to the bartender. I'm drinking beer. I know that I'm going to be sending money to you in very small quantities, so I will open up a channel with you. We're going to do this. We're going to agree that our Bitcoin transactions will not be recorded on the Bitcoin blockchain until we're done with our interaction. So, I'm going to start drinking beer. After 10:15, I'm going to say, "Okay, I'm going to go back home. I'm going to get an Uber." Then, we close the tab, and we do a summary of all those transactions, and we record that summary on the Bitcoin blockchain. The result is instead of having these 15 individual transactions, each of them paying a fee on Bitcoin, it's only going to be one.
Chris: Right.
Juan: That's what we mean by Layer-2. It's a different way of doing a bunch of transactions, pushing them elsewhere. Off-chain, we call it. Then, we do a summary. We write a summary of these transactions using cryptography, obviously, on the main blockchain. The reason for that is because classic blockchains are extremely expensive, and they're getting more expensive as more people are using them. So, how do we fix this? Because these are decentralized systems, it's not as easy to just say, "Well, let's just expand capacity." We can't change the core fundamentals of a blockchain because blockchains are immutable. Part of that means you can't just upgrade them.
Typically, what you do is you keep everything as is on Layer-1. That will be the blockchain, and we start experimenting with cool, different solutions on Layer-2. That's a separate thing. The only thing we need to figure out is, "Okay, how do these two interact? We're going to do all these transactions. We're going to do them over here. We're not going to use the blockchain. But how do we write them back into the blockchain in a way that is secure?" That's where the different solutions come into play.
Chris: Right. That was the whole friction between Bitcoin and Bitcoin Cash (BCH, Tech/Adoption Grade “B-”), right?
Juan: Yeah.
Chris: In the Bitcoin Cash world, the belief system is to just do everything on the base layer. In the Bitcoin world, the BTC world, it's like, "Well, let's keep the base layer pretty standard, pretty secure, simple, safe, concise. Then, let's build a special second layer for smaller transactions, faster transactions." So, in Bitcoin, it becomes BTC Network, Lightning Network.
I think for people who already understand how the internet works, it's the same paradigm shift the internet went through. The internet's in four different layers of technologies. The IP layer, internet protocol, that's akin to the blockchain right now, right? But in order to get to this streaming video, you can't do that on the base layer, right? There are other layers of technology on top of the internet protocol that allow things like high-frequency data, video streaming, big downloads and broadband. The blockchain, in the way you describe it, maybe there'll be such a thing as third- or fourth-layer solutions.
Juan: Absolutely. Yeah. We were discussing that this morning with a group of analysts.
Chris: Okay, good.
Juan: There are going to be several layers. It's not going to just be Layer-2. Eventually, you're going to saturate this second layer, whatever that ends up being called. Then, we're going to have Layer-2 on Layer-2, which technically is a third layer, fourth and fifth. Very difficult to predict, but we know it's going. I'm glad you mentioned the Bitcoin Cash thing because that proves the point. You can’t just upgrade the base layer of the blockchain. You can try, but you're not going to convince everyone. If you can't convince everyone, you end up with conflict and uncertainty.
So, it's better not to go there. It's better to just say, "Okay, let's just build this thing in parallel. Let's connect it to Layer-1 without changing anything there so that we don't go into any debates and philosophical debates about what Bitcoin should or should not be. Let's keep it as is. Let's keep it simple. Then, we build things on top." That's why Layer-2 is important. Even though you can upgrade Layer-1s all you want, and there are ideas on how to do this, especially on Ethereum (ETH, Tech/Adoption Grade “A-“). However, at some point, you need Layer-2. At some point, you run out of capacity on Layer-1. It's going to happen.
Chris: You won't be able to compete, right? If you don't engage with those layers of abstraction, you just wouldn't be able to compete with these Layer-2 enabled networks.
Juan: That's correct. I think. Yeah, we're already seeing that on Ethereum. We talked about Bitcoin, but I think if you want to see what Layer-2 looks like, you have to go to Ethereum. Ethereum is today ... I mean, some people might say it's blasphemy, but there's a lot of innovation going on in Ethereum right now vs. Bitcoin. Bitcoin is basically ... static compared to Ethereum. If you go over to Ethereum, we had the DeFi revolution in 2020. To me, personally, what DeFi meant are real use cases for smart-contract platforms. It was Ethereum's moment to shine and prove to the world that, yeah, there's a lot to this. I have seen a lot of ETH and smart-contract skeptics be converted into ... I wouldn't say Ethereum bulls, but at least they respect it. Chief among them, I don't know if that's the right expression, but—
Chris: It is.
