DeFi continues to advance, despite current price weakness and volatility

Insights

Written by
Graeme Taylor, Matyas Karacsonyi, and Justin Trinkley

Published

July 14, 2022

While the volatility of token prices has commandeered much of the blockchain spotlight, the rapid technological advancements in distributed ledger technology has been left largely unsung.

Blockchain engineers have rapidly developed solutions and innovations to deal with the challenges of creating systems that are scalable, secure, and decentralized. Some of these changes have taken shape in a series of layers, created over time to improve the efficiency of distributed ledger systems. Layer-2 solutions work through batching multiple operations in a single database transaction on the L1 blockchain through the use of rollups, effectively reducing transaction costs. Such advancements have made it possible for developers to incorporate characteristics of complex capital transactions into their protocols, leading to a number of successful borrowing and lending platforms that mirror the traditional financial industry. 

As DeFi protocols have grown in complexity and size throughout the 2020 “DeFi Summer”, the limits of many layer-1 blockchains were pushed to the brink. As DeFi made blockspace scarce, subsequently high transaction fees presented a problem. Layer-2 solutions were developed as the answer. Such efficiency improvements, brought on by the adoption of Layer-2 solutions, have allowed for DeFi to continue scaling without crowding out retail users.

Layer 2s and Rollups

  • Layer 2s are secondary systems that sit on top of already existing blockchains, particularly those that suffer from throughput issues 
  • A few notable layer-2s are Polygon, Arbitrum, and Optimism 
  • Layer-2s are powered via rollups, which convert large volumes of transaction data into better sized batches
  • These rollups can take data from a variety of transactions and “roll them up” into a single layer-1 transaction
  • Layer-2s such as Abritrum and Optimism have far cheaper gas fees than Ethereum becauseLayer-2’s split up the Layer-1 transaction load and optimize how they compute individual transactions. Once the Layer-2 transaction process has “finished", only a single transaction will be written to the Layer-1 in a bundle.

Two of the most significant rollups are Optimistic Rollups and Zero Knowledge Rollups

  • Optimistic Rollups: Optimistic rollups (pictured below) assume neither party is a bad actor (whilst incentivizing a third party to note potential malicious action), acting as a notary to the transaction. Optimism processes transactions off chain, and periodically writes the batches of processed transactions back to the Layer-1 chain as a single transaction. By bundling multiple transactions from the crowded Layer-1 to multiple less crowded layers, Optimistic Rollups greatly reducing the cost associated with processing them 
  • Zero-Knowledge Rollups (zk-Rollups): Like Optimistic rollups, Zero-Knowledge Rollups (zk-Rollups) (pictured below) will process transactions off-chain and “roll them up” into batches before posting them to the Layer-1 chain. Unlike Optimistic rollups, zk-Rollups do not need any incentive structure to flag wrong actions, as they use mathematical proofs to guarantee that every transaction that was executed in the batch on the Layer-2 blockchain was executed correctly.

On Optimistic Rollups:

  • Because Optimism rollups don’t run computations, they have a fraud-proof mechanism that triggers upon a transaction being challenged. Because of the fact that wrong data could be written on the Layer-1 blockchain in Optimistic rollups, there is a need for a delay period before transactions are submitted to the Layer-1 blockchain. During that delay period incentivized actors can flag wrong transactions and get rewards if they do so. This challenge period is necessary due to the incentive structure for third parties to flag malicious transactions.
  • This means that Optimistic rollups can be slower in their transaction times than zk-Rollups, if they are challenged
  • Optimistic rollups are capable of directly executing layer-1 smart contracts; however, zk-Rollups cannot
  • Per Optimism’s development team, “Optimistic rollups can offer up to 10-100x improvements in scalability dependent on the transaction. This number will increase even more with the introduction of shard chains as more data will be available if a transaction is disputed.”

