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The Rise of the Vertical Scaling Narrative

5.0
| by
Kofi J
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What is Vertical Scaling in Crypto?

Vertical scaling targets the scalability issue faced by Layer 1s like Ethereum. Rollup chains, known as Layer 2s, are built on top of the Ethereum mainnet; they execute transactions off the Ethereum chain but post the summary data to the leading network. 


Key Takeaways

  • Vertical scaling targets the scalability challenge in the blockchain trilemma, leaving decentralization and security to the Layer 1 (like Ethereum).

  • Vertical scaling works by outsourcing some of the computational work to another layer (Layer 2), where transactions are executed off-chain, but posts the summary data to the Layer 1 network (settlement layer).

  • This results in faster transactions and lower gas fees for users.


Vertical scaling in crypto Layer 2

The vertical scaling narrative has been the only area of crypto to deny the larger macro bear market. Throughout 2022 over-leveraged players were flushed out, traders got margin called, and fresher, more brutal lows succeeded the prior lows. Bear markets have a wonderful habit of – paraphrasing Buffet – showing who is wearing trunks and who is swimming naked. The big losers were centralized service providers and, as usual, retail.

However, throughout 2022 a secular bull market raged within crypto; the vertical scaling of Ethereum, colloquially termed Layer 2 season. This article discusses the Layer 2 vertical scaling narrative, its origins, technicalities, and potential future path. 

Ethereum’s Scalability Concerns 

Ethereum transaction fees in the height of the bull market in 2021 eclipsed hundreds of dollars. Vitalik Buterin envisages the Ethereum network as a world computer, but if the fees charged for operating on the network remain prohibitively expensive for the vast majority, Ethereum cannot be fairly said to be achieving its mission. Hence the importance of scalability. Vitalik himself foresees an era when Ethereum processes more than 100,000 transactions per second, with each transaction fee totaling no more than five cents.

The Flood of Alternative Layer 1s

Ethereum’s lack of scalability drove the proliferation of alternative Layer 1s collectively dubbed ‘Ethereum-Killers’ in the prior cycle; this has proven to be a relatively poor thesis long-term. These Layer 1 blockchains all aimed to be faster and cheaper than Ethereum, upgrading the throughput, but this comes at the cost of decentralization or security. 

The Blockchain Trilemma 

Understanding scalability requires a basic understanding of a problem proposed by Vitalik, the blockchain trilemma. It states that a Layer 1 monolithic blockchain can only optimize two of the following characteristics: decentralization, scalability, and security.


Blockchain Trilemma Scalability, Decentralization Security

For example, the Layer 1 blockchains that use the Designated Proof of Stake (DPoS) consensus mechanism power enormous throughput but are highly centralized. In October 2022, an exploiter exploited a vulnerability in an old Binance Bridge and minted millions of BNB tokens. The network was rapidly shut down, squashing doubts about the chain’s centralization.

Ethereum’s design explicitly focuses on maintaining a relative degree of decentralization and security to the detriment of scalability. Ethereum’s roadmap has included the idea of rollups (vertical scaling) and sharding for years. In this moment, rollups have become the central attack vector to scale Ethereum in the short to medium term. 

Vertical Scaling Versus Horizontal Scaling 

There are two basic formats for scaling: scale the base layer (horizontal scaling) or outsource some of the computational work to another layer (vertical scaling). In the long term, Ethereum has taken a hybrid approach focusing on sharding and Layer 2s. However, vertical scaling remains the most prolific area of growth. 

An On-Chain Picture of Vertical Scaling

On-Chain Activity Layer 2s

L2BEAT, an analytics platform for Layer 2s, shows that in early October 2022, Layer 2s as a whole have consistently started processing more transactions than the Ethereum mainnet. This growth has only been on the rise. Scaling factor is a metric that shows the increase in transaction count driven by Layer 2s, where a scaling factor of 4.02 means that the Ethereum mainnet has executed four times more transactions thanks to scaling solutions, and this metric will likely only continue to increase.

The current state of the Layer 2 race shows Arbitrum processing more transactions than the Ethereum mainnet. The vertical scaling narrative is very real, and this narrative, unlike many others, will be persistent and a defining part of the crypto ecosystem moving forwards. 

What are Layer 2s?

The huge success of Layer 2s points to their excellent product market fit. These rollups leverage Ethereum’s settlement layer, benefitting from Ethereum’s security while optimizing gas fees for end users through batching transactions. In essence, users can access Ethereum’s security guarantees at a higher speed for a fraction of the cost.

In simple terms, a Layer 2 rollup solution is a chain built above the Ethereum mainnet that executes transactions off the Ethereum chain but posts the summary data to the leading network. A Layer 2 is an execution module that executes huge batches of transactions, compresses the data (or rolls it up hence the name), and posts it to Ethereum in a single transaction.

The Effect of Layer 2s 

Layer 2s have driven vast amounts of economic activity. For example, if the average cost of a transaction on Ethereum is $10 (depending on the complexity of the request, this can be and often is far higher), transaction fees on Arbitrum for a similar transaction would cost a little under $0.02. Layer 2s suddenly create a market for every transaction under this value, and on-chain evidence explicitly highlights user appetite for these cheaper transactions.  

According to A16z’s 2023 State of Crypto Report, Layer 2 scaling solutions accounted for 1.5% of the total fees paid on Ethereum in 2022. In 2023, that number has risen to 7%.

Chains sorted by TVL

Ethereum and projects designed to help scale Ethereum represent four of the seven largest blockchains ranked by TVL (Total Value Locked), showing their fearsome ecosystem dominance. 

