Produced by: CGV Research
Author: Cynic
TL;DR
1. From Layer1 to Layer2
How is scalability achieved technically? Ethereum considers Rollup as the only Layer2 solution because it expands Ethereum without compromising decentralization and security. From a modular perspective, Layer2 is responsible for execution, while settlement, consensus, and data availability are handled by Layer1.
2. From Layer2 to Layer3
What is the difference between Layer2-Layer3 and Layer1-Layer2? While Rollup technology addresses Ethereum’s computational bottleneck, it doesn’t solve the issue of data availability. The upper layer needs to compress transaction data to pass it down to the lower layer, but compression cannot be repeated, and the performance from Layer2 to Layer3 does not bring significant improvement.
Why do we still need Layer3 with Layer2 in place? Layer2 maintains decentralization as a general-purpose computation layer, providing composability, while Layer3 should serve as an application-specific chain that meets unique application requirements such as compatibility, efficiency, and privacy.
Regarding the application chain ecosystem, what is the difference between Layer3 and Cosmos? Layer3 relies on the Ethereum ecosystem, making it easier to access users and funds. However, due to its strong binding with Ethereum, it also loses some sovereignty, such as capturing the value of tokens.
3. From Layer3 to LayerX?
Current development status of Layer3: Arbitrum released Orbit Chain on June 22nd; zkSync announced the launch of ZK Stack in a few weeks on June 26th; Starknet’s madara has helped a project deploy a Starknet Layer3 application chain within 24 hours during a hackathon.
With the advent of Layer3, will Layer4 and Layer5 be far behind? CGV believes that from a technical perspective, Layer3 cannot achieve a performance leap through simple stacking. Although the ecological correlation between Layer1–2–3 is close (Ethereum ecosystem), and interoperability is stronger than traditional heterogeneous chains (cheaper cross-chain), they still cannot achieve complete ecological inheritance between each other. The narrative of Ethereum’s scalability may come to an end with Layer3.
From Layer1 to Layer2: Scalability
There exists an “impossible triangle” in blockchain, where security, decentralization, and scalability cannot be achieved simultaneously. Ethereum has chosen the first two, but lacks support for the latter. On a typical day, a swap in Ethereum costs $3-$4 in Gas Fees, while during a bull market with high transaction volumes, a single swap can cost nearly $100, resulting in severe congestion.
Despite the emergence of many new public chains focusing on scalability since 2018, Ethereum still dominates the market due to its established ecosystem. As a result, attention has turned to scalability solutions built on top of Ethereum.
The widely used solutions include Sidechains, Validium, and Rollup, each with different trust assumptions.
Sidechains are independent blockchains running separately from Layer1, connected to the Ethereum mainnet via bi-directional bridges. Sidechains can have separate block parameters and consensus algorithms, enabling efficient transaction processing, but they do not inherit Ethereum’s security properties.
Validium uses off-chain data availability and computation to improve throughput, processing transactions off-chain, and publishes zero-knowledge proofs on Layer1 to validate off-chain transactions and ensure security.
Rollup performs computation off-chain but uses Layer1 as the data availability layer, validating off-chain computations through the submission of fraud proofs or validity proofs in Layer1 smart contracts, inheriting Ethereum’s security properties.
Ethereum considers Rollup as the only Layer2 solution because it extends Ethereum without sacrificing decentralization and security. From a modular perspective, Layer2 is responsible for execution, while settlement, consensus, and data availability are handled by Layer1.
Rollup can be further categorized into Optimistic Rollup and ZK Rollup based on different proof submission approaches.
For Optimistic Rollup, the rollup batch executes transactions and sends the batched transactions, pre-state, and post-state to the Rollup contract deployed on Layer1. Layer1 does not validate the state transition process; as long as the initial state submitted by Rollup matches the one stored in the Layer1 contract, the state transition is optimistically finalized. Prevention of fraudulent behavior is ensured through fraud proofs. During a period of dispute, other validators can challenge the state root by submitting fraud proofs to the Rollup contract on Layer1. This would revert the Rollup state back to a known state before the dispute and recompute the legitimate state, imposing penalties on validators. In practice, fraudulent cases are rare, so optimistic state transitions significantly save validation resources.
ZK Rollup differs from Optimistic Rollup in that state transitions require validation, which is performed within the contract using validity proofs. Once the validation is completed, the state transition achieves finality immediately without waiting for a one-week dispute period.
Projects using Optimistic Rollup include Arbitrum and Optimism, which have already launched on the mainnet. Arbitrum has implemented fraud proofs but limits submission to a whitelist, while fraud proofs are still under development for Optimism. Both projects are actively decentralizing their systems, including the decentralization of sequencers and validators. According to L2Beat data as of June 26, 2023, the Total Value Locked (TVL) on Arbitrum One and Optimism is $5.81 billion and $2.25 billion, respectively. Other projects utilizing Optimistic Rollup include Boba Network, Zora Network, Layer2.finance, Fuel, BNBOP, and Coinbase, with some projects built using the open-source OP Stack developed by the Optimism team.
