Edan Yago: The Rise of Layer 2 Spells Ends For Altcoins
Phase 1 of the Bitcoin journey is over. Over the past 10 years, we’ve seen the Bitcoin network dismiss the question of whether it would survive as a concept. Today we see the Bitcoin cryptocurrency earning a monetary premium as prominent institutional investors identify it as the ultimate inflation hedge. As we move to 2021, observers are looking to what a financial market built around the world’s first cryptocurrency will look like.
The city’s discussions over the past year have focused on the potential of Decentralized Finance (DeFi) for digital assets and Ethereum-based smart financial contracts, protocols and applications. Layer 2 technologies, the overlay network of services that extend the capabilities of a blockchain, is a development with equally promising potential to shake up crypto markets.
This article is part of CoinDesk’s 2020 Year in Review – a collection of opinion pieces, essays, and interviews on the year in crypto and beyond. Edan Yago is a neuroscientist and entrepreneur who gave it all up nine years ago to focus on Bitcoin. He recently contributed to the native Bitcoin Sovryn DeFi platform. Previously, Yago founded Cement DAO and Epiphyte to provide global remittances with Bitcoin.
This year saw the rollout of Layer 2 projects. In fact, Ethereum co-founder Vitalik Buterin himself has stated that Layer 2 is now the roadmap for Ethereum, and by extension other blockchains, too. This means that other scaling solutions or ways to improve the functionality of a blockchain, such as tokens – bits of code specific to an application – could become obsolete.
Will the success of Layer 2 developments mean the demise of altcoins?
2020: the high watermark for altcoins
At first it was just Bitcoin, and that did something pretty remarkable – it created value out of nowhere. The Bitcoin blockchain was designed to create just one thing: bitcoin. As others jumped into this alchemist movement, a plethora of alternate pieces were created, meant to work in a specific application like healthcare, identity, or gaming. In reality, almost all of these projects did not lead to anything.
There was one notable exception. Ethereum, and its supply of smart contracts have provided real functionality even though the results of its open system are questionable. Its native currency, ether, is the second most popular cryptocurrency after bitcoin and it is rapidly growing. Ethereum’s first “killer app” was the initial coin offering, a way to create more tokens.
However, with the rise of DeFi in 2020, Ethereum’s technological flaws have emerged.
Ethereum is known to be incredibly slow, expensive to use, and inefficient to the point that sometimes it is difficult to even get a transaction. Progress has been frustratingly slow on Ethereum 2.0, the blockchain upgrade designed to address these issues. As a result, Ethereum developers in 2020 turned to Layer 2.
Get up, layer 2
This year, the technologies around layer 2 have evolved considerably. On Ethereum, this has taken the form of DeFi projects built on rollups (off-chain aggregations of transactions in an Ethereum smart contract) comprising both bullish rollups and zero-knowledge evidence or ZK-Rollups. When executing transactions on a rollup, the only confirmations made on Ethereum are global, which means that for the vast majority of transactions, Ethereum’s native currency does not need to be involved at all. Such a move dramatically changes the importance of the underlying chain.
On Bitcoin, DeFi applications are being deployed on the Lightning network and sidechains such as RSK. 2020 was also the year of the commissioning of cross-chain solutions such as Polkadot, NEAR and Cosmos, as layer 2 solutions for Bitcoin and Ethereum connected via “blockchain bridges”. For example, Sovryn, a decentralized Bitcoin trading and lending platform, takes advantage of Bitcoin layer 2 technology while deploying a bridge to the Ethereum ecosystem. Keeping your native currency in the form of bitcoin and putting stablecoins primacy translates into a faster, cheaper, more secure, and easy-to-use solution. This means that the primacy of the “chain” is rapidly diminishing.
Until now, the success of a blockchain has depended on the number of people willing to believe in its mission. Buying in an initial coin or token offering was similar to betting on that particular chain’s success against competitors in a crowded market.
Layer 2 solutions represent a fragmentation of the chain first approach. Because there are so many Layer 2 methods and systems, and there’s no clear way for the ecosystem to merge around one of them, the fragmentation we’ve seen this year will get worse. While Layer 1 systems like Bitcoin and Ethereum have built-in interoperability standards, Layer 2 does not. The implication is that the network effect will no longer be in the chain but in the assets. Look at Bitcoin and Tether in 2020. Both have migrated massive value through the chains because the tokens themselves are the focal point, not the chains.
As fragmentation accelerates, the exchange of value will increasingly rely on interoperable or “cross-communication” solutions. The different rollups will eventually have to subscribe to a common set of standards, and those standards will be tokens or assets, rather than chains. In this new world, altcoins will be at a serious disadvantage compared to bitcoins and stablecoins. Indeed, until now, altcoins have been based on the promise of a chain with unique properties. Their existence was founded on the idea that they would be the native currency of a chain that would gain in importance.
In other words, the value of these currencies comes only from the fact that they are the “native currency” of a chain with unique characteristics. Faced with the irrelevance of layer 1, these altcoins will by nature lose their justification for existing. Rather, money bonuses will revert to the things that money bonuses traditionally accumulate, namely broad acceptance and deep liquidity.
This tendency to irrelevance will include ETH. People assumed that ETH as an altcoin should be valuable because Ethereum is popular. But something strange happened on Ethereum in that there is so much value on the Ethereum chain in the form of Bitcoin, stablecoins and other tokens, as in the ether.
See Also: Ethereum Launches Own ‘Ether’ Coin, With Millions Already Sold
Ethereum chain dollars and bitcoins do offer the ability to transfer value without the need for ETH. Smart contracts can easily be ported to a different chain when transferring tokens across a bridge (which happens if you switch to RSK, Polkadot, or a rollup). What we’re going to start to see is the breakup of the Ethereum ecosystem in a world where two particularly larger currencies, the dollar and bitcoin, are accepted and liquid forms of value transfer. The primacy of ETH is not clear, its future is uncertain.
What is coming
Going forward, it is predicted that fees on Ethereum will very soon become so high that new and existing users will be kicked out. Some of them will completely abandon DeFi and self-sovereignty and go to exchanges. Some will migrate to Layer 2 in the form of rollups. And some will benefit from the interoperability offered by “bridges” via RSK, Polkadot or Cosmos.
The fragmentation of the smart contract space is expected shortly. Instead of consolidating around the different base layer blockchains, consolidation will occur around the assets.
Tokens will flourish more than ever, but the nature of those tokens will change. Rather than trying to capture a monetary premium, tokens will represent other types of asset classes such as stocks and debt in the form of crypto bonds and derivatives.
See also: Edan Yago – Forget Ethereum, DeFi is being built on Bitcoin
What we will achieve in 2021 is that the decentralized monetary system is effectively only represented by bitcoin and stablecoins. That’s it – they won this game. Now that the game is over, the next challenge will be the decentralization of the financial layer, and the creation of financial tokens will play an important role in this regard. For bitcoin, we are at the end of the beginning.
It is no longer a proto-currency, bitcoin is becoming the reserve currency of the future of finance. For altcoins, we are at the beginning of the end. Bitcoin is no longer limited to a single chain and the theory of chain specific currencies is being debunked.