Many are asking: why do we need crypto and blockchain within the payments space, don’t we already have many electronic means of payment that are working just fine and are adapted to the digital native? The fact is that many of the current modern payment methods, especially for cross-border payments, still rely on traditional ways of sending money from one place to another, where the messaging about payment is broken from the actual payment. Take for instance the SWIFT network that doesn't transfer funds but instead, sends payment orders between banks using SWIFT codes. What crypto proposes is a paradigm shift where the message accompanies the payment in real-time.
And how does it do this? By building new payment rails based on blockchain technology. By this we mean not just Bitcoin’s blockchain, but also many other DLTs and protocols like Ethereum, Ripple, Stellar, Binance Smart Chain, Solana, Avalanche, and others that are enabling transactions.
But then again many argue that these systems are not scalable. The Bitcoin blockchain can process approximately 5 transactions per second, with Ethereum handling roughly double the amount. And if we compare these numbers with Visa’s handling of 1,500-2000 transactions each second, the blockchain stands no chance. So why not just use these solutions? Well, the main challenge is that Bitcoin, Ethereum, and other blockchains aim to compete with that while still maintaining a high degree of decentralisation.
Layer 2 protocols may be a solution. These protocols aim to boost the performance of the network while keeping some of the blockchain's initial properties. But first things first.
To understand what is layer 2, let’s go back to the basics – the layer 1 network is the base layer, or the underlying infrastructure of a blockchain, also known as the main network or ‘mainnet’. Layer 1 defines the core rules of the ecosystem, validates, and finalises transactions. The main features of layer 1 are decentralisation and security, supported by the diverse, global network of developers and participants like validators.
Examples of layer 1 protocols include Ethereum, Bitcoin, Solana, BNB Chain, Avalanche, Cardano, Algorand, Elrond, Celo, Terra, Near, Hyperledger, and many others.
Because of the immense resources it takes to maintain a fully functional ecosystem, layer 1 often lacks scalability. Bitcoin and other big blockchains have been struggling to process transactions in times of increased demand. A blockchain game could not realistically use the Bitcoin network due to lengthy transaction times. However, the game may still want to use layer 1’s security and decentralisation.
For layer 1 scaling, some options include:
Increasing block size, allowing more transactions to be processed in each block. e.g. SegWit and the 2017 fork of Bitcoin (Bitcoin Cash)
Changing the consensus mechanism used: moving from Proof of Work (that is energy consuming) to Proof of Stake (what happened with the Ethereum 2.0 update). e.g. Celo is a layer 1 network forked from Go Ethereum (Geth) in 2017. The Celo Web3 ecosystem includes DeFi, NFTs, and payment solutions, with more than 100 million transactions confirmed. On Celo, anyone can use a phone number or email address as a public key.
Implementing sharding, which is a form of database partitioning. e.g. - Elrond is a layer-1 network founded in 2018 that uses sharding to improve its performance and scalability. The Elrond blockchain can process over 100,000 transactions per second (TPS).
However, to boost scaling, the best option is to have layer 2 solutions that are built on top of the main chains. Layer 2 refers to a set of off-chain solutions (separate blockchains) built on top of layer 1s that reduce bottlenecks with scaling and data. These protocols provide a second framework that offloads the burden of managing transactions from the mainnet and thereby enables greater transaction inclusion and throughput.
Layer 2s on Ethereum include solutions like Arbitrum, Optimism, Loopring, zkSync, Polygon, Plasma, etc. E.g. By handling transactions on a separate Ethereum-compatible blockchain, Polygon aims to fix Ethereum’s scalability issues. Polygon then returns transactions to the main Ethereum blockchain post-processing. This approach lowers the network load on Ethereum, speeds up transactions, and lowers transaction costs to less than a cent. By using Polygon, users can interact with any decentralised application (DApp) without ever having to worry about network congestion.
For Bitcoin, the most popular layer 2 protocol is the Lightning Network.
Bitcoin’s Lightning network is a Layer 2 scalability solution making Bitcoin transactions cheaper and near-instant. The network is comprised of user-generated channels that send payments back and forth in a trustless fashion, meaning that the user doesn't need to trust or even know the counterparty. For instance, if I watch a video from another user, and I need to pay that user, I can pay for each minute of the video that I am watching by opening a lightning channel. As the minutes roll by, periodic payments could be made from my wallet to theirs. When I’m done watching, we would close the channel to settle the net amount on the Bitcoin blockchain.
Because the transactions are just between me and another party and don’t need to be broadcast to the whole network, they are almost instantaneous. And because there are no miners that need incentivising, transaction fees are low or even non-existent.