Projects using ZK Rollup technology include zkSync Era, StarkWare, and Polygon zkEVM, which support virtual machines. They have already launched on the mainnet with TVL of $618 million, $68.11 million, and $42.65 million, respectively. Projects supporting specific types of transactions include dydx, Loopring, and zkSync Lite, with TVL of $350 million, $98.47 million, and $97.69 million, respectively. The development direction for ZK Rollup is better Ethereum compatibility, with projects such as Taiko, Scroll, and Linea currently in development for zkEVM.
From Layer2 to Layer3: Customization
Layer2: 100x, Layer3: 100x²=10000x?
The cost from Layer1 to Layer2 reduces to 1/100. It is natural to consider building Layer3 on top of Layer2 to achieve a cost reduction of 1/10,000. Unfortunately, the answer is negative.
While Rollup effectively solves Ethereum’s computational issues by moving execution off-chain, it does not solve the problem of data availability. Layer2 needs to pass the bundled transaction data to Ethereum’s smart contracts in calldata format. Although the packed transaction data is compressed, it cannot be compressed twice in the same way. Layer3’s transaction data must eventually be submitted to Layer1 (to inherit security), but the compression level of the transactions cannot be further reduced. Therefore, data availability cannot be achieved through stacking and cost reduction.
Thus, Layer3 cannot be achieved through simple stacking. The solution proposed by the StarkWare team is customization, where Layer3 and Layer2 assume different functionalities.
Why do we need Layer3 with Layer2 already in place?
Ethereum provides security and decentralization, while Layer2 offers scalability, effectively solving the trilemma of blockchain. So why is Layer3 needed?
The concept of Layer3 was initially proposed by the StarkWare team in the article “Fractal Scaling: From L2 to L3”. The team believes that this hierarchical structure and encapsulation are the core principles that maintain vitality in computer science. Additionally, while the Layer2 virtual machine maintains decentralization as a general-purpose computation layer, Layer3 should serve as an application-specific chain that meets unique application requirements. The Turing completeness lays a solid foundation for the hierarchical structure, enabling the creation of any possible application on it.
In practice, to maintain its generality, Layer2 inevitably involves trade-offs and cannot meet the needs of all applications. A direct example is StarkWare developing the Cairo language and CairoVM for more efficient proof generation, which is not compatible with Ethereum. In such cases, a Layer3 chain can address the security concerns.
Potential use cases for Layer3 include:
Compatibility: Implementing an interpreter for other virtual machines on the Layer2 virtual machine to achieve compatibility with other virtual machines.
Efficiency: If an application requires extremely high TPS (e.g., gaming, social media), sacrificing some security and settling on Layer2 using the Validium solution can be considered. Applications can also customize transaction formats to achieve higher compression rates.
Privacy: Establishing a dedicated privacy chain for settlement on Layer2, which cannot be publicly observed.
Furthermore, since application chains are specialized, they are not directly influenced by other applications, and the performance and costs of the chain are relatively predictable. Additionally, bridge transactions do not need to be sent directly on Layer1, resulting in lower costs, making bridging between L2-L3 and L3-L3 cheaper. Layer3 also has a significant advantage in batch transaction submissions, as it requires lower fixed Gas for submitting a batch, eliminating the need to wait for more transactions to reduce average Gas. This significantly mitigates the dilemma between confirmation time and cost in Layer2.
In the application chain ecosystem, what are the differences between Layer3 and Cosmos?
Cosmos can be considered the earliest project to introduce the concept of application chains. Users can easily customize and issue their own application chains using the Cosmos SDK. Cosmos IBC aims to be the TCP/IP protocol of the Internet, providing native interoperability for application chains built using the Cosmos SDK. In simple terms, Cosmos envisions building a blockchain universe with interconnected chains.
Both Layer3 and Cosmos have invested in interoperability. Due to their similar technical architectures and low transaction costs, cross-chain transactions between Layer3 chains are trustless, fast, and inexpensive. From an interoperability perspective, the functionalities provided by Layer3 and Cosmos are almost the same.
The main difference between Layer3 and Cosmos, according to CGV’s research team, lies in their binding with the Ethereum ecosystem, which is both an advantage and a disadvantage. In terms of advantages, Ethereum has a vast liquidity pool and a large user base. Although Cosmos has powerful technology and is the preferred choice for many giants to launch their chains, it still cannot escape the fate of low market share. As of June 26, 2023, Ethereum’s TVL was $26.2 billion, while the entire Cosmos ecosystem’s TVL was less than $1 billion. The Ethereum ecosystem is a key factor for the success of Layer3.
Regarding disadvantages, the high binding with Ethereum results in the loss of some sovereignty. For projects using Cosmos chains, the token model is entirely designed by the project according to their needs, granting strong token empowerment. However, the native token of a Layer3 chain is subject to Ethereum’s restrictions. Although project tokens can be used as Gas tokens, the submission of final transaction data to Ethereum consumes ETH. Therefore, if Gas tokens are not ETH but native tokens issued by the project, the project needs to constantly convert native tokens to ETH for submission, ultimately transferring the empowerment to ETH.
