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Layer 3 switches

Why not implement a router in the switch itself and do the forwarding in hardware?

Although this setup is possible, it has one limitation: Layer 2 switches need to operate only on the Ethernet MAC frame. This scenario in turn leads to a well-defined forwarding algorithm which can be implemented in hardware. The algorithm cannot be extended easily to Layer 3 protocols because there are multiple Layer 3 routable protocols such as IP, IPX, AppleTalk, and so on; and second, the forwarding decision in such protocols is typically more complicated than Layer 2 forwarding decisions.

Do Layer 3 switches completely eliminate need for the traditional router ? No, routers are still needed, especially where connections to the wide area are required. Layer 3 switches may still connect to such routers to learn their tables and route packets to them when these packets need to be sent over the WAN. The switches will be very effective on the workgroup and the backbone within an enterprise, but most likely will not replace the router at the edge of the WAN (read Internet in many cases). Routers perform numerous other functions like filtering with access lists, inter-Autonomous System (AS) routing with protocols such as the Border Gateway Protocol (BGP), and so on. Some Layer 3 switches may completely replace the need for a router if they can provide all these functions.
Layer 3 switches were not designed to replace routers, they were designed to fill a niche that new network designs found they needed.

Source: http://www.cisco.com
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