Decoding blockchains: An introduction to Layer 1
- Layer 1 blockchains are the foundation of the Web3 ecosystem and the emerging internet of value.
- Bitcoin and Ethereum are the two largest Layer 1 blockchains, but both are facing scalability issues, resulting in high fees, especially on Ethereum.
- As a result, we are witnessing the emergence of newer, faster Layer 1 blockchains along with Layer 2 scalability solutions.
- As the understanding of Layer 1 is essential for all users and investors in the Web3 space, we will decode the landscape of Layer 1 blockchains in this blog.
Layer 1 blockchains such as Bitcoin and Ethereum are the foundation of the emerging digital economy. They build the infrastructure for decentralized applications (dApps) within the decentralized finance (DeFi) ecosystem.
However, as innovation thrives and advanced cryptographic breakthroughs emerge, newer, so-called alternative Layer 1 blockchains, such as Solana and Avalanche, have emerged. These have lured projects, users, developers and liquidity with lower transaction fees and faster transactions.
The race for dominance among Layer 1 blockchain networks is one of the most exciting events among cutting-edge technologies, as those who bet on the winner could see themselves owning a part of the decentralized internet of tomorrow.
As the understanding of Layer 1 networks is essential for all users and investors in the Web3 space, we will decode the landscape of Layer 1 blockchains in this blog. How do they work, what do they offer, what are their limitations, and which metrics are important to watch?
What is a Layer 1 Blockchain?
Layer 1 blockchains are capable of processing and finalizing transactions on their own blockchain. They typically have their own native coins (such as BTC, ETH or SOL) with which users must pay for transactions or the use of dApps.
To understand the basics of Layer 1 blockchain networks, let's first take a look at Bitcoin's inception.
The Bitcoin network
In 2008, Satoshi Nakamoto proposed a digital scarcity concept that would serve as the foundation for his vision of a “peer-to-peer electronic cash system”.
In simplistic terms, the Bitcoin blockchain is a growing decentralized public ledger, shared across a network of computers, that users can utilize to process transactions without the involvement of a centralized third party.
Each new transaction is recorded in a new block, with all blocks immutably linked together to form a blockchain.
Bitcoin's Proof of Work consensus mechanism
To ensure the network's security, new transactions are verified by miners, who secure the blockchain network in exchange for fees and newly issued BTC.
This built-in incentive mechanism has worked astonishingly well since its inception. Today, Bitcoin is known for being the most secure blockchain in the digital asset space, with security ensured by the network's hashrate.
Hash rate refers to the total amount of computing power used to process transactions on a PoW blockchain. Miners compete to “guess” a hash (a fixed-length alphanumeric code) that is equal to or lower than a target hash in exchange for block rewards, which are paid out for each new block added to the blockchain. Blocks added to the blockchain validate the new transactions stored in that block.
Bitcoin's Proof of Work (PoW) consensus mechanism is often criticized for being too energy intensive. However, some argue that Bitcoin mining in fact supports the transition to renewable energy, as it often uses surplus energy from renewable energy sources to find the least expensive energy.
In our blog post "Could Bitcoin green the planet?”, we explore how Bitcoin could help reduce carbon emissions in more detail.
Proof of Work vs Proof of Stake
Next to PoW, Proof of Stake (PoS) is the most used consensus mechanism, known for securing and validating transactions of blockchains such as Ethereum, Polkadot, Cardano, Binance Smart Chain, Tron and Solana.
While Bitcoins' PoW mechanism is the oldest and therefore most tested and secure consensus protocol in the space, PoS is now favored by almost all emerging Layer 1 blockchains.
The Merge – Ethereum's transition to Proof of Stake
Ethereum, which was secured by PoW until 15 September 2022, has just transitioned from a PoW to a PoS blockchain and thereby reduced its energy consumption by around 99.95%.
This is because PoS does not require miners to solve complex mathematical problems. Instead, participants have to lock or “stake” the native token of the blockchain in order to validate new transactions.
The result: PoW blockchains are secured by the energy consumption of the miners, while PoS networks are secured using the capital of the validators.
