Ethereum, the Mille-Feuilles Blockchain

Ethereum’s initial goal to become a ‘world computer’ has evolved due to limitations caused by the blockchain trilemma, a concept formulated by its founder Vitalik Buterin that suggests protocols can’t combine scalability, security and decentralisation. Instead, they have to make a tradeoff, which means prioritising two of these features.

Layer 2s (L2s) are one of the solutions developed to address the trilemma. This article explains how L2s scale Ethereum, a pioneer in blockchain functionality and the second-biggest protocol by market capitalisation, and what impact they might have on its future.

Ethereum History and Architecture Reminder

Ethereum was introduced in a whitepaper published by Vitalik Buterin, who was at that time a newcomer but has since become one of the most respected voices in the crypto space. Whereas bitcoin’s blockchain was designed to process transactions, Vitalik outlined a vision for a protocol bringing greater functionality to the technology through the use of smart contracts, programs that automatically execute when preconditions are met.

The Ethereum Virtual machine (EVM) is the engine that executes smart contracts and updates records, such as wallet balances. It operates across thousands of computers known as nodes, which run the software and help to secure the network. Other protocols like Binance Smart Chain and Avalanche integrate the EVM to leverage its functionality and tap into its ecosystem of developers and users.

Ethereum held an initial coin offering (ICO), the crypto version of a public offering, between July and September 2014. The ICO raised over $18 million through the sale of ether, the protocol’s native token. The blockchain launched in July 2015, initially relying on the same ‘proof of work’ consensus mechanism employed by bitcoin before transitioning to its current ‘proof of stake’ mechanism in September 2022, an event dubbed the Merge by the crypto community.  

The protocol charges fees, referred to as gas fees, for all operations, from simple transfers between two wallets to more complex transactions involving smart contracts, such as yield farming on decentralised finance (DeFi) apps. Users pay these fees in ether, although they’re typically measured in gwei, its smallest denomination. Validators, who are responsible for processing transactions in the proof of stake consensus mechanism, receive a share of the fees.

The cost of gas fees depends on supply and demand. If the protocol experiences congestion due to high levels of traffic, they can spike, which happened most recently in September 2024. A rush in on-chain activity from the 16^th to 26^th- incidentally with no obvious catalyst- caused gas fees to increase by nearly 500%, as reported by crypto media platform Cointelegraph.

The Birth of Layer 2s

L2s are networks built on top of a blockchain, referred to as a base layer or Layer 1, to enhance its capabilities. They leverage the security of the base layer, which verifies transaction data on behalf of the L2, such as the sender’s balance. In Ethereum’s case, scalability was the greatest challenge, so L2s ease the burden by processing transactions.

L2s come in two forms. Permissioned L2s can restrict access to approved users and specific activities. They’re typically developed for a particular organisation or ecosystem and managed by a single authority. For instance, companies like IBM or Fidelity are using Hyperledger Fabric to streamline their services and explore digital assets. Permissionless L2s, on the other hand, are open to the public and generally decentralised. 

Optimism is one of the most popular L2s built on Ethereum with $8.5 billion (as of December 2024) of total value locked (TVL), a metric used to measure the amount of funds deposited by users in a DeFi app. It uses a technology known as optimistic rollups where sequencers, similar to Ethereum validators, process batches of transactions on the network and add them to a single block, which it sends to the base layer. Crypto exchanges Coinbase and Kraken recently launched their own L2s respectively called Base and Ink, two DeFi ecosystems, using the same technology stack as Optimism. 

Other widely adopted L2s built on Ethereum include Arbitrum (TVL $21 billion as of December 2024), which also leverages optimistic rollups, and Starknet (TVL $1.1 billion), which uses rollups powered by zero-knowledge proofs, a cryptographic technique facilitating the verification of transactions without revealing sensitive data.

Looking Ahead

So what do L2s mean for the future of Ethereum? The Dencun hard fork, a network update that went live in March 2024, helped Ethereum scale by introducing a cheaper way to store transaction data. However, it was nearly too successful because it allowed L2s to increase the volume of transactions they attract from the base layer without replacing the gas fees. For context, fees fell by over 50% between the first and second quarters of 2024. As a result, CoinShares lowered its target for Ethereum’s price in five years from $8,219 to $1,541.

Nonetheless, the future still looks bright for Ethereum. According to the 2024 Developer Report published by venture capital firm Electric Capital, it’s the leading ecosystem in terms of developer activity, a key indicator of a protocol’s health. Ethereum had the biggest share of developers overall and the most active developers across all regions in 2024. It also ranked second in the number of new developers who joined the ecosystem.

In another boost for Ethereum, some of the finance industry’s major players are using its technology to tokenise funds (convert shares into tokens issued on the blockchain). At the start of December 2024, British bank Standard Chartered announced plans to launch a US dollar money market fund on Ethereum through Libeara, a tokenisation platform it launched at the end of 2023.

It’s also worth remembering that L2s need the base protocol to succeed. Even if they cannibalise transaction volume to a degree, many still rely on the security provided by Ethereum’s consensus mechanism.  

In Summary

Ethereum launched in 2015 to bring greater functionality to blockchain technology through smart contracts, which execute on an engine called the EVM. The protocol charges gas fees to process transactions which vary according to supply and demand.

The blockchain trilemma suggests that protocols must make tradeoffs between security, decentralisation and scalability. L2s help to solve the trilemma, boosting Ethereum’s scalability by easing the transaction burden.

While L2s may reduce gas fees generated on Ethereum, its future is bright given it’s the most popular protocol among developers, major financial institutions are using its technology, and many L2s rely on it for security.