Everything we have done so far is known as 'On Chain'. This is Layer 1. This is the final settlement layer. Everyone on the network processes Layer 1 transactions. This is why it is slow, expensive and does not scale - to limitless amounts.
What we need is a way of transacting with other users without having to go on chain. A way of only dealing with people involved in the specific transaction itself. This is known as Layer 2. This is Off Chain. Off chain transactions are instant, free and scale.
Effectively, on Layer 2, users swap contracts with each other, and as long as everyone plays their part, they can remain on Layer 2 happily transacting, at speed, countless times.
Should the Users wish to stop or should there be an issue - that is when the transactions jump down to Layer 1 - the arbitration layer, the settlement layer, and the Layer 2 transactions are 'collapsed' into a single Layer 1 transaction.
Let's take a look at the most basic example.