Juan: ... chief among them is Arthur Hayes, legendary Bitcoin maximalist and the founder of BitMEX. He wrote a very famous piece in 2018 calling Ethereum “a double-digit shit coin.”
Chris: Okay.
Juan: I remember that piece because I thought, "Man, this guy is so wrong. He doesn't get it." Recently, he published another blog post where he didn't apologize, but he said, "I wish I would have bought ETH at the beginning. I even called it a ‘double-digit shit coin’ at the time, in an early version of this newsletter." So, I'm like, "Hey, that's as big an apology as I've seen," and I've seen other people go through this process where it’s like, okay, they get it. They understand that there is such a thing as a programmable smart contract that can do just about anything. There is such a thing as the notion that Bitcoin can do payments, but hey, wouldn't it be cool if we could use this technology to do all manner of things?
The answer is obviously yes, but we didn't have any proof of concept. When people said, "Can you prove that?" before 2020, we would say, "Not really, but look, there are these cool projects out there that I think have some value there." But with DeFi, you can say, "Hey, there's $115 billion in assets here trading, staking, lending and borrowing. There's a whole thriving ecosystem here on Ethereum Layer-1." Now and then comes the problem. What happens with Ethereum?
Well, it's too expensive. So, it is unable, as I said ... If you think of it as a highway, there's only one or two lanes in there, but we need 10 in order to accommodate all this demand. We can't do that because we can't build new highways once the highway is there.
Chris: There's something built around it so you can't start bulldozing skyscrapers just to make a wider highway.
Juan: Yeah, exactly. I don't know how to continue that analogy, but let's just say we build a subway or whatever. We build something that runs in parallel. We're not going to expand the main roads because we all agree this is very difficult to do.
Now, Ethereum intends to do this, but it's going to take two years. It's very uncertain. And even by the time you get there, you're going to need the subway anyway. You're going to need the airports. You're going to need all these alternative methods of transportation. You're going to need buses. You can't have everybody in a car. You need buses.
Chris: Maybe buses are a good way to extend the analogy. Because a four- or five-decker bus uses the same footprint on the road, but it carries five times as many passengers.
Juan: Perfect. Exactly. That's the whole point behind Layer-2. So DeFi explodes, now we know that Ethereum is useful, but we have a problem: We don't have enough capacity, and we cannot upgrade the roads. What do we do? We start batching transactions. The bus example is great because that is exactly what some of these technologies do. I think others are more like a subway and we can get into those.
Chris: So that's like a parallel transportation network underground, right?
Juan: Yeah, exactly. That connects to the main transportation.
Chris: And you can choose whether to take the bus on the road or the subway. That's kind of like a choice between base layer or special sidechain, or Layer-2 scaling solution type of thing, right?
Juan: Yeah, exactly. If we want, we can go over what I think are the three main solutions for scaling. A little bit of history as to why these are the three.
Chris: Okay, before we go there, I just want to make it clear for the viewers so they can follow what we're talking about here. We've got these different platforms, like Bitcoin and Ethereum. They're two separate blockchains that are both Layer-1s in their own rights. Then, each base layer has its own second-layer solutions. So, we talked about Bitcoin, and then the Bitcoin Lightning Network is a specific Layer-2 scaling solution for the Bitcoin network.
Then, we've got Ethereum. And you're going to talk about a few of the second-layer scaling solutions specifically for Ethereum, right?
Juan: Yeah, exactly. Before we do that, though, I would say this technology typically can be ported over. If you have Lightning on Bitcoin, you can have Plasma on Ethereum, which is basically the same thing. Correct me if I'm wrong, but I believe the Plasma is Lightning on Ethereum. And I actually wanted to start with Plasma. Even though it's not one of the main Layer-2 solutions for Ethereum right now, it’s where we come from. It's historical.
So, Plasma or Lightning are called payment channels. They have a major drawback: If I open a channel to you, I have to deposit all the money that I intend to pay upfront. This would be if I am going to go into a bar but don't know how much I'm going to spend. Let's just say up to $100. I need to deposit the $100 in a special — let's call it escrow — account.
Chris: And you get one chance to figure out how much beer you're going to drink.
Juan: Exactly. What if I typically spend only $15? Well, I have to lock up 100 just in case. Because you know, maybe my friends show up, and we're all going to be drinking more than I expected. So that's a major drawback — they're expensive.
Payment channels are expensive. They require you to put up a lot of capital upfront. The Ethereum community, realizing this issue, has eventually moved on from payment channels, and they basically settled on what's called a rollup.
A rollup is the same concept as a payment channel in that you’re putting a lot of transactions and batching them together, then recording that on the mainnet. So, the bus example is great. And instead of each person driving their own car, you put everybody on a double-decker bus, and it takes up a lot less space.
