# L1 and L2 chain fragmentation problem. A crypto payments centric view ![Sprintcheckout (3)](https://hackmd.io/_uploads/HybYIu771e.jpg) > **TL;DR** > * Propose a way to enhance crypto payments on Ethereum by building synergies with its rollups. > * Suggest that ERC20 stablecoins adopt the same pattern Visa and Mastercard use with the banking network. > * Call for a workstream to fast-forward the growth of the crypto payment use case. ## Background With new Layer 2s launching every day, there is a lot of discussion about fragmentation in the Ethereum ecosystem. This resembles the Layer 1 fragmentation seen a few years ago with Polygon, Avalanche, Solana, Cardano, etc. In this article, we want to position this problem from a payment processing point of view (customer-to-merchant type of payments). ## Why payment processing use case is important? **Market Size:** Last year 2023, Visa alone processed $12.3 trillion. The entire card payments industry processes over $24 trillion per year. The revenue generated in the card payments industry is $572 billion in 2023. **User Growth Impact:** Payment processing is the use case that has the potential to bring the **first billion** users on board. It's a use case we can utilize in our everyday lives. While trading, holding assets, and borrowing are infrequent use cases for a subset of the population, paying on an e-commerce site or at a brick-and-mortar store is something people do multiple times a day. **Impact on Society:** In developing countries, card payment infrastructure is precarious, with merchants facing chargebacks and users unable to access stable fiat currencies like USD, or accessing them at a very high cost. This population is forced to find workarounds to pay for everyday goods and has limited access to global commerce. ## What crypto payments need to compete with card payments? Here's a list of technical, regulatory, and network effect enablers deemed necessary to compete at the level of Visa and Mastercard. ### Technically 1. **Near-Free and Secure Transactions:** This is now possible due to blob space launched in 2024 hard fork, and a work in progress [EIP-4844: Proto-Danksharding](https://www.eip4844.com/) evolving toward zero transaction fees. 2. **One-Click Gasless Payments:** Now possible due to Paymasters and the ERC20 Permit function. This is rapidly evolving, and wallets like Coinbase Wallet now support a user-friendly permit message. 3. **Fast and Cheap On/Off-Ramps:** This is currently possible via centralized exchanges (CEX) and their Web3 wallets—Binance with Binance Web3 wallet or Coinbase with Coinbase Wallet. On and off-ramps are instant and nearly free on chains like Base, Optimism, Arbitrum,... 4. **Recurring Payments:** It's already technically feasible with Account Abstraction (AA) wallets, but these need wider adoption. Coinbase Wallet also proposes the [Spend Permissions](https://www.smartwallet.dev/guides/spend-permissions/overview?utm_source=substack&utm_medium=email) approach. ### Regulation Europe and the UK are currently creating new regulations that will provide more clarity. The US is expected to catch up soon. With a potentially more pro-crypto administration, the US may regulate within the next few years. This regulatory clarity will allow those merchants who see unregulated payment methods as unappealing, to start considering crypto payments as they would any other payment method. ### Network effects Even after sorting out the technical and legal challenges, it will still be challenging to compete with the convenience and availability of Visa and Mastercard worldwide. To grow at a global scale, network effects need to be enabled. From Visa and Mastercard, we learned the following growth levers: * **An Incentives Mechanism:** Visa and Mastercard's four-party model rewards card issuers on each transaction, same way crypto payments need a mechanism to reward wallet providers. This incentivizes them to drive customers to spend at participating merchants. This point is key to unlocking the chicken-and-egg problem: if wallets are incentivized, they will bring users to merchants; if merchants see user demand, they will adopt crypto payments; if merchants accept crypto, users will develop the habit of paying with their Web3 wallets. ![Sprintcheckout](https://hackmd.io/_uploads/Hkh_AMAzkx.png) * **Unified Liquidity as Opposed to L1/L2 Fragmented Liquidity:** When making a payment in USD with a Visa or Mastercard-branded card, the customer pays dollars, and the merchant receives dollars (USD). What really happens is that the bank accounts of the user and merchant settle overnight according to Visa/Mastercard recorded messages during the day (this is an oversimplified explanation). In crypto payments, it's different. Imagine if the customer had a Visa-branded card but could only pay merchants that have a Visa account. Then the merchant needs to bridge the USD(v) (Visa USD) funds to different networks like Mastercard, etc., to pay suppliers, staff, etc. We need the stablecoin balances to sit on a canonical chain (same our USD sits on the banking network). Ethereum is the perfect layer to settle on. ![Sprintcheckout (1)](https://hackmd.io/_uploads/HyniCfCGkx.png) Let's expand on this last point in the next