Slow settlement times, expensive cross-border payments and difficulties modernising legacy systems have long plagued the financial industry. Blockchain has been positioned as a solution to these issues for some time now, but the first-generation networks were often lacking in the speed and scalability needed by the institutional finance sector.
The widespread roll-out of Layer 2 (L2) technology is set to change that – significantly increasing transaction speeds while maintaining the essential underlying security. The fundamental difference which supports the enhanced capabilities of L2 is that, while results are still recorded on the main blockchain, the transactions are actually processed separately.
The need for evolution
With a heavy reliance on intermediaries, payments within today’s financial infrastructure can take days to settle – particularly across borders – which not only ties up capital, but also increases the level of risk involved. Considerable time is spent by financial institutions reconciling transactions and resolving disputes, with market access often slow and expensive due to regulatory requirements.
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The potential to address many of these issues lies within blockchain and its more transparent, secure and efficient way of recording transactions. Yet the performance requirement for large-scale financial applications has been lacking within traditional financial applications. Until now.
Solving the scalability challenge
L2 infrastructure has become one of the fastest-growing blockchain development areas – and represents an opportunity to solve challenges around sustainability by processing transactions off-chain before securely recording the outcome on the underlying blockchain. With the ability to group thousands of transactions rather than tackling each one individually, throughput is dramatically increased alongside a reduction in cost.
There are naturally differences depending which type of L2 technology is utilised: roll-ups bundle transactions together before submitting them to the base chain; state channels allow parties to transact privately before settling the final result; and sidechains operate as independent blockchains connected to the main network.
Crucially, they all offer the enhanced security of a blockchain system without sacrificing performance.
Striking the right balance, however, is essential – with developers needing to consider scalability, security and compliance, given the strict regulatory requirements financial institutions operate within. In addition to considering reporting obligations and anti-money laundering regulations, there is a question of integration, with legacy banking and payment systems needing to integrate with blockchain platforms which often operate on completely different architectures.
The L2 difference
Tokenised assets can simplify issuance, trading and settlement within financial markets: capitalising on the digital representation of assets by automating manual processes and significantly reducing settlement times. Transaction batching also ensures high-volume trading is more cost-effective through the grouping aspect of L2 technologies.
L2 is also proving game-changing for banks and financial service providers, assisting them to accelerate clearing and settlement whilst also improving transparency throughout the transaction lifecycle. Rather than an overnight replacement of existing infrastructure, efficiencies can be realised and operational costs reduced through the integration of current systems and L2 solutions.
Tokenisation also creates opportunities for investment funds, venture capital, real estate and insurance – with smart contracts automating fund administration, capping table management and insurance payouts, and enabling organisations to demonstrate regulatory compliance without exposing sensitive customer data.
For regulators, L2 roll-out represents a step forward, empowering the faster verification of financial records, more efficient auditing, and improved transaction visibility; the embedding of compliance rules directly into blockchain-based processes also helps to strengthen oversight without over-burdening organisations with administrative tasks.
Cross-border payments
It is clear, therefore, that L2 technology has the potential to enhance and speed up processes whilst also benefiting a range of financial organisations and regulators alike. But perhaps one of the most apparent benefits of L2 is its impact on cross-border payments. By removing unnecessary intermediaries, payments can be processed more quickly and with greater transparency. The real-time tracking of transactions and automated compliance enabled by shared blockchain infrastructure also has great potential when it comes to overcoming the challenges associated with traditional processes.
But this wave of technology is not simply about making blockchain faster, L2 enables financial institutions to rethink how markets, payments and financial services operate. By implementing L2 technology to solve genuine business problems, organisations can reduce costs, improve efficiency, strengthen compliance and create better customer experiences. And it is for this reason that, as the technology continues to mature, L2 is set to become a core part of the financial infrastructure that will underpin the next generation of digital financial services.
Ibraheem Kabir, software engineer and Prune Payments co-founder