For those looking to deepen their knowledge of consensus mechanisms, we have covered everything you need to know in our detailed blog on PoS vs PoW.
How to use a Layer 1 blockchain? – Public and private keys
To use a public Layer 1 blockchain network, users simply need to create a Web3 wallet, which can be downloaded as a browser extension or decentralized app (dApps) on a smartphone.
To have control over the wallet and conduct transactions, users need to be in possession of the private keys to the wallet, similar to a password.
To receive funds, users need to share their wallet address, which is safe to share with a counterparty.
In contrast to the Web2 experience, users won't need to create an account when they wish to use a Web3 dApp. It is sufficient to connect the Web3 wallet with the dApps in order to use it.
However, most of these dApps are not based on the Bitcoin network. Bitcoin was solely designed to be the most secure distributed monetary network and, except for its scaling solution, the Lightning Network, has little room for innovation (more about blockchain scalability later).
This is where Ethereum comes in, which turned the industry upside down with the introduction of its smart contract functionality.
Smart contracts – Enabling applications on Ethereum
Technically, smart contracts on Ethereum are no different than another type of user account. However, once deployed on the blockchain, they are not controlled by a user but run autonomously.
Decentralized exchanges (e.g. Uniswap), lending protocols (e.g. Aave), stablecoins (e.g. Maker DAO's DAI), and even Layer 2 blockchains are all built using smart contracts.
The cause and solution for network congestion
The main features of smart contracts are automatic execution, predictable outcomes and the public record of transactions (as they are stored on public blockchains).
As our modern society is built upon agreements recorded in contracts, the potential to digitalize and automate the execution processes is tremendous.
As a result of this innovation, thousands of dApps have already been deployed on Ethereum, attracting vast amounts of liquidity. This has led to the emergence of decentralized payments, lending and credit platforms, but also digital art and decentralized autonomous organizations (DAOs), which quickly congested the Ethereum network, causing fees to soar to astronomical highs.
One solution to this scalability dilemma comes in the form of Layer 2 blockchains, which are also built using smart contracts. These blockchains execute transactions in batches before deploying the results in a single transaction on Layer 1.
It is believed that the synergy between Layer 1 and Layer 2 blockchains could be the solution that will scale blockchain technology and prepare it for mainstream adoption. As such, we will dedicate our next blog in this series to focus entirely on these cutting-edge scaling solutions.
However, because much is at stake, namely to provide the infrastructure of the emerging internet of value, many other alternative Layer 1 blockchains have been built to compete with Ethereum, offering higher throughput and cheaper gas fees.
While it is impossible to predict which of these blockchains will dominate the space in the coming years, there are some important metrics to watch in order to stay on top of the developments in this industry.
To get started, let's take a look at the seven largest Layer 1 blockchains by market cap.
Top layer 1 blockchains by market cap
The older and more established blockchains, Bitcoin and Ethereum, have proven their credibility and security and have the highest market cap in the ecosystem, while newer blockchains will still have to prove themselves.
For example, the market cap of Solana is around 29 times smaller than that of Bitcoin and Ethereum. Even Binance Smart Chain, which is the third largest blockchain network in the world by USD market cap value, is still three times smaller than Ethereum and seven times smaller than Bitcoin. However, this provides these smaller, challenger blockchains with more opportunities to grow.
Fully diluted valuation (FDV)
When comparing the tokens of Layer 1 blockchains, it is important to understand how the supply of those tokens is likely to change in the future. A metric that can be used to gain insight into this is the fully diluted valuation (FDV) - calculated by multiplying the token price by its maximum supply.
If we divide the market cap by the FDV, we can extract the percentage of tokens that has already been released to the market. The higher the value, the less likelihood that the token will be devalued over time.
Layer 1 blockchain ecosystem by FDV
- With around 19 million tokens, Bitcoin has reached around 91% of its total supply cap of 21 million BTC.
- Ethereum has implemented a dynamic supply function. As the base fees users pay for transactions get burned (destroyed), increased activity on the network reduces the supply of the ETH token. On 9 November 2022 Ethereum officially turned into a deflationary asset.