Optimistic Rollups

On zk-Rollups:

  • zk-Rollups create a cryptographic validity proof that is used to verify the transaction
  • zk-Rollups function through the utilization of Transactors and Relayers:
  • Transactors create and broadcast transactions to the network
  • Relayers collect the transactions and then create rollups using Zero-Knowledge Succinct Non-Interactive Argument of Knowledge (zk-SNARK) proofs which compare the blockchain state prior to and after the transaction in question
  • zk-SNARK creates a verifiable hash for each transaction that is sent to the mainchain
  • While zk-Rollups are faster than Optimistic rollups, the proofs it uses for verifying transactions require large amounts of hash power to compute. Thus, blockchains with lower levels of activity might be better fit using Optimistic rollups

zk-Rollups
Since their release, two of the largest layer-2s (Optimism and Arbitrum) have steadily cut into Ethereum’s dominance of Daily Transactions on the blockchain

What Does This Mean for DeFi?

The advancement of layer-2 solutions for blockchains in recent years has broad implications for the DeFi industry:

Non-Fungible Tokens (NFTs):

  • Layer-2 solutions have major implications for NFTs. The gas and minting fees for layer-1 based NFTs have notoriously been an issue, as the incentive to create and trade NFTs is curved when the cost of doing so rises too high

With a layer-2 solutions: 

  • Users can exchange their NFTs peer-to-peer (P2P) without paying gas fees 
  • Carbon emissions that result from gas fees are reduced (as lower gas fees means less energy is used in the transaction)
  • Example: Immutable X looks to solve those issues using layer-2 solutions; with the goal being to reduce the minting and trading costs of NFTs while maintaining the same level of security

Decentralized Applications (DApps):

  • Decentralized Applications (dApps) are one of the core creations to come out of distributed ledger technology. A dApp is simply an application that runs on a blockchain and is powered by smart contracts
  • Layer-2 solutions make dApps cheaper and thus has the potential to make the widespread adoption of dApps more feasible
  • Example: Quickswap is a decentralized exchange (DEX) based on Ethereum, and it is powered by Polygon’s Layer-2 infrastructure. As a result, users of QuickSwap can trade any ERC20 asset at close-to-zero gas costs and at fast speeds. Without layer-2 solutions, a dApp such as QuickSwap would not be able to exist in its current form

Challenges

Layer-2 solutions come with their own unique set of challenges and problems. Differing methods of delegating trust are found across Layer-2’s:

  1.  zk-Rollups are trustless systems 
  2. Optimistic Rollups entrusts verifiers with the ability to submit a fraud proof of a transaction they determine to be suspicious.   

Some of the largest hacks in digital assets have occurred on side-chains that share Layer-2’s goal to reduce transaction costs. One advantage that Rollups have compared to side chains is that they use the underlying Layer-1 chain to secure and verify the transaction. How different Rollups are secured and verified depend on each individual implementation of a Layer-2 solution, with some being more centralized than others. 

Another challenge that Layer-2 solutions face is the necessity to prove what specific types of transactions happened on Layer-2’s. On the Layer-1 chain, only the aggregated results of all transactions are visible. Thus, auditing a full transaction chain that involves Layer-2’s is not possible end to end by only looking at Layer-1 transaction indexers.

Identifying security and operational improvements for Layer-2 solutions is of key importance for developers looking to build a robust and secure system that enhances the utility of blockchains.

Conclusion

Layer-2 solutions have massive implications for DeFi and distributed ledger technology, as they utilize concepts such as rollups to overcome the limitations of the first designs of distributed ledger systems. While there remains a host of fixes and improvements necessary for the security and utility of Layer-2 solutions, their benefits – reducing fees, cutting down on latency, and increasing network capacity – are making DeFi activity viable on the large scale to which it has grown, with billions of dollars of value distributed across DeFi protocols. 

Whether digital assets are in a “bull market” or a “bear market”, developers will continue to build upon and improve blockchains, and the resulting advancements in efficiency will enable further growth of the DeFi ecosystem.

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