To understand the differences between Layers, you must first understand scaling. In Blockchain technology, the term scaling refers to an increment in the system throughput rate, as measured by the number of transactions performed per second.
Why is Scalability Important?
Now that description is a mouthful so let's break it down. As more and more people and applications start to use the blockchain the amount of traffic on the blockchain increases. Scalability is the term used to describe how well a blockchain is able to handle this increase in transactions.
When there are more transactions on a blockchain there is a spike in gas fees from network congestion. To make transactions more affordable a blockchain needs to be able to effectively scale up to handle these spikes.
Layer 1 Blockchains
Layer 1 is used to describe the underlying blockchain. These are the primary blockchains, such as Bitcoin, Ethereum or Litecoin.
To increase scalability on a Layer 1 Blockchain would mean a complete overhaul of that blockchain. An example of changing a blockchain to improve scalability is the Ethereum network's move to Ethereum 2. This move for Ethereum is transitioning from Proof of Work (PoW) to Proof of Stake (PoS).
Layer 2 Blockchains
Layer 2 refers to the overlying network that improves some aspect of the blockchain. These technologies operate on or adjacent to an underlying blockchain.
These networks take on a portion of a Layer 1 blockchain transactions to improve efficiency. While they still use Layer 1 features, such as smart contracts and security protocols, they aren't burdened by the same transaction limitations. A Layer 2 network can help boost throughput to as much as 2,000 to 4,000 transactions per second.
Types of Level 2 Blockchains
There are several type of Level 2 blockchains:
State Channels
A state channel is a two-way communication channel between parties. This communication channel allows handling of transactions that would normally be completed on the blockchain to be completed off blockchain.
An example of state channels is Bitcoin's Lightening Network.
Nested Blockchains
A nested blockchain operates on top of another blockchain. The Layer 1 blockchain sets the parameters. The nested Layer 2 blockchain will handle the execution of the transactions.
An example of a nested blockchain is the OMG Plasma Project.
Sidechains
A sidechain is responsible for handling a large number of transactions. The process that a sidechain uses for processing transactions is independent of the base Layer 1 blockchain it is operating on.
An example of a sidechain is Bitcoin's Liquid Network.
Potential for Layer 2 Blockchains
As the adaption of the Blockchain increases the number of transactions increase. Layer 2 blockchains will be responsible for improving the scalability of the Layer 1 Blockchain on which they operate.
This increase in scalability will be crucial in handling the increase transaction load as the Blockchain becomes more popular.
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