- Unlike all the other blockchains listed, Solana has an initial total supply of 500 million tokens and has no cap on the maximum supply.
In general, high transaction fees on a Layer 1 blockchain network are seen as a problem, especially on Ethereum.
Yet while it is true that high gas fees exclude some users from participating in the Layer 1 blockchain, which may lead them to switch to another ecosystem, they also symbolize trust in the ecosystem. The willingness to spend hundreds of dollars on a trade can be seen as a premium for Ethereum's high level of security.
Total value locked (TVL)
Another important metric to keep an eye on is total value locked (TVL) - the cumulative worth of all crypto assets that users have deployed into DeFi protocols on a blockchain. This indicates the overall health of a particular blockchain.
As DeFi first emerged on Ethereum, it is no surprise that it has the highest TVL in the ecosystem, making up more than 58% of total DeFi TVL at the time of writing (around $25 billion, as of 15 November 2022).
Binance smart chain (11.23%, $4.82 billion) and Tron (10.09%, $4.33 billion) are the two major Layer 1 protocols that have taken substantial market share from Ethereum to date.
Other blockchains competing for TVL include Polygon, Arbitrum and Optimism - these are all Layer 2 blockchains settling on Ethereum. As such, the combined market share of Ethereum's entire network is 64.59%.
Since Bitcoin is lacking smart contract compatibility, DeFi has not yet emerged on the world's largest blockchain.
The activity of blockchain developers is critical to the success of blockchain networks, as a platform without developers may struggle to grow.
As the first blockchain to introduce smart contract compatibility, Ethereum was the foundation for the early innovation of the industry.
After seven years, it still attracts developers with extensive developer tooling and a supportive community, which counts around 4,000 active developers today.
However, as the graphic below shows, Polkadot and Solana are on a similar path and therefore have the potential to see exciting future innovations.
Source: Electric Capital
TPS and scalability solutions
Blockchain scalability is expressed in the transaction speed of the network and its throughput (number of transactions per second) that can be implemented without increasing the cost of validating the transactions.
However, the metric often used to compare blockchain throughput is the official number of transactions per second (TPS), not the realized TPS.
Solana, for example, boasts a capability of 65,000 TPS. However, it currently averages at around 2,000-3,000 TPS. While outpacing Ethereum by far (which has around 15 TPS), Solana has experienced significant outages in recent years, for which the blockchain has often been criticized.
It is also important to note that Ethereum's roadmap, unlike Solana's, aims to scale via Layer 2 blockchains, which execute multiple transactions before deploying the state to the main chain of the underlying blockchain protocol. Learn more here.
Scaling the Bitcoin network
Interestingly, Bitcoin's lightning network – its own Layer 2 scaling solution – is theoretically capable of processing 1,000,000 TPS.
This, however, only applies to payments, which are less complex than most applications on other Layer 1 blockchains.
Layer 1 blockchains are the foundation of the Web3 ecosystem and the emerging internet of value. Their native tokens serve as the digital currency used in all applications running on the blockchain and to pay transaction fees.
Just like central banks, Layer 1s have their own kind of monetary policy that impacts the revaluation or debasement of their currency.
While fees are a burden for some users, they also reflect the sustainability of an ecosystem, as they allow rewards for validators via a yield to secure the network. These are similar to interest rates on a bank account. However, if transaction fees are burned (destroyed), it can prevent the debasement of the on-chain currency which will be reflected in a token's FDV.
Additionally, metrics like TVL and developer activity are helpful to analyze the growth prospects of these ecosystems.
While TVL reflects the overall health of the DeFi ecosystem on a Layer 1 blockchain, developers are ultimately the ones who will build the next generation of dApps which will attract new users to Web3, ensuring healthy future growth.
While we are witnessing a race for scalability and adoption, it is likely that we will see multiple chains co-existing with each other. As such, interoperability could become one of the hot topics in the coming years.
However, to date, none of the Layer 1 solutions would not be capable of onboarding mainstream users and applications due to scalability issues. Layer 2 chains have emerged to solve this scalability dilemma. This will be covered in depth in the second part of our "Decoding blockchains" series: An introduction to Layer 2.