In the decentralized ecosystem, a Layer-1 network refers to a blockchain, while a Layer-2 protocol is a third party integration that can be used in conjunction with a Layer-1 blockchain (Gemini).
Scalability is one of the biggest challenges blockchains face. While Bitcoin can handle 7 transactions per second and Ethereum ~30, VISA claims to manage 24k. Blockchain's throughput numbers are still far from those of traditional finance, and they will need to improve if they want to become a really mainstream alternative. The consequences of lower transaction speeds are often felt, especially in Ethereum's transaction fees.
Layer 1 and 2 are two different approaches in which the industry is attempting to increase the throughput of blockchains.
Layer 1 solutions are brand new blockchains designed with optimization as a main goal. In contrast, Layer 2 solutions are protocols built on top of prior blockchains that provide extra services to help make the chains more efficient.
Imagine the blockchain was like a concert ticket sale. A ticket sale done in a single booth, with payments were only available in cash, tickets printed on the spot and handed on paper...in other words, imagine we were in the 90s again. A long queue would form in front of the ticket booth, full of frustrated people blocking the streets.
A Layer 1 approach to solving the queue would consist of redesigning the ticket booth to make the queue move as quickly as possible: bigger spaces to attend two lines, more people in the booths, credit card payments, mobile phone wallet integrations...
A Layer 2 approach would be sending off credited salespeople to approach people in the queue to write down names and addresses of buyers and sell them IOUs that they would later exchange for actual tickets in the main ticket booth and send them through regular mail.
Layer 1 platforms include Solana, Terra, Avalanche, Binance Smart Chain... They have recently been in the list of best performing assets, showing the increasing interest from investors in smart contract platforms alternative to Ethereum. Some like to call them ETH killers, because their virtues build on Ethereum's flaws, namely transaction speed and its impact in transaction fees. An impact that has been recently felt strongly, with NFT summer pushing the boundaries of block performance. These layer 1 smart contract solutions are slowly maturing in all the aspects needed to guarantee success. The virtuous cycle of projects, funds, and talent is spinning, pushing the performance of the underlying assets (SOL, LUNA, DOT...) upwards. Layer 1 is finally the home for thriving communities of developers building DeFi and NFT projects with all the perks of new, optimized blockchains beneath them.
Layer 2 scaling solutions take work off the main blockchains through different techniques. For example, by breaking down tasks that can be settled in alternative chains and minimizing the effort put on the main ones. The Lighning Network is the most famous Layer 2 solution built on top of Bitcoin's blokchains. LN opens the door for small, quick BTC payments. Optimism or Arbitrum are some examples of successful Ethereum Layer 2 solutions. The recent onboarding of Uniswap and 1Inch on Optimism has brought great UX improvements to the exchanges.
For a more technical, in depth, view:
- Layer 1 vs Layer 2 : What you need to know about different Blockchain Layer solutions
- Understanding DeFi: Layer 2 explained
- What Are Cryptocurrency Layer 2 Scaling Solutions?