Optimistic Rollups vs. ZK Rollups

The two largest Layer 2s, Arbitrum and Optimism, are both Optimistic rollups, but the current flavor of the Layer 2 scaling race lies with zero-knowledge (ZK) rollups. The rapid advancement in zero-knowledge proofs has been the most significant growth area from a technical perspective in crypto, with several ZK rollups deployed on mainnet and fully operational such as zkSync Era, LoopRing, StarkNet, and the Polygon zkEVM.

The difference between the rollups comes down to the proofs employed for transaction verification. Optimistic rollups use fraud proofs, whereas ZK rollups leverage validity proofs. 

Optimistic Rollups

Optimistic rollups assume transactions are nonfraudulent and post them to Layer 1, hence their name. Optimistic rollups do not need to do any further work if all transactions are valid and have far greater compatibility with EVM, meaning dApps can be ported across without significant changes. However, Optimistic rollups must implement a dispute resolution process, including a time window for agents to submit fraud proofs and ensure no fraudulent transactions. This leads to a lengthy withdrawal process. Another concern is that Optimistic rollups rely on a centralized sequencer to submit batched transactions to the mainnet.

Hypothetically, due to the privileged position of a centralized sequencer (it has priority for the submission and ordering of transactions), it could front-run all user transactions extracting MEV.

MEV (Maximal Extractable Value) is the invisible tax on the Ethereum network. Validators can alter the order of user transactions within a block to extract value from users by frontrunning transactions or using sandwich attacks.

A centralized sequencer is also a cause of concern for security and censorship. Interestingly Layer 2s progressively move towards greater decentralization, but this varies by project, hence the importance of platforms like L2BEAT, which hold Layer 2s accountable.

L2BEAT tracks TVL and network activity but, more importantly, the potential security flaws of layer twos. It analyzes data availability (the data required to reconstruct the state available), the procedures in place for validator/sequencer failure, and whether the contracts are upgradeable, along with other security concerns.

Arbitrum, for example, allows anyone to become a validator (usually controlled via whitelist) if no validator publishes a Layer 2 state root within seven days. In the event of a sequencer failure after one day or 5,760 blocks, users can force the transaction to be included in the Layer 2 by sending it to the Layer 1. 

ZK Rollups 

ZK rollups do not have a dispute resolution and leverage zero-knowledge proofs – proofs that provide the validity of a statement without revealing the statement itself. ZK rollups submit cryptographic proofs with each batch of transactions proving the validity of each transaction at the time of submission, meaning invalid batches of transactions are rejected immediately. However, the underlying technology of ZK rollups remains much more complex, requires more computational power, and is far less compatible with EVM.

The general positioning of the crypto space is that ZK rollups are the way forward. The technology is currently in its infancy, but the massive explosion in development points to a ZK rollup-centric future, and even Vitalik Buterin shares this vision. 

Ethereum Enters the Era of Modularity

Ethereum has entered its era of modularity as it increasingly outsources execution to Layer 2 solutions. As a result, Ethereum continues to grow denser as a settlement layer. Ether (ETH) remains the native currency of Layer 2s, where it is used as the primary form of collateral within the ecosystems and to pay gas fees. All Layer 2 economic activity feeds Ether’s value. 

Still, the tokens belonging to Layer 2s arguably remain undervalued, given the economic bandwidth of the networks.

Comparing L2s to L1s

Look at market caps, consider where users transact, and where the bulk of the crypto economic activity currently takes place. This list will change in the next twelve to eighteen months. Ethereum will still be ranked second, but do not be surprised to see a Layer 2 push towards and possibly enter the top ten.  

Ethereum's Layer 2s also offer further scalability opportunities through interoperability, such as Optimism's Superchain, which is a unified network of chains built using the OP stack. This promises to remove the hassle of bridging and network switching, allowing users to easily explore dApps across blockchains.  

Scaling Beyond Ethereum

The idea of scaling is not limited to Ethereum. Fantom, which currently runs the EVM, has plans to introduce the FVM (Fantom Virtual Machine), overcoming the current EVM bottlenecks such as slow block processing time and the complex storage design. Fantom’s FVM will introduce a new data structure and parallel processing to accelerate block processing time; Fantom has chosen to opt for monolithic scaling.

Avalanche has opted to scale through subnets allowing entities to build specialized blockchains where creators can dictate tokenomics, the nature of the subnet permissioned/ permissionless, privacy, and validator incentives. Subnets allow for the creation of a theoretically limitless number of app-specific blockchains within the larger Avalanche primary network.

Polkadot achieves scalability through interoperability, creating a Layer Zero network with each Relay chain securing close to 100 parachains – separate parachains process transactions in parallel, driving scalability.

Cosmos Network famously opted for modularity, aiming to scale horizontally instead of vertically. The Cosmos SDK allows developers to create application-specific blockchains validated by Tendermint consensus. And thanks to the IBC (Inter-Blockchain Communication) protocol – a general purpose stand for interchain communication – these blockchains are fully interoperable within the broader Cosmos Network ecosystem.

Summarizing the Ethereum Layer 2 Vertical Scaling Narrative 

Users derive the benefits of Ethereum’s settlement layer but with faster transactions and lower gas fees. The result is the creation of huge economic demand for Ethereum blockspace, the continued appreciation of Ether, and a whole new generation of Layer 2 chains.

This heightened scalability opens the path to onboard the next billion users into crypto. It will also enable the creation of the next wave of dApps, providing more utility for end users and feeding the larger crypto flywheel.

Narratives work with momentum. The pendulum began with Ethereum, swung toward alternative layer ones in the last cycle, and now returns to Ethereum – when a pendulum swings back, it does not stop in the middle; it swings all the way back.

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Kofi J
Kofi J
Kofi J has been active in DeFi since the 2020 summer explosion and has been rugged more times than he can remember. He hopes to make the decentralized economy a little bit more accessible through his prose. Follow the author on Twitter @k_pangolin

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