Layer 2 vs Sidechains | XSN Research
Bitcoin holds value in the hundreds of billions in its blockchain, and because of this it is widely regarded to be the most secure and tested public codebase ever to exist. There are clear limits to the on-chain scalability however and you are starting to see increasing needs for what are called Layer 2 (L2) solutions. Layer 2 occurs when you “Lock” funds usually as collateral, state channels, or in some other form using on chain smart contracts.
The contracts are created on Layer 1 of the native chain (directly supported by the underlying chains security) so although they are a able to have different traits (L2 tx’s are instant for example) users hold the same strength of ownership as any on-chain transaction. In all chains, including more complex ones where you find smart contracts, DAPPs and thriving ecosystems with huge appetites for tx throughput we see clear future growth of L1 + L2 in unison. One good example of this is the Ethereum blockchain.
ETH is a trial tested novel successor to BTC, even with ETH 2.0 and the scaling planned, due to the use of smart contracts/ DAPPs layer 1 has an ever increasing demand for higher throughput. When you consider the potential demand to disrupt not only global finance but an ambitious space such as IOT, scalability needs are virtually limitless leading to growth and demand for a strong L2 ecosystem. This crowding effect is already taking place with on chain DEX’s and DeFi which although nascent have had visible effects to longer confirmation times and higher gas prices on ETH’s first layer.
With that being said, it is also important to differentiate L2 with what are called “sidechains” or “pegs” seen in many DEX’s as “wrapped” assets. Layer 2 protocols such as Lightning (BTC) and Raiden (ETH) as mentioned earlier are backed by the chain itself. There are also other solutions such as cross chain “wrapped” assets (with the exception of WETH which is backed by its own ETH chain) that depend on a sub chain or side chain for consensus which results in an inherent loss of security, as opposed to L2 protocols mentioned above.
Sidechain networks and oracles for wrapping BTC or ownership of assets could be akin to holding gold in a strong, stable country, then the owner deliberately puts it through a contract where ownership depends on an external (smaller) government. If by chance this 3rd party (smaller, less stable) country gets corrupt, invaded, or dishonors its contracts ( Hong Kong or Venezuela in 2020) you would lose your asset. The question then becomes is this gold pegged to the smaller sub network the same asset as the unpegged native? Or does the loss of value, due to its loss of security create an inherently different asset in nature.
In conclusion we find the case of sidechains useful when usability and practicality outweigh L2. Functions such as sending, receiving, or exchanging can be done in L2 and provide far more value, however for experimental, and creative concepts where you apply consensus to real world events using oracle networks (applied to events not achievable via on chain consensus) there is great potential for breakthroughs and we look forward to seeing progress and development of both in the future.