Layer 1 protocols like Ethereum, Bitcoin, and Waterfall Network form the foundational layer of a blockchain. They operate independently and manage the core functions like consensus, security, and transaction validation. Layer 1 solutions are highly decentralized and secure, but they often face scalability challenges due to limitations on transaction throughput. For example, Ethereum has historically been limited to around 15 transactions per second (TPS), and Bitcoin even fewer, making it difficult to scale for large user bases.

In contrast, Layer 2 solutions like the Lightning Network for Bitcoin or Optimistic Rollups for Ethereum are built on top of these Layer 1 blockchains to improve scalability. They do this by processing transactions off-chain (in the case of Lightning) or bundling multiple transactions together (with rollups) before submitting them to the Layer 1 for final validation. This reduces the load on the main chain, allowing for faster and cheaper transactions while retaining the security of the underlying Layer 1.

Unique challenges and advantages:
- Layer 1 protocols prioritize security and decentralization but struggle with scalability and higher transaction costs, as seen in Ethereum's gas fees during peak times. However, innovations like Waterfall Network, a new Layer 1 protocol, are designed to handle scalability better. Waterfall, for instance, began with 2048 validators and has seen tremendous growth, making it one of the more scalable Layer 1s out there.
 
- Layer 2 solutions excel at increasing transaction speed and reducing costs. However, they can add complexity to the user experience, as users may need to move assets between layers, and security for Layer 2 depends heavily on the security of the underlying Layer 1.

Both layers play crucial roles in the blockchain ecosystem: Layer 1 focuses on security and decentralization, while Layer 2 enhances scalability and user experience.