The Problem
To accommodate global adoption and compete with legacy financial systems, modern-day blockchain networks are grappling with the problem of scalability.
While Layer-1 (L1) solutions are native blockchains with varying performance and utility, such as Avalanche, Solana, Terra, and others, Layer-2 (L2) solutions are protocols focusing on integrating with the underlying L1 blockchains to increase throughput and usability to accommodate the exploding market demand from users.
The Ethereum network today routinely facilitates the transfer of tens of billions of dollars in daily value, with over $150 billion in value currently sitting in smart contracts on its network to facilitate decentralized asset exchanges such as lending, insurance, and payments.
The inherent issue with scalability across blockchain protocols is known as the blockchain trilemma: decentralization, security, and scalability.
A protocol historically had to sacrifice one of these three factors to optimize the other two. Creating highly specialized nodes to handle the workload of the base layer, for example, leads to higher centralization, lowered security, and lowered censorship-resistant properties of the network.
The Blockchain Trilemma
Ethereum vs. Layer-1 Blockchains
While Ethereum 1.0 has optimized for decentralization and security, it has sacrificed scalability, with modern-day time-to-finality for ETH taking 12-60 seconds, around 15-30 transactions per second (tps). This tps being far lower than for legacy payment systems such as Visa, at around 1,700 transactions per second in the real world, amidst Visa’s claims of 24,000 tps. Layer-2 scaling solutions on Ethereum can increase this processing power for Ethereum to handle between 2,000-4,000 transactions per second.
In contrast, other Layer-1 protocols such as Solana, Binance Smart Chain, and Avalanche have achieved faster transaction throughput and faster time-to-finality, with Avalanche having achieved <1-second finality and 4,500 transactions per second before considering any sharding or layer-2 optimizations, Solana regularly processing 2,000+ transactions per second daily with around 13-second time to finality, and Binance Smart Chain handling approximately 150 tps with a 3-second block time.
These competing Layer-1 protocols have been innovating with new consensus algorithms, blockchain architectures, and execution environments. Gas (transaction fees) prices have deterred many from using Ethereum to explore other L1 platforms that offer similar applications, with lower transaction fees, and varying decentralization and security profiles.
Total Value Locked (TVL) in DeFi across all blockchains, with 62.43% in ETH in Q4 2021 (Source: https://defillama.com/chains)
In contrast, at the beginning of 2021, ETH dominance in DeFi TVL was at 96.91% (Source: https://defillama.com/chains)
The Need for Scaling Ethereum
There are two major ways to scale blockchains: scaling the base layer itself (Layer 1) or scaling the network by offloading transactions to another layer, called Layer 2. L2 scaling does not require any changes in Layer 1, as it can be built on top of L1 using its existing elements such as smart contracts. L2 also leverages the security of the corresponding Layer 1 by anchoring its state into Layer 1.
In regards to scaling Ethereum, either with a more developed L1 or with L2 scaling solutions, the need is greater than ever due to the many instances of network congestion that have arisen for the Ethereum network, most notably during the 2017 bull market when CryptoKitties and Initial Coin Offerings (ICOs) caused a major spike in gas fees.
During 2020-2021, the network congestion got worse, caused by the popularity of DeFi and yield farming. There were times when gas fees were as high as 500+ gwei or $80 on certain days while being on average <$1 at the start of 2020, and in hundreds of dollars for certain types of transactions in 2021.
Ethereum network utilization & average transaction fees 2015-2021
What is ETH 2.0?
ETH 2.0 is a multi-phased upgrade that aims to address the Ethereum network’s scalability and security through changes to the network’s infrastructure itself, starting with a switch from the proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) consensus model.
Ultimately, ETH 2.0 will lead to Ethereum being able to process more transactions at a faster throughput, ease scalability bottlenecks that currently exist, and make the network more accessible for the average user, with lower gas fees and faster transaction time to finality, changing Ethereum from a single blockchain to a multi-chain network.
ETH 2.0 is launching in several phases, the first of which, called the Beacon Chain (Phase 0), went live in December 2020. The Beacon Chain introduces native staking to Ethereum, a feature of the shift to a PoS consensus mechanism.
The second phase of ETH 2.0 is called The Merge and is expected by Q2 of 2022, and it will merge the Beacon Chain with the Ethereum mainnet and mark the official move from PoW to PoS. In this phase, the Ethereum network in its current state will be ported over to Ethereum 2.0 as a shard.
The final phase is Phase 2.0 or Shard Chains, which takes transaction execution into the shard chains, expected during 2023, which will play a role in scaling by introducing sharding to spread the settlement of all operations across 64 new chains instead of one single blockchain, ultimately increasing the transaction throughput on the base layer significantly.
The current Ethereum infrastructure has a blockchain consisting of a single chain with consecutive blocks which is very slow and inefficient. With the introduction of shard chains, this one blockchain will be split up, enabling transactions to be handled in parallel chains.
With ETH 1.0, the network can support around 30 transactions per second max, but ETH 2.0 promises up to 100K transactions per second. ETH 2.0, in contrast to most PoS networks that have a small set of validators, requires a minimum of 16,384 validators to make it more decentralized and therefore secure.It has reached more than 200K validators with over 6.6M ETH staked, totaling $14 billion as of Q3 2021. Avalanche, in comparison, currently has 1,205 validators, and Solana has 1,331 validators.
It is still unclear whether Phase 2.0 (Shard Chains) will happen or if the future will depend on roll-ups; if the future is “roll-up centric,” then the Ethereum 2.0 network will solely be used for security and data availability rather than transaction execution. There will be implications for the L2 scaling solution market and the Layer-1 blockchain market depending on these developments.
However, even with sharding, Ethereum will possibly still need L2 scaling to be able to handle hundreds of thousands or even millions of transactions per second for future demand.
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