Market Basics

What are the Different Protocols and Layers of Crypto Assets?

Grasping the entirety of the industry landscape can be daunting for those new to crypto. Over the past decade, the adoption of crypto has blossomed, leading to the creation of thousands of crypto assets.

Most crypto assets rely on blockchain technology, which typically utilizes a decentralized network with a distributed digital ledger to maintain record of transactions. Innovators and investors have flocked to the space believing that the technology can provide a more secure, efficient, and scalable medium of exchange than traditional methods.

How are Crypto Assets Structured?

Crypto assets can be broken down into different layers: Layer-1 Protocols or base layer protocols and Layer-2 Protocols.

Layer-1: Base Layer Protocol

A Layer-1 Protocol refers to a base layer network that can be built on top of. Crypto protocols are fundamental rules managed by code that permit data to be shared and secured on a blockchain ledger.

One way to think of a Layer-1 Protocol is to compare it to internet protocol HTTP as an example. In this example, HTTP is the Layer-1 Protocol. HTTP is used as the base layer protocol to transfer data over the web, whereas Layer-1 Protocols are used as the base layer network to transfer data over the blockchain. The Layer-1 protocol allows creators to build on top of it, so long as the rules are followed. Using the internet as an example, participants in the Layer-1 (HTTP) protocol include base layer developers, whereas the Layer-2 protocol includes user interfacing applications (think websites like Google and Amazon).

Two examples of base layer protocols are listed below:

• Bitcoin Network: Founded in 2009 by an anonymous individual or group with the pseudonym Satoshi Nakamoto, Bitcoin was the pioneering crypto asset. Nakamoto realized that since the Bitcoin network would be peer-to-peer and decentralized, it needed a way to verify and secure transaction data. This realization led to the invention of the Proof of Work (PoW) verification method. Proof of Work leverages a decentralized consensus mechanism where network “miners” are rewarded when they solve mathematical puzzles to prohibit tampering with the network. The network’s base layer value and adoption are represented by the Bitcoin network’s coin bitcoin (BTC).
• Ethereum Network: Ethereum was launched in 2015 by its founder Vitalik Buterin, a programmer from Russia. At the time of this writing, the Ethereum network utilizes blockchain technology and runs on a Proof of Work system (like Bitcoin) to reach a distributed consensus. However, the future roadmap for the Ethereum network includes plans to transition to a Proof of Stake (POS) system for verification and security. Proof of Stake models rely on randomly selected holders to verify transactions rather than the competitive validation method inherent in Proof of Work models. The network’s base layer value and adoption are represented by the Ethereum network’s coin, ether (ETH).

Layer-2 Protocol: Improve Network Performance

Layer-2 networks operate on top of a base layer protocol. In the Crypto space, Layer-2 networks are built with the intention of improving the performance of the base layer blockchain network. As a Layer-1 Protocol experiences rapid growth, scalability issues can become prevalent, leading to a cumbersome network experience. Transaction speeds may slow, while transaction costs may rise.

Layer-2 protocols look to be the solution to the problem. Layer-2 networks alleviate some of the base layer network’s strain by moving some of the transactional data processing responsibility to a parallel network, which then reverts to the Layer-1 blockchain to conclude the transaction. By removing some of the transactional load from the Layer-1 network, greater efficiency and scalability can be achieved.

Two examples of Layer-2 protocols can be found below:

• Lightning Network: Because the Bitcoin network’s block (record) creation time is limited in terms of frequency, the network has a finite short-term capacity, which can slow transaction speed. The Bitcoin Lightning network is a Layer-2 protocol that was created to improve Bitcoin’s transaction speed. The goal of the Bitcoin Lightning network is to enhance Bitcoin’s network performance in terms of speed and scalability without losing the powerful security it harnesses (The Bitcoin Network has never been successfully hacked) providing the trustless aspect of the network (no third party such as a bank) that Bitcoin proponents perceive as a key benefit.
• Plasma Network: Observing that the base layer Ethereum network needed more scalability, Plasma uses a secondary blockchain that runs alongside the Ethereum Network and looks to improve scalability and transaction speed. The network seeks to achieve greater efficiency by terminating non-essential data and reducing the size of transactions.

  While both the Bitcoin and Ethereum networks offer smart contract capability and decentralized finance applications, Bitcoin maximalists believe Bitcoin is the only truly decentralized store of value in the crypto space, due to the fact that it’s founder’s true identity is not known. Regardless of opinions, a store of value is not the only use case in the crypto space. Digital programmers have found that Ethereum and other crypto assets offer the right infrastructure and environment to house different use cases and applications.

Applications Layer

Creators in the crypto space have invented a variety of user-facing applications which leverage and are built on top of base layer blockchains. A plethora of use cases exist, but one popular use-case is Non-Fungible Tokens (NFTS). NFT’s are a one-of-a-kind deed or title to digital assets. NFT’s include but are not limited to digital art, music, games, and more.

Summary

As you’ve learned, three significant categories of crypto asset structure exist, each including several sub-categories. Though the layers differ in structure, they share the common goal of providing crypto users with diverse options. Although not all crypto projects succeed, those that do may have the potential to improve payment transactions, real estate contracts, and so much more.