The rapid growth of the decentralized finance sector (DeFi) took a shock after the recent 17.5% drop in Bitcoin (BTC) price. However, it is likely that the DeFi sector will continue to grow as Bitcoin recovers, especially as users continue to look for high-yield strategies as a means to earn interest on their Bitcoin and crypto holdings.
If the sector continues to grow as it did in the first half of 2020, the Ethereum network will find itself between a rock and a hard place. In recent times, the network has shown several symptoms of being overloaded and unable to scale.
These symptoms include exponential increases in gas usage which lead to higher fees and slower confirmation times. This in turn has made some smart contracts pretty too expensive to use and also causes significant challenges to leveraged DeFi investors and borrowers who are unable to quickly adjust their collateral to avoid liquidations.
Clearly, there is a need for viable solutions that can help sustain the growth of DeFi. The nascent sector is undoubtedly one of the most promising facets of decentralized blockchain technology and is certainly the biggest use case for the Ethereum blockchain at the time. So much so that Uniswap is the biggest gas guzzler on the network followed by Tether (USDT), according to onchain data resource, ETH Gas Station.
In order to scale the network and ensure its long-term success, the Ethereum development team has been working on Ethereum 2.0. which would bring a completely new version of Ethereum to reality, turning it into a proof of stake network with multiple side chains that can work simultaneously to improve transaction throughput and scalability.
What are layer 2 solutions and how do they work?
Ethereum 2.0. has recently begun testing on the Medalla testnet but after a bumpy launch there is still a long way to go before it can be used. Vitalik Buterin has also recently stated that the project has revealed itself to be harder to execute than anticipated.
While layer 2 solutions are often referred to as one of the possible solutions and many are already available to use, they are often overlooked and hard to grasp.
Layer 2 solutions work like an additional blockchain that works in tandem with the main network in order to save space. In these “second layers” transactions can be bundled before being broadcast to the Ethereum network, saving on fees and space.
While layer 2 solutions are currently available, they haven't been widely used by the community. Ilya Abugov, open data lead at analytics platform DappRadar, told Cointelegraph:
“It doesn’t feel like there is a lot of adoption of these layer 2 solution taking place. I think the market is waiting to get clarity on Ethereum 2.0. If there are more delays then there may be more engagement from DeFi dapps, otherwise they’ll spend their efforts on Ethereum 2.0 integration.”
What are the current options?
There are multiple layer 2 solutions available or being worked on with some of the most popular iterations being OMG, Loopring and ZKsync. Although these projects work with the same premise they employ the concept in different ways.
The OMG network focuses on transactions and allows up to 4,000 transactions per second (TPS) while still maintaining the security of the Ethereum blockchain through smart contract technology.
The OMG network caters to developers and companies, offering significantly reduced business costs to operate on Ethereum.
Tether has recently integrated with the OMG network and this development was followed by a sharp rally from the OMG/USDT pair. OMG Network COO, Stephen McNamara told Cointelegreaph:
“The OMG Network supports fast, cheap and safe value transfer of ETH and any ERC-20 token. By moving token transfers to OMG Network, other more experimental and expensive smart contract services can continue to run on Layer-1. Integrating with the OMG Network allows for transaction fees as low as a few cents and validation time of a few seconds while maintaining Ethereum-level security.”
OMG daily performance. Source: CoinMarketCap
The OMG token is the native network token and it is required to interact with the network. After the Tether integration the OMG/USDT pair saw a massive increase in August right as Ethereum fees reached record numbers. According to data from CoinMarketCap, OMG reached its all-time high of $7.37 on August 21, roughly a 340% rally.
Loopring on the other hand focuses on increasing the transaction throughput on the Ethereum blockchain for decentralized exchanges, allowsing for 2,500 TPS. The network uses zkRollup technology to power its protocol and the native LRC token is also an ERC-20 token that can be staked by holders to earn protocol fees. Lately, LRC has also performed well, rising from $0.13 to $0.25 in the month of August.
Investors might conclude that the strong performance seen from each of these tokens in the month of August is significant as this coincides with DeFi reaching peak activity. This shows the growing demand for cheap transactions on the Ethereum network, which in turn creates demand for these layer 2 tokens.
DeFi scaling is the next frontier
While the layer 2 solutions can certainly help Ethereum scale, there are still many challenges ahead and it will take some time for users to interact with these options. However, if the DeFi sector resumes its parabolic growth rate, there will be an urgent need for solutions and this may kickstart the use of protocols like OMG and Loopring.
As Ethereum co-founder Vitalik Buterin stated in a recent tweet, the options are there, they just need to be used. Buterin said:
“To those replying with "gas fees are too high", my answer to that is "well then more people should be accepting payments directly through zksync/loopring/OMG". Seriously, scaling to 2500+ TPS for simple-payments applications is here, we just need to... use it.”
Nevertheless, there are still challenges for these projects, namely adoption and ease of use. McNamara told Cointelegreaph:
“Our primary focus at the moment is on growing the B2B market, that includes helping exchanges, wallets, and market makers to enable integration with the OMG Network. At the moment, end user adoption sits with the exchanges themselves as they need to ensure the UX is smooth to transition into and out of Layer-2.”