My DEFI diary — day 4: checking out Layer 2

This series is a look back at the last few months as I’ve made my way into the crypto space, and particularly into the DEFI space, as a complete newbie. I aim to catalogue the moves I’ve made, the tech I’ve experimented with, and the mistakes I’ve made along the way. I include some details around fees and logistics, hopefully to be useful to others wanting to follow in my footsteps.

24 April 2021 19:07 ETH @ $2216.56 Gas Price: 51 Gwei

So now I had a small amount of ETH in my Metamask wallet, and was keen to start exploring DEFI proper. As mentioned in my previous post, DEFI replicates the different components of the traditional financial system, but on blockchain technology — lending, borrowing, insurance, trading, investing — all of these become possible, but instead of some kind of private corporate entity standing in as middleman between market participants, that role is played by a smart contract sitting on a blockchain!

If all of that seems a bit strange, don’t worry, this is all very different from what we’re used to in the traditional financial world. It might help to think of a smart contract as the online equivalent of a vending machine. You put a certain amount of money into the vending machine, and it follows a pre-programmed set of rules to give you a certain outcome in return.

It might help to think of a smart contract as the online equivalent of a vending machine.

The only problem that I was having was that gas fees were still so high on Ethereum. Pretty much any transaction I considered had a gas fee upward of $10, and sometimes as high as $50. This meant that a lot of transactions didn’t make sense from a financial perspective. I was looking to earn a return on my crypto, but the transaction fees would put me so far in the red that it would take ages just to earn that back.

I became aware of a potential solution — layer 2. Whilst Ethereum itself is working on making certain changes to bring down transaction fees, a raft of smart, enterprising companies and individuals have created what are called layer 2 solutions. These come in different forms, but the common feature is that they allow you to transact ‘off-chain’, thus radically reducing your transaction fees. So, instead of transacting on the main Ethereum blockchain, you can move some of your crypto off on to a ‘layer 2’ chain, and transact there.

This has all been done in a way to look to preserve all of the security and traceability advantages of the blockchain, but with reduced cost. Obviously there is some additional level of risk, so buyer beware — always check out the credentials of any layer 2 solution, and whether it has traction and good standing in the general blockchain community.

…always check out the credentials of any layer 2 solution, and whether it has traction and good standing in the general blockchain community…

The first layer 2 solution that I tried was Loopring Exchange— “an Ethereum Layer-2 scaling protocol [that] allows for building high-throughput, low-cost, non-custodial AMMs, orderbook exchanges, and payment applications on Ethereum by leveraging Zero-Knowledge Proofs.”

I first transferred 0.05 ETH ($133.44) to Loopring, which cost me $9.98 in gas fees. But then I realised that I needed at least 0.1 ETH to transact on Loopring, so I immediately transferred another 0.075 ETH ($201.98), costing me another $7.57 in gas fees. This is super annoying, because gas fees are not a percentage of the amount you’re transferring, so I could have transferred the entire amount for one gas fee!

It’s quite possible that Loopring stipulated this minimum trade amount somewhere, but as with many things in this nascent environment, the risks and requirements are not always as clearly spelled out as one might like, and oftentimes there aren’t really any guardrails to stop you from making stupid mistakes. Again, buyer beware!

Having made this second deposit, I then found out that I would need still more ETH if I wanted to enter into a liquidity pool. So I had to make a third transaction, this time of 0.08 ETH ($216.49), costing me $7.60 in gas fees.

Now that I finally had enough money in the Loopring Exchange, I traded half of my Ether for Loopring (the native token of the Loopring Exchange), and then put a combination of Ether and Loopring into a ETH-LPR liquidity pool. I will discuss liquidity pools in more depth in my next post, but for now let’s just say that by putting my money into the pool, I am providing liquidity that makes it possible for others to trade ETH for LPR, and in return for providing that liquidity I earn a small percentage fee on every trade that gets made in the pool. These liquidity pools (or LP’s) are a key feature of DEFI, but they come with their own risks as well, which we’ll discuss next time!

Got any questions or comments? Pls post below — keen for this to be a two way conversation!