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L1 and L2 Battle for DeFi Dominance

DeFi has been one of the hottest trends of 2020 and 2021, yet, the vast amounts of capital pouring into this nascent space have exposed many of the troublesome features of early blockchain designs.

While layer 2 (L2) solutions and scaling alternatives have attempted to fill the void, the debate on whether layer 1 (L1) or L2 solutions will become the dominant destination for DeFi rages. Both offer potent responses to transaction costs and scalability challenges but some nuances could shape the future and offer answers on eventual user and developer preference.

L2 to Ethereum’s Rescue

L2 solutions have been the stuff of dreams since Lightning Network first proposed improving Bitcoin payment transaction speeds. Despite still not coming to fruition, the idea itself was valuable. The notion behind L2 is to leverage the security of the main chain while adding higher transaction throughput at lower costs.

For Ethereum, the DeFi boom created problematic congestion levels on a network that can only process tens of transactions per second instead of thousands. This catalyzed enormously high gas fees for single transactions that temporarily took the wind out of DeFi’s sails.

The result has been dozens of proposed scaling solutions and the implementation of different methodologies, among them Plasma, Sidechains, Rollups, State Channels, Validium, and hybrid solutions. Yet, the vastness of these dozens of solutions have exposed a critical weakness: interoperability.

L2 solutions aren’t highly interoperable, meaning that the composability component, or ability of different protocols to communicate with each other seamlessly, can be lost in the L2 ether. L1 solutions, by comparison, can communicate between multiple protocols and call upon their smart contracts to construct brand new financial products.

This interoperability problem also extends to liquidity and ease of use. Ethereum-based protocols currently share all the liquidity on L1. However, with L2 solutions, liquidity is also split between multiple L2 protocols instead of solely existing on L1, creating fragmented liquidity that cannot move freely between layers. The same is true for user friendliness. Users operating on L2 will need to move back to L1 to move to another L2 solution, creating unnecessary headaches, fees, and friction within the process.

Polygon presents a novel solution to this Layer 2 challenge. Through its highly interoperable design for all Ethereum-compatible blockchain and network that is both highly scalable, super fast, and affordable, Polygon has given many existing Ethereum DeFi dApps a new lease on life. Yet, for L2 to win out over comparable L1 answers, more solutions will be needed to bridge between L2 protocols and reduce the friction in the areas of liquidity and ease of use.

Answering Demand for Scalable Layer 1 DeFi

On the other side of the equation, emerging L1 solutions are improving upon initial blockchain weaknesses by offering native lower environmental footprints through Proof-of-Stake variants, higher scalability in terms of thousands of transactions per second, lower-to-no transaction costs, and robust security on the main chain itself.

While certainly not at the level of widespread popularity that Ethereum has already achieved, the embedded nature of these solutions within an L1 blockchain is compelling for multiple reasons. For one, it means that no middleware, external service providers, or secondary layer solutions are needed to accomplish high-level functionality that can support DeFi’s immense resource demands.

The high degree of interoperability touted by newer L1 blockchains like Polkadot make it ideally suited for DeFi, especially considering it can seamlessly transfer value and data between blockchains. Acala, which aims to be the DeFi hub of Polkadot, effectively addresses many of the challenges that face Ethereum and L2 solutions.

This platform allows smart contracts written in Solidity (Ethereum’s smart contract language) to be implemented through Polkadot’s Substrate framework without requiring any changes to the code. This makes it easy for existing DeFi applications to migrate and still retain composability with Ethereum-based protocols. The inclusion of micro gas fees ensures that high transaction costs, blamed on Ethereum network congestion due to the costs of transferring between L2 protocols, can be entirely mitigated for DeFi participants.

Moreover, Polkadot can handle 1000 transactions per section (parachains offer a minimum of 200 per second), far-outstripping Ethereum’s tens of transactions per second, making it natively more supportive of transaction-intensive DeFi applications. Yet, because parachain slot auctions have yet to launch, projects like Acala cannot yet compete with Ethereum’s DeFi hegemony. While it proposes a promising answer, until a live protocol existing Ethereum dApps are unlikely to migrate.

On The Flipside

  • Most L2 solutions don’t interoperate with each other, thus limiting composability. 
  • Fragmented dApps across several L2 chains may split up the related liquidity of these dApps, potentially increasing market volatility
  • Updating existing L1 protocols may require a hard fork, approved by the community. This can create schisms and split communities (for example, Bitcoin and Bitcoin Cash). Governance voting is a long and complicated process that can take years to implement.
  • Existing L1 chains already command significant value. Adding new code and features to these chains may hinder performance, leading to a dip in overall value.

Why Should You Care?

DeFi is driving serious changes across the blockchain ecosystem by spotlighting the shortcomings of existing L1 chains. L1 and L2 solutions are different sides of the same coin, making existing blockchains more highly performant, especially for accommodating the influx of new users.

Regardless, these developments will positively impact the DeFi ecosystem because these competing solutions ultimately deliver more excellent value for users through lower transaction costs or higher throughput. Given the relative pace of adoption for valuable workarounds, the better performing medium-term solution will likely garner faster support and become the chosen answer for overcoming DeFi induced network congestion.

The Verdict

No matter the answer that DeFi users eventually select, there will undeniably be tradeoffs from any chosen model. Whether it is sacrificing stability, speed, security, or costs, the most critical aspect of this supposed winner-takes-all race is the innovation that emerges as a byproduct of competition.

Competition is behind some of the greatest innovations of our era, and this time is likely to prove no different. For DeFi enthusiasts, the L1 and L2 battle simply represents the gradual maturing of an ecosystem, and the likelihood of greater choice, lower friction, and a better overall user experience.

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    This article is for information purposes only and should not be considered trading or investment advice. Nothing herein shall be construed to be financial legal or tax advice. Trading Forex, cryptocurrencies, and CFDs poses a considerable risk of loss

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