Another characteristic of Layer3 is that anything done on Layer3 can be migrated to Layer2, depending on the choice of the DA (Data Availability) layer. If the Layer2 settlement infrastructure that Layer3 depends on experiences security vulnerabilities or a decrease in activity, Layer3 can migrate to another Layer2 at a lower cost or even rely on Layer1 for DA and settlement, effectively becoming Layer2. Due to its high binding with the Ethereum ecosystem, Layer3 has the potential to foster numerous innovative applications.
Looking towards LayerX from Layer3
Current development status of Layer3:
On June 22nd, Offchain Labs released tools for issuing the Arbitrum Orbit Chain. Orbit Chain is a Layer3 solution built on top of the Arbitrum Layer2 and can settle on one of the three Layer2 options: Arbitrum One, Arbitrum Nova, or Arbitrum Goerli. Users can choose to use either Rollup or Anytrust technology, with the difference being that Anytrust utilizes DAC without submitting transaction data to the chain, resulting in lower costs but slightly weaker security. The advantages of Orbit Chain include a simple process for launching chains, interoperability with the Arbitrum ecosystem, instant updates with Nitro, and EVM+ compatibility provided by Stylus (supporting Rust, C, C++ writing, running on a WASM virtual machine). Users can issue any Orbit Chain with customized features, but settlement must occur on the Arbitrum Layer2, unless authorized by Offchain Labs or Arbitrum DAO.
On June 26th, zkSync published an article announcing modifications to existing open-source code to launch ZK Stack in the coming weeks. ZK Stack enables users to build their customized ZK superchains. Unlike Arbitrum’s Orbit Chain, ZK Stack emphasizes sovereignty and interoperability, allowing complete customization based on user needs. Chains built using ZK Stack can achieve bridgeless interoperability. ZK Stack can be used to construct both Layer2 and Layer3 chains, with no specific requirement for settlement on zkSync. In this regard, ZK Stack seems to provide stronger sovereignty.
StarkWare, the team that first proposed the concept of Layer3, is actively promoting the development of Layer3 within its Starknet ecosystem. Madara is being tested for public-facing stacks. During the @PragmaOracle hackathon, a team used Madara to launch an application chain within 24 hours. However, due to Starknet’s unique zk-STARK proof technology, it still requires further development to mature the product before publicly releasing Starknet Stack.
The current Layer3 ecosystem is still in its early stages. However, with the introduction of convenient tools for launching Layer2 chains, it is expected that Layer3 chains will be operational soon. As the infrastructure gradually improves, attracting users has become the most important concern for all chains.
With the arrival of Layer3, will LayerX be far behind?
From a technical perspective, Layer3 cannot achieve a significant performance leap through simple stacking. Although Layer3 can obtain specific advantages through customization, the loss of generality makes further stacking challenging. Of course, hierarchical stacking can be infinitely performed if desired, but CGV’s research team believes that currently, such stacking cannot meet any specific requirements and will exponentially increase system complexity.
Most importantly, although the Layer1-Layer2-Layer3 ecosystem is closely related (Ethereum ecosystem) and offers stronger interoperability compared to traditional heterogeneous chains (cheaper cross-chain transactions), they still cannot achieve complete ecological inheritance from each other. Contracts deployed on Arbitrum One cannot be directly called on the Orbit Chain, and liquidity from DEX deployed on zkSync cannot be directly aggregated on ZK Stack.
The current situation is that the marketplace has been built, and it is getting taller, but there are not many merchants and customers. Although the lower levels are overcrowded (Ethereum), people are still unwilling to go to the higher levels of the marketplace because there are fewer merchants there.
Therefore, CGV’s research team believes that it will be challenging for Layer3 to gain a significant number of users until blockchain technology achieves widespread adoption. As for Layer4, Layer5, and LayerN, even if some specific applications have specific needs, it is unlikely that they will be advertised under the LayerN banner.
As the saying goes, “The Dao produces one, one produces two, two produce three, and three produce all things.” The narrative of Ethereum scalability may come to an end with Layer3, but it may take time to validate.
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About Cryptogram Venture (CGV):
CGV (Cryptogram Venture) is a crypto investment institution headquartered in Tokyo, Japan. Since 2017, its fund and predecessor funds have participated in investing in over 200 projects, including the incubation of the licensed Japanese yen stablecoin JPYW. CGV is also a limited partner in several globally renowned crypto funds. Since 2022, CGV has successfully hosted two editions of the Japan Web3 Hackathon (TWSH), supported by Japan's Ministry of Education, Culture, Sports, Science and Technology, Keio University, NTT Docomo, and other institutions and experts. CGV has branches in Hong Kong, Singapore, New York, Toronto, and other locations. Additionally, CGV is a founding member of the Bitcoin Tokyo Club.
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