The decentralized nature of blockchain and its high security are unique features of Bitcoin (BTC). However, low transaction speeds and high fees have hindered this goal’s achievement.
Legal Challenges of Layer 2 Technologies
In 2008, the world experienced a global financial crisis that led to bank bankruptcy and the loss of many people’s assets. This crisis made many people question the safety and reliability of the traditional financial system. At this time, Bitcoin (BTC) was designed to serve as money, with decentralization and high security as its unique features. However, low transaction speeds and high fees have prevented it from fully realizing this goal.
Developers are exploring various solutions to enhance transaction speeds. One of these solutions is the Layer 2 network, which improves the scalability of the blockchain. Layer 2 is a secondary network that runs on the main cryptocurrency network and can be used for faster transaction processing. In this article, we will examine the function and mechanisms of Layer 2 networks and the regulatory challenges they face.
Blockchain Trilemma
There is a theory known as the Blockchain Trilemma (Scalability Trilemma), which posits that no blockchain can simultaneously possess all three of the following characteristics:
- Scalability: The ability to process a large number of transactions per second.
- Security: Resilience against attacks from malicious actors.
- Decentralization: Distribution of power across many nodes.
For instance, a highly scalable and decentralized blockchain might be less secure because coordinating defense against attacks becomes more difficult.
Many proposals have been made to address the scalability trilemma. Some aim to increase blockchain scalability without sacrificing security or decentralization. Others seek to balance these three features to meet specific application requirements.
The Concept of Scalability
Scalability in blockchain refers to handling many transactions per second (TPS). Scalability is a significant challenge for blockchains, as they need to manage an ever-growing transaction volume. TPS varies depending on the blockchain network and transaction type. Some blockchains have high TPS, while others process more slowly. The transaction speed of cryptocurrencies is generally lower than that of traditional payment systems like Visa, which can process about 24,000 transactions per second, whereas Bitcoin and Ethereum (ETH) process 7 and 15 transactions per second, respectively. However, Solana is one of the fastest cryptocurrencies, able to handle 65,000 transactions per second. These figures are approximate and can fluctuate. Moreover, transaction speed on blockchains may vary due to transaction types, network congestion, and technological advancements.
Improving Scalability
One of the most effective methods for addressing the scalability trilemma is through Layer 2 solutions. Layer 2 solutions are protocols built on existing blockchains and can be used for off-chain transactions, enhancing scalability without compromising security or decentralization.
Challenges of Scalability
Improving cryptocurrency scalability comes with challenges, including:
Cost: Developing and implementing scalable solutions can be expensive. Layer 2 solutions often require investment in new hardware and software.
Security: Some scalability solutions may compromise security, potentially creating new vulnerabilities in the network that criminals could exploit.
Consensus: Developers must agree on scalable solutions that are acceptable to all users, which can be challenging given differences in priorities and goals.
“Blockchain has the potential to transform how we share information, buy and sell things, interact with the government, verify identity, and validate everything – from the food we eat to the medicine we take to who we say we are.”
— Julie Sweet, CEO of Accenture
Objectives of Creating Layer 2
- Increased Scalability: Layer 2 can enhance scalability by processing transactions in parallel or batches, reducing latency and increasing transaction speed.
- Cost Reduction: Layer 2 can reduce transaction costs by minimizing transaction size or using alternative consensus algorithms, making blockchain more affordable for small-scale users.
- Improved Usability: Layer 2 can offer new and enhanced features, improving blockchain usability and attracting more users.
Types of Layer 2
Blockchain, as an innovative technology for secure asset transfer, has limitations, such as low transaction numbers and processing speeds. Layer 2 technology was developed to address these issues and increase scalability. Below, we introduce various types of Layer 2 and their functions:
State Channels
State channels allow two or more parties to conduct numerous transactions off-chain without sending each transaction to the entire network. This capability significantly increases blockchain scalability by reducing the number of transactions the network must process, thus lowering costs.
An example is the Lightning Network, implemented on Bitcoin.
To understand how state channels work, consider this example:
Alice and Bob want to conduct business with each other. They can open a state channel and conduct multiple transactions within it, without sending each transaction to the Bitcoin network. When they close the channel, only one transaction is sent to Bitcoin to finalize all the transactions in the state channel.
Since not all transactions are stored on the blockchain and only the balance between the two parties is recorded, privacy is significantly enhanced.
Additionally, methods like CoinJoin also enhance privacy in cryptocurrencies. CoinJoin is a technique used to improve Bitcoin transaction privacy by allowing users to combine their transactions, making it harder to trace the source and destination. This technique is also used in privacy coins.
CoinJoin functions in two main ways:
- Input Mixing: Users combine their transactions, making it harder to trace sources and destinations.
- Coin Mixing: Users mix their cryptocurrencies, making it difficult to identify specific transactions.
“Blockchain can provide a level of privacy that is lacking in today’s centralized systems.”
