The rise of the Layer 2s spells ends for Altcoins
Phase 1 of the Bitcoin journey is complete. For the past 10 years, the Bitcoin network has rejected questions about whether it would survive as a concept. Today we see Bitcoin cryptocurrency receiving a cash bonus as prominent institutional investors identify it as the ultimate inflation hedge. During the transition into 2021, observers turn their attention to what a financial market will look like, built around the world's first cryptocurrency.
The talk of the town last year focused on the potential of decentralized finance (DeFi) for digital assets and smart finance contracts, protocols and applications based on Ethereum. A development with just as promising potential for shaking the crypto markets is Layer 2 technologies, the overlaid network of services that expand the functions of a blockchain.
This post is part of CoinDesk's 2020 Year in Review – a collection of posts, essays, and interviews about the year in Crypto and beyond. Edan Yago is a neuroscientist and entrepreneur who dropped everything nine years ago to focus on Bitcoin. Most recently, he contributed to the Bitcoin-based DeFi platform Sovryn. Previously, Yago Cement founded DAO and Epiphyte to transfer Bitcoin worldwide.
The first Layer 2 projects were introduced this year. In fact, the co-founder of Ethereum, Vitalik Buterin, himself declared that Layer 2 is now the roadmap for Ethereum and therefore also for other blockchains. This means that other scaling solutions or ways to improve the functionality of a blockchain, such as B. Tokens – application-specific code bits – may be out of date.
Will the success of Layer 2 developments mean the demise of altcoins?
2020: The high watermark for altcoins
In the beginning there was only Bitcoin, and it did something very remarkable – it created value out of nothing. The bitcoin blockchain was designed to create only one thing – bitcoin. When others jumped on this alchemical train, a variety of alternative coins were created that were meant to work in a specific application such as healthcare, identity, or gaming. In reality, almost all of these projects went nowhere.
There was one notable exception. Ethereum and the provision of smart contracts offered real functionality, even if the results of its open system are dubious. The home currency ether is the second most popular crypto currency after Bitcoin and is growing rapidly. Ethereum's first "killer app" was the first coin offering that could create more tokens.
However, with the rise of DeFi in 2020, Ethereum's technological flaws have been fixed.
Ethereum is known for being incredibly slow, expensive to use, and inefficient, to the point where it is sometimes difficult to make a transaction at all. Frustratingly slow progress has been made on Ethereum 2.0, the blockchain upgrade to fix these issues. As a result, Ethereum developers turned to Layer 2 in 2020.
Get up, shift 2
This year the technologies around Layer 2 have matured dramatically. At Ethereum, this has taken the form of DeFi projects based on rollups (off-chain aggregations of transactions within an Ethereum smart contract) consisting of both optimistic rollups and zero-knowledge proofs or ZK rollups consist. When executing transactions as part of a rollup, only the only confirmations for Ethereum are made. This means that for the vast majority of transactions, the mother currency of Ethereum doesn't have to be involved at all. Such a step changes the meaning of the underlying chain significantly.
On Bitcoin, DeFi applications are being introduced in Lightning networks and sidechains such as RSK. 2020 was also the year in which interchain solutions such as Polkadot, NEAR and Cosmos went live as Layer 2 solutions for Bitcoin and Ethereum, which were connected via "blockchain bridges". For example, Sovryn, a decentralized Bitcoin trading and lending platform, uses Bitcoin Layer 2 technology while creating a bridge to the Ethereum ecosystem. Keeping the home currency as Bitcoin and the primacy of stablecoins lead to a solution that is faster, cheaper, safer and more user-friendly. This means that the precedence of the "chain" is rapidly decreasing.
So far, the success of a blockchain has been the number of people willing to believe in its mission. Buying an initial coin offering or token was akin to betting on that particular chain that would do well against competitors in a crowded market.
Layer 2 solutions represent a fragmentation of the chain-first approach. Since there are so many Layer 2 methods and systems and there is no clear way for the ecosystem to band together around any of them, the fragmentation will increase that we've seen this year worsen. While Layer 1 systems like Bitcoin and Ethereum have interoperable standards, Layer 2 does not. The implication is that the network effect is no longer in the chain, but in the assets. Take a look at Bitcoin and Tether in 2020. Both have massive value migrated across chains as the tokens themselves take center stage, not the chains.
In the irrelevant face layer 1, these altcoins naturally lose their justification to exist.
With increasing fragmentation, the exchange of values will increasingly be based on interoperable or "cross-communication" solutions. The different rollups may need to subscribe to a common set of standards, and those standards are the tokens or assets, rather than the chains. In this new world, altcoins will be severely disadvantaged compared to bitcoin and stablecoins. This is because altcoins were previously based on the promise of a chain with unique properties. Their existence is based on the idea that they would be the local currency for a chain that was growing in importance.
In other words, the value of these currencies stems entirely from the fact that they are the "home currency" of a chain with unique characteristics. In the irrelevant face layer 1, these altcoins naturally lose their justification to exist. Cash rewards will instead be accrued for the things that traditionally accrue cash rewards, which means wide acceptance and deep liquidity.
This trend towards irrelevance will include the ETH. People have assumed that ETH should be valuable as altcoin because Ethereum is popular. Something strange happened on Ethereum, however, as the Ethereum chain is just as valuable in the form of Bitcoin, stable coins and other tokens as it is in ether.
See also: Ethereum is launching its own ether coin, of which millions have already been sold
The dollars and bitcoins in the Ethereum chain effectively provide the ability to transfer value without the need for ETH. Smart contracts can easily be ported to another chain when tokens are transferred to a bridge (which happens when you switch to RSK, Polkadot, or a rollup). What we will see is the breakup of the Ethereum ecosystem in a world where two significantly larger currencies, dollars and bitcoin, are accepted and liquid forms of value transfer. The priority of ETH is unclear, the future uncertain.
Looking ahead, Ethereum fees are expected to get so high very soon that new and current users alike will be excluded. Some of them will give up DeFi and self-sovereignty entirely and go to exchange. Some are migrated to level 2 in the form of rollups. Some will take advantage of the interoperability offered by “bridges” via RSK, Polkadot or Cosmos.
The fragmentation of the smart contract space is expected in the near future. Instead of consolidating around the various base layer blockchains, consolidation around assets is carried out.
Tokens will thrive more than ever, but the nature of those tokens will change. Rather than trying to capture a cash reward, tokens represent other types of asset classes such as equity and debt in the form of crypto-bonds and derivatives.
See also: Edan Yago – Forget the Ethereum, DeFi is built on Bitcoin
What we will see in 2021 is that the decentralized currency system is effectively only represented by Bitcoin and stablecoins. That's it – they won this game. Now that it's game over, the next challenge will be decentralizing the financial class, and financial branding will play an important part in that. With Bitcoin we are at the end of the beginning.
Bitcoin is no longer proto-money, but is becoming the reserve currency of the future of finance. At Altcoins, we're at the beginning of the end. Bitcoin is no longer limited to a single chain, and the theory of chain-specific currencies is debunked.