What are layer 2 blockchains, exactly?

What are layer 2 blockchains, exactly?

Layer 2 blockchains are sort of like HOV lanes on a highway. This week, we’re breaking down the basics. [Image via Gidon Wessner]

There’s never a dull moment on the blockchain. Here’s what you need to know this week:

Crypto’s correlation with stocks is weakening. A closer look at what analysts are saying and broader crypto market moves.

A quick guide to layer 2 blockchains. We’re breaking down what they are and why they’re making headlines.

Noteworthy numbers. The percentage of Americans who own crypto and other key stats from the week.

MARKET UPDATE

Crypto markets have been resilient in 2023, but what’s next?

After a brief market rally to start the year, some crypto prognosticators dared to wonder: Is the bull market back? Any such proclamations appear to have been premature, especially as inflation continues to plague the economy and the Federal Reserve marches ahead with interest-rate hikes. Still, crypto prices have proven resilient so far in 2023 in the shadow of FTX’s November collapse, with Bitcoin hovering above $23,000, and Ethereum north of $1,600.

Here’s a look at what the latest crypto price action could mean for investors, and what to watch for moving forward.

  • After starting the year below $17,000 and $1,200 respectively, Bitcoin and Ethereum have both clocked more than 35% gains since Jan. 1. But some analysts, like Katie Stockton of Fairlead Strategies, believe it's unlikely for BTC and ETH prices to top $25,000 and $1,670 without promising news on slowing inflation, the Fed’s rate-hike plan, or regulatory clarity. Investors are also awaiting a new catalyst, said Bernstein Research, such as a significant new crypto use-case or more meaningful institutional adoption.

  • Following a period of capital outflows that began in April 2022, funds returned to ETH and BTC at a rate of $4.5 billion per month through most of February. This means that for the first time in nearly a year, more money is flowing into the top two cryptocurrencies than away from it, indicating a return in investor confidence. Another possible marker of shifting sentiment? The Crypto Fear and Greed Index, which measures how investors feel about crypto markets on a scale from 0 to 100. After starting the year with a reading of 26, which indicates “extreme fear,” the index moved up to 53 on Tuesday, a “neutral” rating.

  • Finance giant Citi recently noted that crypto markets have been decoupling from stock performance throughout 2023, bucking a trend from the last two years, during which crypto began to move in near-lockstep with U.S. equities markets (challenging BTC’s long-held inflation hedge narrative). Bernstein Research observed that the weakening correlation could be a bullish signal — since more than 90% of crypto trading happens outside the U.S., crypto markets could benefit from being driven by global capital flows rather than U.S. specific trends. 

Why it matters… Though crypto prices have stabilized lately, investors will need to pay close attention to key data points like capital inflows as well as macroeconomic trends, such as next Friday’s employment report, for signals on what’s to come — even as crypto-stock correlation weakens, it's still a significant factor. Meanwhile, beyond the numbers looms an arguably even bigger factor: the growing threat of SEC enforcement actions against key players in the industry.

LAYER UP

Crypto fans keep talking about ‘layer 2s.’ What are they exactly?

If you’ve been skimming headlines from the cryptoverse over the last few weeks, you may have noticed an increase in references to “layer 2” blockchains. If the term made you raise an eyebrow, worry not — we’re breaking down what layer 2s are, why they matter, and the latest news from some notable L2s including Arbitrum, Optimism, and the Lightning Network. Let’s take a look.

First things first: What is a layer 1?

  • A layer 1 network refers to the foundational level of a blockchain that makes it a peer-to-peer, public ledger without the need for an intermediary like a bank.

  • L1s — like Bitcoin, Ethereum, Avalanche, and Cardano — produce blocks, verify transactions, and rely on native cryptocurrencies to incentivize users to secure the network.

  • Scalability is often a key limitation for L1s. And in instances of high-demand (like recent rebounds in the NFT market), L1s can often run into network congestion issues like slow speeds and high network (gas) fees.

Got it, so what’s a layer 2?

  • Layer 2s are sort of like express lanes on a busy highway. They are separate blockchains built on top of L1s with the goal of reducing network bottlenecks, lowering fees, and improving scalability. 

