Ethereum Layer 2 proliferation causing liquidity fragmentation concerns, analyst says

The proliferation of Layer 2 solutions on Ethereum is fragmenting liquidity across the network, several analysts have said. 

The range of Layer 2 solutions on the Ethereum network, from Arbitrum, Polygon and Optimism, is part of a diverse range of strategies aimed at addressing scaling issues.

"It’s been argued that the large number of Layer 2 blockchains emerging to combat scalability issues on the Ethereum network is causing a fragmentation of liquidity across the blockchain, weakening the operations and adoption of a blockchain or applications on that blockchain," Gemini Principal of Institutional Sales Patrick Liou told The Block.

A recent Gemini institutional insights report added that a new Ethereum Layer 2 is appearing every 19 days, which adds to concerns that liquidity, the availability of assets to trade, is becoming fragmented.

Liou added that moving this liquidity from one blockchain to the next is not always easy but stressed that advancements in bridging applications are making this process more seamless, which could allow liquidity to flow more freely.

The growing amount of new Layer 2 solutions on the Ethereum ecosystem. Image: DefiLlama.

Layer 2 module design affecting liquidity

A CoinShares research blog from March highlighted the same problem, stating that Ethereum Layer 2 roll-ups have "unintendedly fragmented liquidity and composability, reducing the overall application, developer and user experience." 

The CoinShares research report added that each Ethereum Layer 2 processes and orders transactions in blocks in a centralized manner for their own asynchronous asset ledgers and smart contracts. "This modular design leads to a fragmented global state, negatively affecting liquidity," the report added.

In the report, CoinShares analyst Max Shannon added that Layer 2 solutions, "with their asynchronous sequencing and zero-sum proprietary technology stacks, exacerbate fragmentation, posing significant challenges to liquidity, interoperability, and social coordination."

Long-term impact on Ethereum market will not be significant

However, Liou added that there had been similar liquidity fragmentation concerns in the past, which have had only a minor impact on the longer-term development of the Ethereum market.

"For example, the 2020-21 congestion on the Ethereum network caused astronomical gas fees that ultimately encouraged the creation of Layer 2s but did not have a significant long-term impact on the growth of the Ethereum market," he said.

Liou added that the existence of so many Layer 2s, many of which offer new and interesting use cases and benefits, is causing a huge surplus of blockspace.

"This is ultimately giving developers the opportunity to create innovative applications for consumers, which will encourage the market to develop moving forward," he said.