Why are layer 2 protocols important?

Finding new profitable investment ideas is a never-ending task facing any investor or allocator. While Bitcoin and ETH dominate the cryptocurrency discussion, the opportunity for investors goes far beyond that.

However, some candidates are intrinsically related to the Bitcoin and Ethereum blockchains due to the need to enhance the functionality of these networks. Bitcoin and Ethereum are referred to as Layer 1 (L1) protocols, while L1 scaling efforts are referred to as Layer 2 (L2).

The value of L1 comes from the “block space”, which is the territory where information or smart contracts exist on the blockchain. BTC, ETH and other L1 tokens are priced based on block space requirements. They can be likened to tickets to a prom, they cost more when more people want to attend, and the reason to buy them early is that you expect the price to be higher later on as everyone rushes to buy them.

Bitcoin allows anyone to participate in peer-to-peer transactions, and the price of BTC rises as demand increases. Ethereum and similar L1 protocols give everyone access to smart contracts, decentralized finance protocols, and ultimately things we can’t yet imagine. Likewise, the price of ETH and such tokens move in tandem with demand.

But block space is limited. Ethereum – L1 is based on the largest smart contracts and cannot handle the “huge” transaction volumes in the financial sector. The network can process dozens of transactions per second, far behind Visa or the New York Stock Exchange. This is a major obstacle for DeFi to take over traditional financial tasks.

layer 2

Transactions per second | Source: Ledger Academy

So if the L1 agreement is an auditorium where everyone rushes into it, imagine a long queue in front of the gate, and the entrance fee skyrockets. This is where L2 comes in. They are like an extra room in a meeting. If you can’t get into the main auditorium to watch the live broadcast, you can go into the adjoining room, where the lecture is being played on TV screens, and meet the other attendees.

L2 is similar. This is where transactions can be offloaded from L1 for faster and/or cheaper processing, but essentially transactions are still linked and can be fed back to L1. If L1 is the auditorium that people want to enter directly, then L2 represents another way to enter the interior, allowing more access and reducing congestion.

For Ethereum, well-known L2 protocols include Polygon, Arbitrum, and Optimism. For Bitcoin, there is stack.

Like L1, L2 protocols typically have their own native tokens that serve as incentives for using the network. So L2 is an investment in infrastructure that allows for easier access to the main auditorium while giving developers space to build new and useful things.

Here are some L2s that stand out in the field today:

Year-to-date earnings | Source: TradingView

Polygon is the first L2 platform that most people think of. As a scaling system, the platform allows developers to build decentralized applications on top of Ethereum. It’s worth mentioning that Polygon is much faster, capable of processing around 65,000 transactions per second compared to Ethereum’s 30. JPMorgan drew more publicity last year when it used Polygon for DeFi transactions. The network’s native MATIC token currently has a market cap of $8.7 billion and revenue of $47 million. Year-to-date, MATIC is up 48%.

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MATIC 1-Day Chart | Source: Tradingview

Immutable X acts as a scaling system for NFTs to address high gas fees and slow processing times. The project’s native token, IMX, lags far behind MATIC in terms of market capitalization, at $785 million. Still, this discrepancy highlights MATIC’s massive market share and potential opportunity for smaller tokens. Year-to-date, IMX is up 173%.

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IMX 1-day chart | Source: Tradingview

Stacks has exploded in popularity over the past month or so. While Polygon and Immutable X help Ethereum scale, Stacks is focused on Bitcoin, enabling NFTs on the leading blockchain called Ordinals. In other words, Stacks extend the limitations of Bitcoin beyond peer-to-peer transactions. And for good reason, this caught the attention of the crypto community. As a result, the native token, STX, leads all tokens with a market cap above $1 billion in year-to-date performance (up 254%).

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STX 1-day chart | Source: Tradingview

The list of L2 certainly does not end there. Optimism (OP), Loopring (LRC) and many other projects aim to increase the utility of the cryptocurrency ecosystem. Additionally, Arbitrum is gaining massive traction as L2 Ethereum, even surpassing Ethereum in transaction volume in the last 24 hours.

The success or failure of these projects will be determined over time, but the impact, opportunity and impact they bring will surely leave an indelible mark.

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According to Coindesk

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