  • L2s refer largely — but not exclusively — to scaling solutions for Ethereum. Since the second-biggest blockchain by market cap is home to the majority of DeFi activity, Ethereum’s network has a history of high fees during bull runs, when some users are more willing to pay higher costs to prioritize transactions (time will tell if last year’s Merge will improve some of these traffic issues).

  • Among Ethereum’s best known L2s are Optimism and Arbitrum. (Polygon is a well-known “sidechain” that helps make Ethereum faster and cheaper, but is technically an independent network). 

  • Bitcoin’s leading L2 is the Lightning Network , which has powered things like Twitter’s tipping feature and instant global remittance efforts in places including the Philippines and Nigeria.

Why have L2s been such a hot topic lately?

  • A new Ethereum L2 called Scroll debuted on the blockchain’s Goerli testnest on Monday. Scroll is notable for being a Zero Knowledge Rollup (ZKR), a long-awaited type of L2 that would enable Ethereum to bundle thousands of transactions into a single batch, allowing faster and cheaper settlement while also maintaining the privacy of each user.

  • Arbitrum, the L2 market leader, overtook Ethereum last week in daily transactions and logged an all-time high 2.95 million unique wallet addresses. It’s worth noting, though, that this milestone might have been bolstered by users speculating about a potential, unconfirmed token airdrop.

  • Last Thursday, Coinbase announced Base, an Ethereum L2 built in partnership with fellow layer 2 blockchain Optimism. The new chain has ambitions to “bring the next billion users to web3” by being an open-source sandbox for developers building crypto-powered apps.

Why it matters… Bear markets are for building, or so goes one of the many crypto-winter adages. Layer 2 scalability solutions are one of the key things being built and improved right now, which means there will be increased competition to gain market share in a space where there’s already more than $6 billion locked across L2 networks. As a recent article in the Defiant put it — with a touch of hyperbole — L2 blockchains are about to enter “a full-blown contest for supremacy in scaling the No. 1 smart chain network.” 

NUMBERS TO KNOW

20%

The percentage of Americans who own crypto, according to a national survey commissioned by Coinbase in February. The survey, conducted with Morning Consult, polled more than 2,000 members of the general population on a range of questions regarding the financial system. “Despite the tumultuous events of 2022, crypto ownership has remained largely unchanged since early 2022,” the survey found. 

$40K - $60K

The price range that the manuscript for “Snow Crash,” a 1992 novel by Neal Stephenson — famous for having coined the term “metaverse” —  is expected to fetch at an online Sotheby’s auction. And it’s not just stacks of paper that the winning bidder will receive: the auction item also comes with “a hand-forged tachi sword inspired by the weapon wielded by the novel’s protagonist.”

19:20:00

The amount of time that the Solana network was down over the weekend with service unavailable to the blockchain’s users. Outages have been a longstanding challenge for Solana, a popular blockchain which is seen as a faster and less expensive alternative to Ethereum. Solana’s co-founder, Anatoly Yakovenko, has previously acknowledged that outages are “the biggest challenge for us, and the number one priority.” 

AROUND COINBASE

More ways to learn and engage with the launch of Base

  • In a new blog post, Coinbase’s VP of Engineering, Will Robinson, discusses the launch of the Base testnet and the network’s goal of offering a secure, low-cost, developer-friendly way for “anyone, anywhere, to build decentralized apps, or dapps, onchain.”

  • The commemorative “Base, Introduced” NFT is still available to mint for free by heading to mint.base.org. The NFT has attracted more than 300K unique minters so far to help celebrate Base’s launch.

  • This one is for all you current and aspiring web3 developers: On March 2, Coinbase is launching a Base bounty challenge that will allow participants to make smart contract calls and solve a series of riddles for potential rewards. Keep an eye on our LinkedIn for more details soon.

DISCLAIMER

This material is the property of Coinbase, Inc., its parent and affiliates (“Coinbase”). The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Coinbase or its employees and summarizes information and articles with respect to cryptocurrencies or related topics that the author believes may be of interest.

TOKEN TRIVIA

Who of the following is not an Ethereum co-founder?

A

Vitalik Buterin

B

Eth Ledger

C

Gavin Wood

D

Charles Hoskinson

Find the answer below.

Trivia Answer

B

Eth Ledger