LK Venture Research Report: Can Layer3 bring about a huge explosion in the application chain ecosystem?

Original source: Cynic, LK Venture Researcher  

TL;DR

From Layer1 to Layer2

How to achieve expansion technically? Ethereum regards Rollup as the only Layer2 solution because it expands Ethereum without losing decentralization and security. From a modular perspective, Layer2 is responsible for execution, while settlement, consensus, and data availability are all handled by Layer1.

From Layer2 to Layer3

What is the difference between Layer2-Layer3 and Layer1-Layer2? Although Rollup technology solves Ethereum's computing bottleneck, it does not solve the problem of data availability. The upper layer needs to compress transaction data to pass it to the lower layer, but the compression cannot be repeated, and the performance of Layer2-Layer3 cannot be greatly improved.

With Layer2, why do we need Layer3? Layer2 will maintain decentralization and provide composability as a general computing layer, while Layer3 should be an application-specific chain to meet the unique needs of different applications, such as compatibility, efficiency, privacy, etc.

As both are application chain ecosystems, what is the difference between Layer3 and Cosmos? Layer3 relies on the Ethereum ecosystem and is easier to acquire users and funds, but due to its high degree of binding with Ethereum, it has also lost some sovereignty, such as the value capture of tokens.

From Layer3 to LayerX?

Layer3 development status: Arbitrum released Orbit Chain on June 22; zkSync announced on June 26 that it would launch ZK Stack in a few weeks; Madara of the Starknet ecosystem has helped a project deploy a Starknet Layer3 application chain within 24 hours during the hackathon.

Layer3 is here, will Layer4 and Layer5 be far behind? LK Venture believes that from a technical point of view, Layer3 can no longer achieve a performance leap through simple stacking. Although the ecological connection between Layer1-2-3 is close (Ethereum ecosystem) and the interoperability is stronger than that between traditional heterogeneous chains (cross-chain is cheaper), they still cannot achieve complete ecological inheritance. The narrative of Ethereum expansion may end at Layer3.

From Layer1 to Layer2: Scaling

There is an impossible triangle in the blockchain, that is, security, decentralization and scalability cannot be achieved at the same time. Ethereum chose the first two, but did not support the latter enough. On weekdays, a swap in Ethereum requires a Gas Fee of $3-$4, while a swap in a bull market with high trading volume even requires a Gas Fee of nearly $100, and the congestion is very strong.

Relying on the huge ecosystem established by the first-mover advantage, although many new public chains focusing on scalability have continued to emerge since 2018, Ethereum still occupies an absolute dominant position in the market, so everyone has turned their attention to the expansion solutions built on Ethereum.

Among them, the most widely used are sidechains, Validium and Rollup, which have different trust assumptions.

Sidechains are independent blockchains that run independently of Layer1 and are connected to the Ethereum mainnet via a two-way bridge. Sidechains can have separate block parameters and consensus algorithms, and can process transactions efficiently, but do not inherit the security properties of Ethereum.

Validium uses off-chain data availability and computation, processes transactions off-chain to increase throughput, and publishes zero-knowledge proofs to the chain to verify off-chain transactions on Layer1 for security.

Rollup performs computation off-chain, but uses Layer1 as a data availability layer, and inherits the security of Ethereum by publishing fraud proofs or validity proofs on-chain for verification in Layer1 smart contracts.

Ethereum sees Rollup as the only Layer2 solution because it allows Ethereum to be expanded without sacrificing decentralization and security. From a modular perspective, Layer2 is responsible for execution, while settlement, consensus, and data availability are all handled by Layer1.

Depending on the different proofs submitted, Rollup can be divided into Optimistic Rollup and ZK Rollup.

For Optimistic Rollup, Rollup executes transactions in batches, and sends batches of transactions, pre-execution states, and post-execution states to the Rollup contract deployed on Layer1. Layer1 does not verify the state transfer process. As long as the initial state submitted by Rollup is the same as that stored in the Layer1 contract, it optimistically transfers the state to the new state submitted by Rollup. The prevention of fraud is guaranteed by fraud proofs. During a period of dispute, other validators can challenge the state root and send fraud proofs to the Rollup contract of Layer1. This will cause the Rollup state to return to the determined state before the dispute, recalculate the legal state, and punish the validator according to the result. In fact, fraud rarely occurs, so optimistic state transfer actually saves a lot of verification resources.

The difference between ZK Rollup and Optimistic Rollup is that the transfer of state needs to be verified, not by the Rollup contract of Layer1, but by verifying the validity proof in the contract. After the verification is completed, the transfer of state immediately obtains finality, and there is no need to wait for a week-long dispute period.

Among the projects using Optimistic Rollup technology, the most mature ones are Arbitrum and Optimism, both of which have been launched on the mainnet. Among them, Arbitrum has implemented fraud proof, but it is limited to whitelist submission, while Optimism's fraud proof is still under development. Both companies are actively promoting the decentralization process, including the decentralization of sorters and validators. According to L2Beat data, as of June 26, 2023, the TVL of Arbitrum One and Optimism are $5.81B and $2.25B respectively. Other projects using Optimistic Rollup technology include Boba Network, Zora Network, Layer2.finance, Fuel, BNBOP, Coinbase, etc., some of which are developed using the open source OP Stack of the Optimism team.

