Blockchain Protocols

Blockchain protocols are critical components of a blockchain-based DLT that facilitate information sharing and dictate processes such as transaction validation, system security, the interaction of participating nodes, etc.

Legacy networks have what we call “thin” protocols and “fat” applications.

Most consumers are unaware of the underlying protocol layer’s existence, despite its tremendous value. For instance, applications like Facebook, Twitter and Google amass several billions of dollars in revenue per year, whereas the developers of TCP/IP and HTTPS make barely a single cent from every application that runs on the network they designed.

Fat protocols refer to the reversed world of blockchain, in which the majority of value is concentrated at the shared protocol level. This makes the protocol fat, while only a tiny portion of the value is allocated at the application level, making it thin.

For example, the Ethereum protocol enables cryptocurrency traders to easily switch between decentralized exchanges (DEXs) like Uniswap, Sushiswap or DODOthrough the MetaMask wallet. All these are products and services that expand the network’s functionality and more or less directly spur the cryptocurrency’s value to rise.

The phenomenon of this feedback loop follows Metcalfe’s law, which states that the value of a network is determined by its user base; the more users, the more the value it accrues thanks to a network effect.

To put everything into a nutshell: User group #n buy ETH, price up, invest in the protocol & products & service, succeed products draw more users=y, #n+y buy ETH, price up and etc....

A layer one protocol, implementation layer, refers to a system associated with the base or main architecture of a blockchain network. A layer one protocol sets the entire network’s rules and parameters, such as its consensus algorithm, block time, transaction throughput, etc.

Layer one may be preceded by a “layer zero,” which lays the groundwork for components to support a new layer above. As such, in the case of Bitcoin, layer zero comprises the hardware, internet, and other components meant to ensure the smooth operations of layer one.

Layer two protocols, also known as second-layer solutions or off-chain blockchain protocols, are protocols that sit on top of layer one networks in order to carry some of the load, providing scalability, or even interoperability, features.

Layer two protocols can handle transaction processing on behalf of the base network.

State channels are mechanisms used to allow users to directly conduct off-chain operations. They only report the results to the blockchain when a channel closes. A great example of a layer two protocol that uses state channels is the Lightning Network.

Lightning Network is a layer two payment channel operating on top of the Bitcoin blockchain, which aims to process multiple small transactions off-chain.

Plasma is a scaling solution for the Ethereum blockchain. Unlike Bitcoin’s Lightning Network, Plasma takes a different approach, as it provides a generalized framework that supports the creation of other “child chains” powered by Ethereum.

Plasma employs Merkle Trees plus smart contracts to create what are essentially stripped-down versions of Ethereum. Unfortunately, the original Plasma model was never implemented and Ethereum is now focusing on other layer two solutions like Optimistic Rollup.

Optimistic Rollup is an off-chain technology built to enhance Ethereum’s smart contracts and DApp ecosystem through scaling. Optimistic Rollup will allow Ethereum to scale to 100-2,000 transactions per second (tps), as opposed to its current 10-20 tps. Note that OR is considered to be the successor of Plasma.

The leading candidate for OR is Optimism, which is set to be integrated with Uniswap v3 shortly after the new DEX version’s launch. During the demonstration stage, Uniswap was able to reduce gas costs by up to 100 times and to improve user experience thanks to Optimism.

Layer two scaling solutions prepare the ground for the proliferation of DApps by preventing the limitations of layer one protocols from being carried over to layer three platforms.

In Ethereum’s case, the applications running on top of it are constantly exhausting its network capacity, causing bottlenecks. Layer two solutions are aimed to decongest the network in order to overcome high fees and slow confirmation times.

Layer 3 protocols, commonly known as application layers, consist of the protocols that allow applications to run on blockchains, as well as the applications themselves. These are the thin protocols discussed earlier.

Layer three blockchain protocols can be split into two major sub-layers:

— application and execution — depending on a given DApp’s use case.

The application part deals with user-facing applications meant to facilitate user interactions with a blockchain, for which the main components are APIs, user interfaces (UIs), and scripts. DApps in this category interact with the base blockchain using APIs.

On the other hand, the execution layer handles the rules and smart contracts. As such, it holds the actual application juice, which is the code. The intersection between the two layers appears during execution.

For example, when a user initiates a transaction, the process moves from the application layer to the execution layer.

Note that different blockchains support different programming languages when creating smart contracts. For instance, Ethereum uses Solidity, whereas EOS supports C++. Other leading programming languages for building smart contracts include JavaScript (NEO) and Golang (Hyperledger).

Uniswap is one of the largest DEXs in the space and is powered by the Ethereum blockchain. Unlike centralized trading platforms like Binance and Coinbase, Uniswap operates without an order book. Instead, it uses an automated market-making (AMM) framework to provide trading liquidity. The DEX’s first iteration was copied bit by bit by a present rival, hence, it issued a business source license for its upcoming version 3 that will prevent anyone from (commercially) using its code for two years.

Yearn.finance is a suite of DeFi DApps operating on the Ethereum blockchain to help users to automatically earn the highest yields on funds that are deposited on decentralized platforms. Some of the products in yearn.finance include Vaults, Earn, Zap, yInsure and StableCredit.

NBA Top Shot is a leading NFT platform offering top NBA highlights in video format. The outlet allows NBA fans to buy and trade these NFT highlights, which vary in value and rarity. Their value also depends on the featured player. For instance, a LeBron James NFT changed hands at $200,000 earlier this year.

Alien Worlds is an NFT-based game that uses the DeFi space to mimic economic collaborations and competition between players.

Unfortunately, most layer three protocols (DApps) are today running directly on layer one protocols, skipping layer two. It’s no surprise that these systems are not running as smoothly as we’d want them to.

Layer three applications ultimately create real-world use cases for blockchains, so they are definitely important. However, in contrast to legacy networks, they won’t capture nearly as much value as their base blockchain.Layer 3 Protocols