— Vinnie Lingham, co-founder of the digital identity company Civic
Sidechains
A sidechain is a separate blockchain that operates independently of Ethereum and connects to the Ethereum mainnet via a two-way bridge. Sidechains can have their own block parameters (block time and size) and consensus algorithms, often designed for efficient transaction processing. Sidechains improve scalability and transaction efficiency by sacrificing some decentralization or security.
Two-way bridges enable asset transfers between the sidechain and the main chain. However, sidechain transactions aren’t automatically sent to the main chain, meaning sidechains don’t share the main chain’s security. Hackers who gain sidechain control could alter transactions or steal assets.
Consensus algorithms used in sidechains include:
- Proof of Authority (PoA)
- Delegated Proof of Stake (DPoS)
- Byzantine Fault Tolerance (BFT)
Like Ethereum, sidechains have validator nodes responsible for confirming transactions, processing blocks, and securing the network against attacks.
Some sidechains are compatible with the Ethereum Virtual Machine (EVM), enabling them to execute contracts developed for Ethereum. Sidechains compatible with EVM support smart contracts written in Solidity and other EVM-compatible languages, allowing Ethereum mainnet contracts to function on these sidechains.
Because they are EVM-compatible, sidechains are a scalable solution for Ethereum-native dApps (decentralized applications). With dApps running on a sidechain, users can experience faster, lower-cost transactions, particularly if the main network is congested. Examples of sidechains include Polkadot, Cosmos, and Polygon.
Plasma
The Plasma chain is a separate chain connected to the Ethereum mainnet. It executes transactions off the main chain and has its own mechanism for validating blocks. Plasma chains, sometimes called “child chains,” are essentially smaller replicas of the main Ethereum network. Plasma chains use fraud proofs (like Rollups) to resolve disputes.
Plasma acts as a bridge for transferring assets between the Ethereum mainnet and the Plasma chain. Although this makes them similar to side chains, Plasma chains—at least to some extent—benefit from the security of the Ethereum mainnet. This contrasts side chains, which are responsible for their own security.
On Plasma chains, transactions are not directly sent to the mainnet. Instead, they are processed within the Plasma chain and only reported to the Ethereum mainnet when fraud proofs or other required security proofs are validated. This optimization allows transactions to be executed quickly and at minimal cost. Through security proofs, transactions are validated and, if needed, reported to the Ethereum mainnet.
Disadvantages
Plasma does not support general computation (such as executing smart contracts). It can only process simpler transactions, like token transfers and exchanges.
You need to regularly monitor the network or assign this task to someone else to ensure the security of your assets, as their security depends on the validation and execution of transactions by other parties.
Withdrawals are delayed to allow time for any disputes or reversals. For tradable assets, this delay may be shortened but comes at a cost.
If many users attempt to withdraw simultaneously, transaction speed may decrease.
Rollup
Rollup is a method of scaling for blockchains. In this method, transactions and their execution occur on an external layer of the blockchain, and transaction data is then sent to the main blockchain (Layer 1) for consensus. This method increases transaction volume and processing speed while leveraging the security of the main blockchain. Rollups are viewed as a key scaling solution for blockchains, particularly Ethereum.
Optimistic Rollup
The main feature of Optimistic Rollup, often called “optimistic,” is that it initially assumes all transactions and trades on Layer 2 are valid and do not require immediate validation. In other words, this layer trusts that transactions are correctly executed.
This optimistic feature allows transactions to be processed quickly on Layer 2, with transaction details later transferred to the main blockchain (such as Ethereum). If no issues or violations occur, transactions are validated by the main layer. The transaction speed in a rollup is 10 to 100 times faster than on the mainnet.
If an issue or violation is detected, corrective mechanisms (such as submitting fraud-proof) are employed to resolve the issue and transfer accurate information to the main layer. This feature adds extra security to Layer 2, allowing fast transactions while maintaining security. Unlike side chains, the security of rollups depends on the main network, giving them higher security compared to other Layer 2 solutions. Users can recover their funds through the Ethereum mainnet if an issue arises in an Optimistic Rollup.
Zero-Knowledge Rollups
Zero-Knowledge Rollups increase transaction capacity by offloading computations and state storage from the Ethereum mainnet. ZK-Rollups can process thousands of transactions in a single batch and only publish limited data to the main network.
Projects like Loopring, Arbitrum, ZKSpace, and Optimism use Zero-Knowledge Rollups.
Zero-Knowledge
Zero-Knowledge in blockchain is a cryptographic method allowing a party (the prover) to prove the existence of certain information or data without disclosing the data itself.
In blockchain, Zero-Knowledge can be used for various applications, including:
- Authentication: Zero-Knowledge can authenticate users without sharing personal information. For example, a user can use Zero-Knowledge to prove they have a specific bank account without disclosing the account number.
- Transaction Verification: Zero-Knowledge can verify a transaction’s validity without revealing transaction details. A user can use Zero-Knowledge to prove transaction approval without disclosing information about the other party involved.
- Privacy: Zero-Knowledge can maintain user privacy on blockchain. For instance, a user can use Zero-Knowledge to prove they met a condition without revealing the condition itself.