Each person is going to pay for the cost of driving that bus. But because there are maybe 20, 30, 40, 50 people on this bus, each person pays less. And this is what a rollup feels like as a user: You're using Ethereum, but it's cheaper because you're sharing that expense with everybody else who’s in that batch.
Let's say a transaction costs $50, but you have 1,000 people there. Each of them is paying 5 cents, right? This is the concept behind rollups. It's batching transactions, but with one major difference: You do not have to put up capital upfront. Basically, you get your cake and can eat it, too.
Also, you can do more complex things with rollups, as there are two kinds. Again, these are just ways to batch transactions.
Chris: You're going to do rollups today, yeah?
Juan: I'm going to go into the differences. Because you can say, well, there are two varieties of rollups and they both do the same thing. So why do we have two? Well, because they're different. They're cryptographically different. I will try to keep the technical terms to a minimum here. One of them is called optimistic rollups (ORs); the other one is called zero-knowledge (ZK) rollups. These are two ways of batching transactions together. They're fundamentally different though.
Chris: In the mathematics side of things. Right?
Juan: In mathematics, but the user experience is different as well. So, this is why I think we need to explain both. So, optimistic rollups are simpler to do, but you cannot fit as many people in a batch as you would with a ZK rollup. The technology is almost there. There is a mainnet for optimistic rollups; the solution will be live this July. So, I guess the main advantage right now is that this is a short-term solution for this problem. We can have this available quickly.
However, the major drawback when using optimistic rollups is you have no way of knowing if the transactions that are batched are true. There's no way to know if the person publishing these batch transactions on the Ethereum blockchain is telling the truth.
Chris: So, is the bus driver honest?
Juan: Is the bus driver honest? We don’t know. Is he or she taking us to where we need to go? We have no idea. However, there's a process to contest, right? So, with an optimism, because you don't know if the driver is honest or not, there's a process in place to say, "Hey, I think you're lying."
Chris: You're taking the long way around.
Juan: Yeah, "you're taking the long way around. Here's my GPS, and it proves no, there's a quicker way to get there.” So, [optimistic rollups] require what we in crypto call trust. It requires you to trust the driver implicitly. I'm going to trust him or her. And I'm going to have a process in place to contest in case this person is lying. That's what you do — you trust, but you verify. I believe that is a quote by Metallic. He said that in a podcast.
With blockchain, typically, the motto is "Don't trust, verify." A blockchain is fully trustless. The breakthrough of Bitcoin is you don't have to trust anyone. You don't have to know anyone. You just know if that transaction makes it to the blockchain, that transaction is true. When you use an optimistic rollup, you don’t know that. When you see a batch of transactions being published on the mainnet, you do not know if these transactions are true or not.
So, what we have is a method. The person submitting the transactions must leave a trace of what they did. And because they left a trace of what they did, anybody can come in and contest and say, "Hey, this person was lying. Here's how I can prove it." Because, going back to the bus example, I know which path the driver took. So, if it's not the fastest way to get there, I can prove it. I can say, "Here's the fastest way and here's what they did, so there's an issue here.”
Chris: And they overcharge you.
Juan: They have to charge me. In the case of Ethereum, you revert the transactions. The transactions up until the point where they were honest are reverted. It goes back to a previous state that is known to be correct.
Chris: So, the fact that there is a way to contest or verify disincentivizes the driver from being dishonest in the first place. If you know you can be called out, then it creates a disincentive to be dishonest, or rather, it creates incentive to be honest, whichever way you want to think about it.
Juan: Exactly.
So, there's some trust involved. It's a big leap, if you ask me, to go from “we don't trust” to “we do.” Of course, there are penalties involved; there's a lot of money at stake. If you get caught lying, you're going to lose money for doing that. But there's a major drawback: Even though the system theoretically works, you have to give people enough time to contest.
Chris: Well, it's exhausting. If you have to check everything, right?
Juan: Exactly.
So, once you have the optimistic rollup in place, if you want to move your funds and your assets, they will be moved to this Layer-2 solution. But if you want to move them back to mainnet, hold on — you have to wait seven days. Why do I have to wait seven days to move my Ethereum from Layer-2 to the mainnet? Well, because we don't know that what’s in that Layer-2 is true. So, we're going to wait seven days to see if someone can prove that someone was lying. This trust factor slows things down very much.
So, yes, optimism is fast. But when you want to move your assets back to the mainnet, which you do all the time, you have to wait seven days. Why? Because we're trusting this piece of code here. We're trusting the people running this system. We don't know if they're telling the truth. The bus driver … we don't know if he took the right path. We just don't know that. So, we're going to give it seven days for someone to come up to contest. If no one contests after seven days, we're going to assume that the bus driver was telling the truth.
