Blockchain Layers Explained

Blockchain networks are designed to be decentralized, transparent, and secure, but these benefits come at a cost to speed and scalability. This guide explains how blockchain layers and scaling solutions combat these issues.

Why blockchains don't scale

Blockchains struggle to scale because thousands of computers around the world verify every transaction. While this makes blockchains secure and decentralized, it can also slow transaction processing.

You may come across the ‘blockchain trilemma’: a challenge for blockchain developers to balance three competing priorities:

Security
Decentralization
Scalability

Improving one area, such as transaction speed, often comes at the expense of another, in this case, decentralization.

During periods of high demand, blockchains can become congested, leading to higher fees and slower confirmation times. Rather than modifying the base blockchain, developers build additional layers to improve performance while maintaining security.

Understanding the layer model?

Instead of relying on a single blockchain to do everything, modern ecosystems consist of multiple layers. Each layer has its own specific role, allowing chains to scale more efficiently while maintaining security.

What is Layer 0?

Layer 0 is the foundational layer of a blockchain that enables nodes to communicate securely and reliably, supporting the network’s decentralization and security. They use peer-to-peer communication to share data directly between nodes without intermediaries.

Because nodes rely on Layer 0 to communicate and agree on transaction validity, its design directly affects a blockchain’s scalability and security.

Popular examples of Layer 0 projects include Polkadot, Cosmos, and Avalanche’s subnet architecture.

What is Layer 1?

Layer-1 is the base blockchain where transactions are executed, validated, and permanently recorded. It also provides the infrastructure for smart contracts and decentralized applications. Popular examples of Layer 1 blockchains include: Bitcoin, Ethereum, Solana, and Cardano.

Layer-1 Blockchains operate independently with their own validator network. Once transactions have sufficient confirmations, altering them becomes computationally impractical.

However, Layer-1 Blockchains often face challenges related to scalability and transaction speed. As the number of users and transactions grows, Layer 1s attempt to address this by employing consensus algorithms and architectural designs built to increase throughput and lower transaction fees. Many Layer 1 blockchains, like Ethereum, rely on Layer-2 solutions to improve scalability.

What is Layer 2?

Layer 2s are secondary frameworks built on top of Layer 1s, designed to enhance blockchain scalability and speed by facilitating off-chain transactions to handle network congestion and delays. They process transactions off-chain and periodically settle them on the main blockchain. By doing so, they can process more transactions faster and at a lower cost.

One popular Layer 2 solution is the "Lightning Network" for Bitcoin. It facilitates faster transactions by allowing parties to open payment channels between them. They can conduct an unlimited number of transactions off-chain, and when they're finished, they settle the net results on the main Bitcoin blockchain.

Like any scaling solution, Layer 2s involve trade-offs. Their security model depends on the specific implementation, and wide adoption is needed for them to deliver meaningful scalability benefits.

Common blockchain scaling solutions

Layer 2s are not one single, applicable technology. Rather, developers have created multiple approaches to scale blockchains, each designed for different use cases.

Lightning Network

The Lightning Network is a pivotal second-layer scaling solution for faster Bitcoin transactions, reducing congestion and fees. It was designed to address the inherent limitations associated with Bitcoin's first-layer protocol.

As Bitcoin’s usage grew, so did the frequency of transactions it needed to process despite limited block space, resulting in slower transaction times and higher fees.

Enter the Lightning Network, a decentralized system enabling instantaneous, high-volume micropayments with minimal fees. This is how it addressed Bitcoin’s congestion issue: by allowing users to open payment channels, conduct multiple off-chain transactions, and settle the final balance on-chain. This approach drastically reduces the burden on the primary network, allowing for faster, lower-cost transactions.

Optimistic Rollups

Optimistic rollups are a Layer 2 scaling solution that executes transactions off-chain before posting compressed transaction data to Ethereum, increasing throughput and lowering fees.

They are called "optimistic" as the network operates on the optimistic assumption that the transactions are valid unless challenged during a dispute period.

Each rollup has a challenge period during which anyone can dispute the validity of the transactions. If a discrepancy is found, the individual who submitted the faulty rollup faces penalties, and invalid state transitions are rejected before finalization. This mechanism ensures that while transactions proceed with speed and efficiency, the system’s integrity is maintained.

Optimistic rollups are well-suited to high-volume dApps and are EVM-compatible, making them relatively easy for Ethereum applications to adopt, thus simplifying the scaling process.

The main trade-offs when using optimistic rollups are the longer withdrawal times due to the challenge period and reliance on transaction data remaining available for verification.

Zero-knowledge (ZK) Rollups

ZK rollups are a Layer 2 scaling solution designed to increase transaction speed and reduce costs on blockchain networks, particularly Ethereum. Popular ZK rollup projects include zkSync and Polygon zkEVM.

Similarly to optimistic rollups, ZK rollups bundle multiple transactions together before submitting them to the main blockchain. However, instead of assuming transactions are valid and allowing challenges, zero-knowledge proofs verify the transactions before they are added to the blockchain.

These proofs allow a party to prove that a transaction is valid without having to reveal all of its underlying information. This way, blockchain networks can process larger numbers of transactions more efficiently.

ZK rollups are technically complex, making them more difficult to develop and maintain. As such, some applications may also require additional development work to become fully compatible with ZK rollup environments.

Sidechains

Sidechains are separate blockchain networks that run alongside a main blockchain, allowing assets or data to move between the two. They process transactions independently, meaning they can offer faster speeds and lower fees than the main network. However, they may use their own security model rather than relying on the original blockchain’s security.

State channels

State channels allow users to conduct multiple transactions off-chain before recording the final result on-chain. This reduces blockchain congestion and transaction fees, making it a useful tool for applications that require frequent payments.

Sharding

Sharding splits blockchain workloads into smaller sections, or ‘shards’, so that transactions can be processed more efficiently. Instead of every validator processing every transaction, the workload is handled by different parts of the network to increase capacity while maintaining decentralization. A popular example of sharding at work is the NEAR protocol.

It is important to note that each solution still has trade-offs between speed, cost, security, and complexity.

Is using scaling solutions taxable?

Simply moving your own cryptocurrency in and out of a scaling solution is not considered a taxable event. However, if you use the network to trade or sell cryptocurrency, or you're earning income via staking and rewards, you may be subject to Capital Gains Tax and Income Tax.

Koinly can help you calculate your crypto taxes, manage your portfolio, and generate specialized tax reports you can use to file your taxes.