Despite the potential to disrupt the incumbents, current Lightning adoption is still tiny (but growing!). Arcane Research estimated that in Q1 22, Lightning facilitated USD 20–30 million in monthly payments. That’s a 4x YoY increase, but a far cry from the USD 866 billion Visa facilitates each month.
Few merchants accepted Lightning payments when the initial network implementations were launched. As it became easier, merchants started to gradually accept Lightning payments. There are over 50 online and physical stores that accept these types of payments with the help of tech providers such as BTCPay Server and OpenNode. When El Salvador made Bitcoin legal tender, large companies like McDonald’s and Starbucks were able to quickly integrate Lightning payments.
NCR Corporation and other point-of-sale companies have expressed interest in becoming interoperable with the Lightning network. Square, a large point-of-sale software and equipment provider for small and medium-sized businesses, and its parent company Block are one of the most pro-Bitcoin companies around. Their Cash App already integrates with Lightning and they have multiple Bitcoin-focused development units.
Web3 has evolved into an ecosystem of layer 1 blockchains and layer 2 scaling solutions, each designed with unique capabilities and trade-offs. As the number of blockchain protocols increases, so does the demand to move assets across chains. To fulfil this demand, we need bridges.
Without a bridge, blockchains are siloed environments that cannot communicate with each other. This is because each network has its own set of rules, governance mechanisms, native assets, and data that are incompatible with the other blockchains. Moreover, blockchains can only send messages in one direction. There is only one-way communication across a channel. One blockchain can send a message to another on one channel, but there’s no way for the other blockchain to reply on the same channel and confirm that the message has been received. To establish trust between blockchains and make two-way communication possible, we need something in the middle, something that can bridge the gap between these blockchains.
For example, if you own Bitcoin but want to participate in DeFi activity on the Ethereum network, a blockchain bridge allows you to do that without selling your Bitcoin.
Blockchain bridges can be used to lower transaction fees, explore blockchain ecosystems, enable users to own native crypto assets, and others. Another advantage of blockchain bridges is that they improve scalability. Some blockchain bridges can handle many transactions, improving efficiency. For example, the Ethereum-Polygon Bridge is a decentralised two-way bridge that works as a scaling solution to the Ethereum network. As a result, users can benefit from faster transactions and lower transaction costs. But the most important benefit of blockchain bridges is the ability to improve interoperability. They enable the exchange of tokens, assets, and data across different blockchains, whether between layer 1 and layer 2 protocols or various sidechains.
Bridges fall into two categories: trusted and trustless bridges. Trusted bridges depend upon a central entity or system for their operations. They have trust assumptions concerning the custody of funds and the security of the bridge. Users mostly rely on the bridge operator’s reputation. Users need to give up control of their crypto assets.
The second category is formed by trustless bridges that operate using smart contracts and algorithms. They are trustless, i.e., the security of the bridge is the same as that of the underlying blockchain. Through smart contracts, trustless bridges enable users to remain in control of their funds.
Many bridging solutions adopt models between these two extremes with varying degrees of trustlessness.
What makes cross-chain bridges so vulnerable? According to Chainalysis, bridges are an attractive target because they often feature a central storage point of funds that back the ‘bridged’ assets on the receiving blockchain. Regardless of how those funds are stored – locked up in a smart contract or with a centralised custodian – that storage point becomes a target.
Also, the effective bridge design is still an unresolved technical challenge, with many new models being developed and tested. These varying designs present novel attack vectors that may be exploited by bad actors as best practices are refined over time.
This editorial was initially published in our Crypto Payments and Web 3.0 For Banks, Merchants, and PSPs Report. The first edition of our report aims to provide a go-to payment resource of crypto terms and concepts for those interested to understand the basics of crypto payments and their long-term impact. Furthermore, it shares practical examples of cryptocurrency-enabled ecommerce and banking services and presents the latest developments in the regulatory landscape. Also, it reveals what are the most innovative companies in this space, that are building the crypto rails.
About Mirela Ciobanu
Mirela Ciobanu is a Lead Editor of the Banking and Fintech domain at The Paypers. She is actively involved in drafting industry reports, carrying out interviews, and writing about the digital assets industry, the regtech space, digital identity, fraud prevention, and payment innovation. Mirela is passionate about finding the latest news on crypto, blockchain, DeFi, and fincrime investigations and is an advocate of the need to keep our online data/presence protected. As a writer, she aims to always get the best obtainable version of the truth. She can be reached at mirelac@thepaypers.com or via LinkedIn.
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