Chris: Or rather, we assume that everyone in the bus was happy with the routes. You had seven days to complain — you didn't.
Juan: Exactly. You have seven days to complain and you didn't, so we're going to assume everyone's happy and, therefore, this worked.
So, that's the major drawback that ZK Rollups do away with, essentially. With a ZK rollup, the moment a batch of transactions is pushed to the Ethereum mainnet, we know it's true. How? Cryptography and math. We're not going to get into how, but this is the breakthrough of ZK rollups. They say, "Hey, we don't have to trust the bus driver. We can install the GPS on the bus itself, and if he or she is deviating, we can call them out immediately and revert immediately.” So, whatever is published on the Ethereum mainnet from a ZK rollup is known to be true.
Chris: Is there any benefit to the optimism approach, given all the drawbacks you just mentioned? Does it have any benefits?
Juan: The benefit is basically that it's easier to do complex things, which is why optimism is coming. It's right around the corner. It's going to come in a few months, and ZK is something that will happen in the future.
The only thing we know to do right now with ZK rollups is simple payments. I can send money to you, and you can send money to me. So we can do an exchange, for example, because an exchange is just people trading back and forth. We know how to do that. And in fact, the only two solutions that I use in ZK rollups for right now are exchanges. There's one derivative exchange and there's another spot trading exchange because these are simple payments. I've used both; they’re fantastic ... very cheap. You can withdraw your funds immediately, even when fees are extremely expensive on the mainnet.
That’s not something you can do with optimism. If you move your funds to optimism and you want to withdraw your money, you have to wait seven days. If you use a ZK rollup-based solution, you hit a button, you wait 30 seconds, you get your money and you pay basically no fee. So, it's a major advantage.
But again, this is all about time. We know how to do complex applications with optimism. We do not know how to do them with ZK rollups. We will get there, but it may take a year or two or more.
Chris: Okay. When we chalk that up, too, like most things in life, the best solutions take a lot more work. You know what I'm saying?
Juan: Yeah.
Chris: It's not either/or. We're going to probably use optimism in the short term and then keep working on the ZK rollups.
Juan: That's exactly what the Ethereum developers are saying. Vitalik Buterin himself said that. He said, "Yeah, long-term ZK rollups is where it's at. But the thing is, we don't know how to do them yet. So, we're going to use ... optimism instead." This is where the Ethereum community has settled. And because Ethereum is the largest, most complex and most heavily used smart-contract platform, whatever they decide to do will be implemented by smaller, competing smart-contract platforms.
Now there's a third Layer-2 solution: sidechains. The concept of sidechains has been around for a while. They were proposed for Bitcoin. In fact, there are many sidechains for Bitcoin right now. A sidechain is a far easier solution, and the way I think about them is, they're very similar to optimistic rollups. You're basically transferring assets from the mainnet to a parallel blockchain that is connected in some way to the mainnet.
Typically what this means is that the sidechain writes a state for itself on the mainnet. In other words, every once in a while, all the activity that took place on the sidechain is recorded on the mainnet. Therefore, if this sidechain begins to lie, if something happens on this sidechain that isn’t true, you can prove it because you can say that is not what you recorded on the mainnet. That's how it can call you out. Very similar to optimistic rollups in the sense that you implicitly trust whatever happens on this parallel blockchain.
The main difference is with optimism, you wait seven days for someone to contest. In the case of a block of a sidechain — the one that we're using right now is called Polygon (MATIC) on the Ethereum blockchain — you just wait three hours. So, you go from trusting this parallel system for seven days to trusting them for only three hours. The benefits of optimistic rollups are we can do things faster and they're cheaper. Sidechains can do the same thing. It's faster, it's cheaper and it's live right now.
They're very similar and, though the tech and math are different, the end result for the user is a very similar experience. However, personally, I think a sidechain is probably better than optimistic rollups because there's a lot more trust implicit on ... optimism than on a sidechain. A sidechain is just another blockchain.
Chris: And you just use the spare capacity on a ... another blockchain, right?
Juan: Exactly. You're just using the spare capacity. So, it's a very elegant solution. It's not being discussed enough, although it is more so now because recently, many large, decentralized finance projects, D5 projects, have opted to move over to the Polygon side chain. And they're using it right now.
Why people use a sidechain instead of something like a ZK rollup needs to be emphasized. It’s because a sidechain allows you to do just about anything. You can write just about any application on a sidechain, and we know how to do them. We do not know how to use ZK rollup technology to do a money market or a complex application like an automated market-maker. These are more complex systems. We only know how to do payments using ZK rollup technology.