section. Which is the trigger of this paper. ## Liquidity Challenge and L2 Fragmentation ### Problem Stablecoins like USDC are actually ERC20 smart contracts deployed on each chain: Base, Ethereum, Arbitrum, Avalanche, etc. Each of them has a ledger of accounts with balances. So, Bob can have 20 USDC on Base and 10 USDC on Ethereum. This causes a liquidity fragmentation issue that avoids network effects: more customers/merchants with liquidity on a network motivates merchants/customers to stick to that network. On the below image it can be visualised the potential of unifying the liquidity of Ethereum and its rollups. Ethereum stablecoin flows would duplicate Tron and Solana. This advantageous starting point would unlock network effects right away. ![Sprintcheckout (4)](https://hackmd.io/_uploads/Hk4nX_Q7Je.png) Chat source [Artemis.xyz: Monthly Adjusted Stablecoin Transfer Volume](https://app.artemis.xyz/chart-builder/4230) ### Solution For the sake of argument, let's propose a solution and open it for debate and ideas. The solution is inspired on the card payment four party model: ERC20 smart contracts could evolve to have balances only on a canonical chain, e.g. Ethereum. The canonical USDC ERC20 smart contract on Ethereum should communicate with the USDC ERC20 smart contracts on other rollups, e.g., Base. Rollup smart contracts can request in real-time to hold a certain amount on the canonical USDC balance. Every day (or less), there should be a settlement process where the canonical USDC smart contract moves balances within the USDC ledger. The process would look like: 1. **Bob has 100 USDC on Ethereum and has a wallet that supports Base.** 2. **Bob wants to pay 10 USDC to Alice Flowers.** 3. **Alice Flowers' point of sale (which has a payments dApp that supports Base and other EVMs) requests Bob to sign a transaction. Bob signs with his Base wallet.** 4. **The Base USDC ERC20 smart contract requests the Ethereum USDC ERC20 to hold 10 USDC.** 5. **The Ethereum USDC ERC20 responds synchronously, confirming that the user has enough funds and has recorded the 10 USDC hold. Bob can now only spend 90 USDC.** 6. **After a period of time, say 24 hours or whatever is cost-effective, the USDC Ethereum ERC20 smart contract creates batch transactions that settles balances across accounts. As a result, Bob now has 90 USDC, and Alice Flowers has 2,010 USDC. The liquidity remains on Ethereum L1.** ![Sprintcheckout (2)](https://hackmd.io/_uploads/Syq0Cz0M1e.png) **Note:** The tricky bit here is that the hold message between the rollup and Ethereum has to be free. How could that be possible? What tech is available or would be needed? A possible constraint—and valid from a UX/business point of view—is that each USDC Ethereum account can only designate one rollup eligible to request balance holding. In the same way, any given bank account has either Visa cards or Mastercard cards, but not a combination. ### Solution critique and open ideation There are plenty of initiatives being worked on at the moment to solve the interoperability problem in general. Vitalik summarises them on Section 6 [Possible futures of the Ethereum protocol, part 2: The Surge](https://vitalik.eth.limo/general/2024/10/17/futures2.html#6)/Cross-L2 interoperability improvements (section 6). To highlight a couple that sound very relevant to the payments use case: * [AggLayer](https://docs.polygon.technology/innovation-design/welcome/) and [ERC7683](https://www.erc7683.org/) propose cross-chain interoperability but still rely on the liquidity moving from chain to chain, which will incur costs. * "[Synchronous composability: allow synchronous calls to happen either between a specific L2 and L1](https://vitalik.eth.limo/general/2024/10/17/futures2.html#6)" This idea seems in line with the Visa/Mastercard-banking system pattern. And Based rollups are the way to go “[Based rollups](https://ethresear.ch/t/based-rollups-superpowers-from-l1-sequencing/15016) are automatically friendly to all of these techniques.” * Justin Drake Beam chain road map is loaded of improvements in the next years. Which ones are required for the payments use case end game? ![Beam chain roadmap - Justin Drake](https://hackmd.io/_uploads/HkkhPk0fkx.png) For Dapp developers it is hard to navigate such a complex and changing roadmap of improvements. So it will be good to join forces to influence existing initiatives and create new ones. ## Call to action Let’s organise a payments use case centric working group to collaborate and speed up the growth of this use case. Who shall be involved: * Stablecoin issuers: Circle, Tether, … * Merchant Payment Dapps: Sprincheckout, Depay,… * Paymaster and account abstraction infra providers: Candide, Plymico,… * Researchers and smart contract auditors: Openzzeplin, Ethereum foundation, AggLayer, ERC7683 contributors,... * Web3 Wallets builders: Metamask, Coinbase wallet, Binance web3, Argent, * Merchants, Marketers, … **Reach out to** [**t.me/joanseg**](https://t.me/joanseg) **or joan (at) sprintcheckout (dot) com** Comment on this Ethereum Magicians topic: [Payments Use Case Working Group](https://ethereum-magicians.org/t/payments-use-case-working-group) Author: Joan | Researcher at [Sprintcheckout](https://sprintcheckout.com/)