Among the projects using ZK Rollup technology, those that support virtual machines mainly include zkSync Era, StarkWare, Polygon zkEVM, etc., which are currently on the mainnet with TVLs of $618M, $68.11M, and $42.65M. Those that only support specific types of transactions include dydx, Loopring, zkSync Lite, etc., with TVLs of $350M, $98.47M, and $97.69M. At present, the development direction of ZK Rollup is better Ethereum compatibility, and the zkEVM projects under development include Taiko, Scroll, Linea, etc.

From Layer2 to Layer3: Customization

Layer2: 100x, Layer3: 100x^2=10000x?

From Layer1 to Layer2, the cost is reduced to 1/100. So it is natural to think that if the same operation is performed on Layer2 to build Layer3, the cost of Layer3 will be reduced to 1/10000. Unfortunately, the answer is no.

Rollup does solve Ethereum's computing problem by moving execution off-chain: L1 nodes no longer need to execute every transaction in the batch to verify the correctness of the state transfer. Thanks to the recursive proof technology in cryptography, the calculation can be continuously recursive to obtain unlimited performance, but data availability cannot be stacked. Layer2 needs to pass the packaged transaction data to the smart contract in Ethereum in the form of calldata. Although the packaged transaction data is compressed, the data cannot be compressed twice in the same way. The transaction data of Layer3 must also be submitted to Layer1 in the end (otherwise it cannot inherit security), but the degree of compression of the transaction cannot be lowered, so the cost of data availability cannot be reduced through stacking.

Therefore, Layer3 cannot take the path of simple stacking. The solution proposed by the StarkWare team is customization, so that Layer3 and Layer2 have different functions.

With Layer2, why do we need Layer3?

Ethereum provides security and decentralization, and Layer2 provides scalability. It can be said that it solves the trilemma of blockchain. Why do we need Layer3?

The concept of Layer3 was first proposed by the StarkWare team in the article "Fractal Scaling: From L2 to L3". The StarkWare team believes that this hierarchical structure and the idea of encapsulation are also the core of computer science to maintain vitality. In addition, Layer2 of the Layer2 virtual machine will maintain decentralization and provide composability as a general computing layer, while Layer3 should be an application-specific chain to meet the unique needs of different applications. Turing completeness lays a good foundation for hierarchicalization. Once Turing completeness is achieved, any possible application can be created on it in theory.

In fact, in order to maintain its versatility, Layer2 will inevitably make some trade-offs and cannot meet the needs of all applications. The most direct manifestation is that StarkWare developed the Cairo language and CairoVM to generate proofs more efficiently, which are not compatible with Ethereum. At this time, a Layer3 chain can be used to solve its security.

Possible Layer3 use cases include:

Compatibility:By implementing an interpreter of other languages on the Layer2 virtual machine to be compatible with other virtual machines

Efficiency:If the application pursues ultra-high TPS (such as games, social networking), it can consider giving up some security and using the Validum solution to settle on Layer2; the application can also customize the transaction format according to its own needs to achieve a higher compression rate.

Privacy: A privacy chain is specially built and settled on Layer2, but it cannot be publicly observed.

In addition, since the application chain is dedicated and will not be directly affected by other applications, the performance and cost of the chain are relatively certain. At the same time, bridge transactions do not need to be sent directly on Layer1, which is cheaper, and L2-L3 and L3-L3 bridges are cheaper. In terms of batch submission of transactions, Layer3 also has an obvious advantage. The fixed Gas required to submit a batch of transactions is lower, and there is no need to wait for a long time for more transactions to be submitted together to reduce the average Gas, which can significantly alleviate the dilemma between confirmation time and cost in Layer2.

Both are application chain ecosystems, what is the difference between Layer3 and Cosmos?

Cosmos can be said to be the first project to propose the concept of application chain. Through Cosmos SDK, users can easily customize and issue their own application chain. Cosmos IBC is even more benchmarked against the TCP/IP protocol in the Internet, providing native interoperability for application chains built using Cosmos SDK. Simply put, the vision of Cosmos is to build a blockchain universe with thousands of chains interconnected.

Layer3 has also put a lot of effort into interoperability. Due to the same technical architecture and low transaction costs, the cross-chain between Layer3 will have the characteristics of trustlessness, speed and cheapness, so it can be considered that the liquidity between Layer3 is shared. From the perspective of interoperability, the functions brought by Layer3 and Cosmos are almost the same.

The LK Venture investment research team believes that the biggest difference between Layer3 and Cosmos is its binding with the Ethereum ecosystem, which is both an advantage and a disadvantage.

When it comes to advantages, it mainly lies in the huge liquidity and user volume of the Ethereum ecosystem.

Although Cosmos has powerful technology and is the first choice for many giants to launch chains, it still cannot escape the fate of low market share. According to DeifLlma data, as of June 26, 2023, Ethereum's TVL is $26.2B, while the entire Cosmos ecosystem adds up to only nearly $1B. For Layer3 to succeed, the Ethereum ecosystem is a key factor.