Zero-Knowledge is an emerging technology with significant potential for enhancing blockchain security, privacy, and scalability.
Also note that each of these technologies has its own unique features and advantages, making it suitable for different blockchains. Using Layer 2 solutions means improving scalability, reducing costs, and increasing transaction speed on the chosen blockchain.
Coinbase’s First Layer 2 Solution
Coinbase has recently launched a Layer 2 solution named Base and claims it is decentralized. However, given Coinbase’s centralized nature, this claim is questionable, as Coinbase reviews all Base transactions.
This raises the question of whether transferring assets anonymously from a non-verified source to a Base is possible. Coinbase has refrained from directly addressing this; however, it is likely that only verified Coinbase customers can use Base. Otherwise, Coinbase would violate U.S. regulations.
“I believe that centralized exchanges will likely bear the most responsibility for preventing money laundering issues and having transaction monitoring programs in place.”
– Brian Armstrong, CEO of Coinbase.
Regulatory Challenges
Layer 2 networks pose regulatory challenges for several key reasons:
Increased Privacy
Layer 2 solutions often provide advanced privacy features, making transaction tracking and monitoring more difficult for regulators. Enhanced privacy measures, such as Zero-Knowledge proofs, allow users to verify transaction validity without disclosing details. This could hinder Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations enforcement.
In addition, the Lightning Network has attracted regulatory attention. According to Jamie Nguyen, founder of the Bitcoin Association, the Financial Crimes Enforcement Network (FinCEN) considers Lightning Network nodes Money Services Businesses (MSBs) and, therefore, must register as MSBs and comply with AML regulations. Otherwise, FinCEN may halt Lightning Network operations, as CoinGeek reported.
Since Arbitrum and Optimism have not (yet) been recognized as MSBs by any government, they are largely exempt from regulations.
Decentralization
Some Layer 2 networks are typically designed to operate in a more decentralized manner. They may lack a central authority or intermediary to enforce regulatory compliance, which makes control challenging for authorities. Decentralization depends on node count, consensus algorithms, and other factors. Zksnark and Lightning are examples of decentralized Layer 2 solutions.
In decentralized systems, users can conduct transactions in ways that make their identities less traceable. This can make it challenging for regulators to identify and track illegal activities like money laundering and trafficking.
However, governments are looking to enact regulations for institutions providing digital asset services. These laws require institutions to verify their users and block and report suspicious transactions to authorities.
Creating clear regulations in this area is challenging due to the rapidly advancing technology of digital assets. Lawmakers must design regulations that protect users without stifling innovation.
“When decentralized blockchain protocols replace the centralized web services that dominate today’s internet, we will see true internet-based governance. The future of the internet will be decentralized.”
– Olaf Carlson-Wee, founder of Polychain Capital, a cryptocurrency hedge fund.
Complex Legal Challenges
Regulating Layer 2 networks can be challenging, as they often operate across multiple countries and legal frameworks. To enforce regulations effectively, lawmakers need to address these complexities and enable international cooperation.
Rapid Technological Advancements
Layer 2 technologies constantly evolve, outpacing regulatory development. Regulators may struggle to adapt their laws to new features and capabilities. For example, stricter regulations may lead to greater privacy in certain currencies, as people might favor privacy-oriented coins to minimize regulatory interference.
In summary, Layer 2 networks present regulatory challenges due to increased privacy, decentralized operation, and facilitation of international transactions. Regulators must adapt to these technological advances and complexities to ensure effective financial regulation.
The Role of Regulation in Layer 2
Regulating Layer 2 can be challenging as these networks often operate across multiple countries and legal frameworks. Lawmakers must address these complexities to implement effective regulations.
Possible Regulatory Reactions
- Mandatory Identity Verification: Regulators may require all financial institutions to verify their customers’ identities to prevent criminal activities like money laundering. This may lead to financial institutions losing customers, as they may turn to decentralized platforms that don’t require identity verification. Additionally, financial institutions may face sanctions or fines if they fail to comply with regulations.
- Removal of Layer 2 Currencies from Exchanges: If a digital currency has high privacy features, regulators may require exchanges to delist it. This could reduce the currency’s adoption, as users may not be able to trade it easily on exchanges.
Reduced Privacy
Regulatory restrictions can reduce users’ privacy. As a result, they may turn to privacy-enhancing methods like CoinJoin or cryptographic technologies like Ring Signatures to make their transactions less traceable. However, this doesn’t mean that those seeking more privacy intend to launder money, as data shows that only 0.43% of global money laundering involves cryptocurrencies.
Solutions to Mitigate These Concerns
Regulators can reduce some of these concerns by adopting a balanced approach. For example, they can establish laws that protect users’ privacy. Additionally, they can collaborate with financial institutions and Layer 2 developers to find solutions for implementing regulations without compromising user privacy.
Sources:
https://ethereum.org/en/developers/docs/scaling/sidechains
https://www.blockspaces.com/blog/layer-2-blockchains-guide
