An L2 network is like a GPS added to our car. It’s not made by our car manufacturer, but it was designed to improve the experience of driving the...
The Blockchain 101: The Layers of Blockchain — L3 & L4
A smart contract is just like a normal contract between two parties. There are terms and conditions that each party must follow.
There is an explosion of activity currently happening on layer three – from insurance to dating.
Layer three refers to decentralised applications that run on top of blockchains. These are apps that have their code run on smart contracts, and then execute on all the computers in the network, as opposed to one centralised server.
A smart contract is just like a normal contract between two parties. There are terms and conditions that each party must follow, such as I will give you $10 if you give me a burger. The major difference is that they are self-executable and run on a blockchain. So, a smart contract might say I will give you $10 if it rains in two weeks-time, if it rains, the contract will automatically execute, and the other party will receive $10. Contrast this with a real-world contract where I might choose not to pay, and then you will take me to Court to sue for damages
As many have pointed out, it means smart contracts are fairly dumb. Unlike real-world contracts which are incredibly complex with many contingent conditions based on real-world outcomes such as making a building ‘to the satisfaction of a reasonable person, smart contracts can only rely on events with a simple yes or no answer. Did it rain in Sydney on the 24th of November? Yes. Did Sarah transfer me 4 Eth? No. Did the price of gold go up in the last two months? No. Based on the outcome of these binary events, the smart contract will then transfer assets to the intended party.
So how does it work? Smart contracts exist on top of an L1 blockchain. Bitcoin can even execute smart contracts. But the most popular smart contracts are built on top of Ethereum, as far more complexity can be programmed into them as it uses a Turing complete programming language called Solidity. Once your smart contract has been written in this language, it can be deployed on Ethereum. As it is tamper-proof, the code/logic will be executed in the same way for all Ethereum nodes.
So, what are smart contracts actually used for? Naturally, the first progression in the history of smart contracts was for pure financial transactions. An example would be that you trade me 5 Eth, in exchange for 1 Bitcoin (a decentralised exchange with no middleman). These types of contracts are perfect for a self-executable computer as they themselves are just lines of code. Progressively, we have seen more and more complexity in financial smart contracts in Decentralised Finance (DeFi). Every type of experiment is occurring on smart contracts that allow for borrowing and lending, derivatives, and margin trading. This will only increase as DeFi is the perfect playground for programmable contracts.
The next question is how can smart contracts be conditional on real-world events. If a smart contract is contingent upon it raining in Sydney tomorrow, how can you have trusted execution of the contract without a middleman telling you whether it has rained or not? Blockchain Oracles solve this problem by connecting blockchains to events from the real world. They also do it in a decentralised manner, where they take multiple data sources from the legacy world, establish consensus, and then input it into smart contracts. With the advent of oracles, smart contracts can now extend to use cases including:
Mirrored Assets (digital assets that mirror the real world)
Stablecoins (peg to real-world currency prices using automatic monetary policy)
Asset Management (mark funds to market by automatic price feeds)
Insurance (insurance based on events such as weather)
Options & Futures (creating advanced financial instruments with price feeds)
Prediction Markets (betting on future events from politics to sports)
For the future of smart contracts, we are especially excited about the convergence of Internet of Things (IoT) devices and smart contracts. Oracles will be able to verify inputs from these devices which can be included in elaborate smart contracts. For example, a health insurer could have a smart contract that automatically gives users $10 if they exercise for more than 10 km a day as verified by their smartwatch. Maybe, when fresh produce is stored, a smart freezer can send proof to a smart contract that the food has been stored properly, leading to the release of money.
Last and probably least interesting for us is Layer 4 (L4). Conceptually, this is the easiest layer to understand. It is the entry point into all blockchains, the user interface layer. This is why it’s not particularly interesting as it is the same as the current internet products that we have today.
L4 is basically a frontend website, that people interact with that is connected to a blockchain. The best illustration of L4 is a centralised exchange. In a centralised exchange, you can go onto the internet and buy Bitcoin without any knowledge of how Bitcoin works. You simply give them your identity, and they will purchase the coins for you on your behalf. In other words, the centralised exchange will deal with the blockchain for you. In this sense, it is a pure L4 application.
To give even more colour, let’s contrast this with a decentralised exchange (DEX) which belongs to L3. In a DEX, you don’t need to submit any identity documents to the platform. You connect directly to other buyers and sellers with smart contracts acting as the intermediary.
So, in L4 applications it is just the front end that the user interacts with - the user requires no direct ties to the back-end blockchain.
The best examples of L4 are exchanges like Coinbase, Binance and rToro.
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