When it comes to disadvantages, it mainly lies in the high degree of binding with Ethereum and the loss of some sovereignty.

For the use of Cosmos chain, the token model is completely designed by the project party according to the needs, and the token empowerment is strong. However, the native token of Layer3 chain will be restricted by Ethereum. Although the project party can empower the native token as a Gas token, it is undeniable that the final transaction data submitted to Ethereum consumes $ETH. Therefore, if the Gas token is not $ETH but a native token issued by itself, the project party needs to continuously convert the native token into $ETH for submission, and the final empowerment is still transferred to $ETH.

Another feature of Layer3 is that anything done on Layer3 can actually be migrated to Layer2, which only depends on the choice of the DA layer.

If Layer2, which Layer3 relies on for settlement, has a security vulnerability or its activity decreases, Layer3 can migrate to other Layer2s at a low cost, or even directly rely on Layer1 for DA and settlement, becoming Layer2. Due to its high degree of binding with the Ethereum ecosystem, many innovative ways of playing may be born on Layer3.

Prospects from Layer3 to LayerX

Current Status of Layer3 Development

On June 22, Offchain Labs released a tool for issuing Arbitrum Orbit Chain. Orbit Chain is a Layer3 on top of Arbitrum Layer2, and can choose to use one of the three Layer2s, including Arbitrum One, Arbitrum Nova, and Arbitrum Goerli, for settlement. Users can choose to use Rollup or Anytrust technology. The difference is that Anytrust uses DAC instead of submitting transaction data to the chain, which is cheaper but less secure. The advantages of Orbit Chain are its simple chain issuance process, interoperability with the Arbitrum ecosystem, instant updates of Nitro, and EVM+ compatibility provided by Stylus (supports Rust, C, C++, and runs on WASM virtual machines). Users can issue any Orbit Chain without customization, but must settle on Arbitrum Layer2, otherwise they need to contact Offchain Labs or Arbitrum DAO for authorization.

On June 26, zkSync published an article announcing that it will modify the existing open source code in the next few weeks and launch ZK Stack, allowing users to use its customization to build their own ZK super chain. Unlike Arbitrum's Orbit Chain, ZK Stack emphasizes sovereignty and interoperability. Users can fully customize it according to their needs. Chains built with ZK Stack can achieve bridgeless interoperability. ZK Stack can be used to build both Layer2 and Layer3. The official has not restricted it and does not require settlement on zkSync. From this point of view, the sovereignty provided by ZK Stack seems to be stronger.

As the first team to propose the concept of Layer3, StarkWare is also vigorously cultivating the development of Layer3 in its Starknet ecosystem. Madara is testing the public Stack. In the @PragmaOracle hackathon, a team used Madara to complete the issuance of the application chain within 24 hours. However, since Starknet uses a unique zk-STARK proof technology, the technical maturity is relatively low, and it may take longer to develop to improve the product before releasing the Starknet Stack to the public.

The current Layer3 ecosystem is still in its early stages, but with the launch of various Layer2 convenient chain-issuing tools, it is believed that Layer3 will be officially operational soon. As the infrastructure gradually improves, how to attract users has become the most concerned issue for all chains.

Layer3 is here, is LayerX far behind?

From a technical point of view, Layer3 can no longer achieve a performance leap through simple stacking. Of course, Layer3 can obtain specific advantages through customization, but the loss of versatility will make further stacking difficult. Of course, this hierarchical stacking can be carried out indefinitely as long as you are willing, but the LK Venture investment research team believes that at present, this stacking cannot meet any needs and will cause the complexity of the system to increase geometrically.

The most important point is that although the ecological connection between Layer1-Layer2-Layer3 is close (Ethereum ecology) and the interoperability is stronger than that between traditional heterogeneous chains (cross-chain is cheaper), they still cannot achieve complete ecological inheritance. Contracts deployed on Arbitrum One cannot be directly called on Orbit Chain; the liquidity of DEX deployed on zkSync cannot be directly aggregated to ZK Stack.

The current situation is that the mall has been built and is getting higher and higher, but there are not many vendors and customers. Although the first floor is crowded with merchants (Ethereum), people are still reluctant to go to the high-rise malls to consume, because the number of vendors on the high floors is not as many as on the lower floors.

Therefore, the LK Venture investment research team believes that before blockchain technology is applied on a large scale, it is probably difficult for Layer3 to obtain a high number of users. As for Layer4, Layer5...LayerN, even if there are specific needs for individual applications, I believe they will not be promoted under the banner of LayerN.

An old saying goes: Tao begets one, one begets two, two begets three, and three begets all things. Will the narrative of Ethereum's expansion end at Layer3? It may take time to verify.

About LK Venture

LK Ventures is a crypto investment and research institution under Linekong Interactive (08267.HK) focusing on the Web3 field. Formerly known as Consensus Lab, it focuses on investing in cutting-edge infrastructure, trading platforms, technical protocols and financial instruments in the market. It has invested in more than 100 projects from North America, Asia, Europe and other countries and regions, including FTX, Polkadot, Filecoin, Casperlabs, Coin98, etc.

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