And I'm most excited about sidechains for the simple reason that we can use them today. People are already using them. Recently, somebody noticed that the main Ethereum sidechain, Polygon, is doing about as many transactions as Ethereum itself. That's a big deal.
The tag line was, Polygon is already scaling Ethereum. This is not a theory. This is not something that's coming in. This is happening today. I've used both. I've used applications on Polygon, and I've used applications on the Ethereum maintenance, and it's night and day. So, sidechains, in the near term, are probably the future. Sidechains and optimism rollouts are the immediate ways of scaling a smart-contract platform like Ethereum. Long-term, it will probably be ZK rollups, but there's going to be a lot of failures between here and there because, again, we don't know how to do them yet. We have theories about how to do them, but we're not there.
Chris: So, are these rollup scaling solutions ... are they, as with the sidechains, separate blockchains with their own tokens? Is there an optimism token? Is there a ZK rollup token? Does it not work like that?
Juan: No, it doesn't work that way. It's just the technology. So, optimism and ZK rollups are scaling technologies. Just like Lightning for Bitcoin. There's no Lightning token.
That's another interesting thing about sidechains. You can invest in them. So as an investor, you can say, "Hey, I can participate in the growth of Ethereum as it becomes more scalable by buying the token that is used in that sidechain.” If I believe that a lot of people will move from the Ethereum mainnet to Polygon, guess what? There's a Polygon token. I can just buy that, and as more people move over, they'll need Polygon’s token, MATIC, to use anything in there. That token will naturally rise in value. If you believe that more people will be using that solution. That’s one side...
You might call it a weakness from a technology standpoint. You don't want to add more tokens, but from an investment standpoint, it allows you to participate in the growth of the ecosystem. So, if you're bullish on Ethereum, but you think Ethereum is too expensive to use, you can say, "Hey, I can invest in an Ethereum proxy by buying the tokens of the sidechains that most people are using." And that creates opportunity for investors and traders like me. I find that to be somewhat of an advantage because I can get exposure. I can expose my portfolio to growth in a particular sector by directly buying the thing that is going to be used in that new sector.
If you're bullish on ZK rollups, sadly, there's nothing you can buy. It’s like, "Hey, this is pretty cool, but there's no way to invest in this."
Chris: You did say that you can invest in Polygon’s token — you could do the other way as well. When you're looking at a D5 project token and so on, as you're reading through the website and it says “uses optimism,” that might swing you in that direction because having a powerful scaling solution for a decentralized app may give it the edge it needs to bet its competitors. So, that's the other side of the coin, as far as I see.
Juan: Yeah. That's a good point. That is an excellent point. Yeah. If you see that there's D5 ... Let's say that tomorrow a new automated market-maker (AMM). An AMM is a very popular way of doing exchanges and ... theorems.
Chris: Swap protocol, right?
Juan: It's a swap protocol, yeah. It's a way to swap assets. The main one right now is Uniswap (UNI). Uniswap is on the Ethereum mainnet and is very expensive to use. What if a competitor comes out and says, "Hey, I figured out a way to do what Uniswap does by using ZK rollups.” Boom. You can invest in that token. It's probably going to do very well. It will attract capital. It will attract value.
Chris: But it would be the token for the new decentralized exchange, not ZK rollups. That's just the technique.
Juan: Exactly. You're not buying the rollup directly. What you're buying is the application that uses that technology. So yes, that's an excellent point. That is another way of investing in Layer-2.
Chris: Gotcha. Okay. So, in closing then, who do you personally think viewers should pay the most attention to as things develop?
Juan: Right now, in the immediate term, I would look at Polygon. The reason for that is, right now, it is becoming the most used Layer-2 solution on Ethereum. Like I said, it does about as many transactions as Ethereum itself, which means this is a scaling solution that’s gaining massive traction right now as we speak.
The only thing I would look at beyond that ... I would say pay close attention to projects that are doing ZK rollups. Pay attention to ZK rollup solutions because those who figure out how to use this ZK rollup technology to do more complex computation will probably be the winners of the future. And we don't know who those are yet.
So, there's an immediate opportunity in sidechains, but long-term, pay close attention to ZK rollup development.
Chris: You bet. Okay. So, lots of great insights there from one of the best groups of analysts in the business, in my opinion. Juan, thanks very much for sharing your wisdom on that topic. Myself and our viewers really appreciate you for coming on today, and that's all for this week.
So, keep a close eye on your inbox for next week's episode of the Weiss Crypto Sunday Special. Until then, it’s me, Chris Coney, saying bye for now.
