The Blockchain 101: The Layers of Blockchain — L1

Like onions, blockchains have layers. These layers can almost be viewed as different segments of the industry.

The automotive industry has engineers who design the car, third parties who sell accessories for the car and software engineers who program the car’s software. Layers refer to the different stages involved in any public blockchain.

To add to the complexity, different naming conventions may be used Layer 2 of a blockchain might be used to describe different things by different people. For the sake of simplicity, we will use the naming conventions most accepted in the industry.

Generally speaking, there are four layers to a blockchain.

Layer one (L1) is the underlying blockchain itself. Think Bitcoin, Ethereum & Solana. In our previous analogy, it is like the production of the car itself. Each brand of car is built differently, and optimised for different use cases. There are race cars, four-wheel drives and luxury vehicles. L1 blockchains are similar in that architects and engineers build protocols with different structures for different trade-offs.

Layer two (L2), is a third-party integration/network designed to improve the performance of the underlying blockchain. Think Starkware, Immutable & the Lightning Network. It is like the people who produce accessories for an existing car such as a GPS or new wheels. These third-party products will make the car faster and better at navigating. L2 networks are all about optimisation.

Layer three (L3) are smart contracts that run on top of these networks & protocols (called decentralised applications or Dapps). Think Compound, Uniswap & Synthetix. They are like the software of a self-driving car. The driver puts in the destination, and the car takes them there. This is closer to a literal description as once smart contracts are programmed, they execute automatically without any human input

Finally, Layer four (L4), is how people connect and interact with these Dapps and blockchains (the user interface layer). Think Coinbase, Binance & Metamask. This is like the steering wheel or other control tools of the car; it’s how the driver interacts with the vehicle. When people mention L4, it usually refers to the front end of a blockchain which looks and feels like a normal website on the internet.

In this article series, we will explore all four, but we will start with L1, the underlying blockchain itself. As we have mentioned previously, a blockchain is basically like a huge Google sheet that anyone in the world can add to and can trust that all rows are valid.

But it’s a bit more complicated than that… A blockchain architect must program the entire rules for the blockchain from block size, consensus mechanism to the cryptographic standard used. It’s basically a trade-off between three things — scalability, security & decentralisation. It’s almost impossible to have all three as they are often inversely correlated with each other.

Architects must choose the balance they want to achieve and the trade-off they are willing to make. Do they want to make a blockchain that is highly scalable and can handle hundreds of thousands of transactions per second but is very centralised or do they want a secure but slow blockchain? These questions can help you understand all the different types of L1 blockchains that exist.

Top L1 Blockchains:

• Bitcoin BTC

• Ethereum Ether

• Cardano ADA

• Polkadot DOT

• Elrond EGLD

• Avalanche AVAX

• Terra LUNA

• Algorand ALGO

• NEAR Protocol

• Tezos XTZ

• Solana SOL

• Cosmos ATOM

• Fantom FTM

These are just a few of the hundreds that currently exist. We are still in the early days of blockchains, and a key question is what happens to these blockchains in the future? Will there still be hundreds in 10 years time, or will there only be one, or a handful? This is a big question that all sophisticated investors are grappling with.

Note: While Bitcoin is an L1 blockchain, it’s less relevant as it is more of a store of value than a general computing platform, which most other blockchains aim to be.

Layer ones are similar to the IOS and Android platforms. The blockchain requires many developers to build applications on top of the blockchain for it to be successful. This brings end users who use apps, which in turn means they use the blockchain more. Just like Candy Crush leading to more phone usage.

Currently, Ethereum has a disproportionate amount of usage as it is the most established developer community. It’s the most popular L1 for smart applications. Its usage can be seen with over $100B locked on the platform as of late December 2021. Many think it will be the main L1 for the future.

However, many disagree. The term ‘Eth Killer’ is often used to reference new L1 blockchains that come along and have a greater value proposition in terms of scalability. Take for example Solana, it can process over 50,000 transactions per second, compared to Ethereum which can only perform about 50 a second. Although it is a long way from dethroning Ethereum it already has $12 billion locked in contracts on the platform.

It’s important to form a view of what L1s you believe will be used in the future. This is because if companies build their product on top of a particular blockchain, and then a superior blockchain comes along, competitors may build superior products simply by virtue of leveraging a different underlying technology.

Take for example a company that offers options trading on top of Ethereum. An identical company could build its options’ platform on Solana. It could offer 100x the speed and there would be nothing the original company could do to compete as it is constrained by the L1 blockchain itself.

We will touch on our view of L1’s in another post, but for now, just remember the basics.

Everything is built on top of a layer one blockchain. Each has different trade-offs based on security, scalability, and decentralisation. While there are many competing at the moment, it is likely in the future, it will consolidate to only a few that really matter. People might use a Ferrari for speed and might use an SUV for off-road. In the same sense, a government might choose to use a highly secure blockchain like Ethereum, but high-frequency traders may prefer Solana.

Aura Group subsidiaries issuing this information include Aura Group (Singapore) Pte Ltd (Registration No. 201537140R) which is regulated by the Monetary Authority of Singapore as a holder of a Capital Markets Services Licence, and Aura Capital Pty Ltd (ACN 143 700 887) Australian Financial Services Licence 366230 holder in Australia.