A Layer 2 protocol (L2) is a blockchain scaling solution that inherits the security of the underlying blockchain upon which it is built, while enabling higher throughput of transactions.
The Long Explanation
A layer-2 protocol or framework is a secondary blockchain protocol built on top of an already existing one. These blockchains look to build upon the security structures of the original blockchain, while solving problems specifically of the primary chain or layer 1.
Most layer-2 protocols set out to solve either of two problems: scalability difficulties or issues with either the transaction speed or cost. This is especially important as many layer-1 blockchains are either impossible or too expensive to be directly improved upon.
Few blockchains demonstrate the importance of layer-2 protocols like Ethereum. Designed as a programmable, censorship-resistant network, Ethereum’s adoption rate has grown exponentially over the years. Unfortunately, it can only process a few transactions (between 7 and 11) per second.
Compared with the tens of thousands of transactions processed by traditional payment service providers per second, Ethereum’s limitations place it in a disadvantaged position as it intends to lead the way in decentralized finance.
As Ethereum’s adoption increases, the blockchain becomes increasingly congested, forcing users to compete in order to enjoy faster transactions. This leads to a bidding war for space in each block, leading to much higher transaction costs.
The above is also true of the Bitcoin network whose similar Proof of Work (PoW) consensus mechanism requires a lot of computational resources. Like Ethereum, transaction confirmation times are slow and transaction fees are high.
For Bitcoin, a popular layer-2 network is the Bitcoin Lightning Network which is based on state channels, attached to the main Bitcoin network. Operating as off-chain solutions, they confirm blockchain operations outside of the main chain, and report back to it later.
Likewise, layer-2 Ethereum solutions have sought to increase the throughput of transactions by abstracting them away from the main chain. Popular examples of layer-2 Ethereum protocols include Arbitrum and Ethereum Plasma.
In other words, layer-2 protocols handle all of the transactions themselves, using their own transaction confirmation frameworks to increase throughput to hundreds or even thousands of transactions per second, before reporting back to the main chain.