Coinbase report: The real "Ethereum killer" may be Ethereum itself

This article comes from Coinbase, the original author is David Duong, Director of Institutional Research at Coinbase

Contents

• Layer 1 (L1) alternatives are becoming increasingly popular, mainly because high gas fees on the Ethereum network make DeFi-related transactions increasingly expensive;

• Ethereum is trying to solve the network scalability problem through Layer 2 solutions, as well as moving to a proof-of-stake consensus model and sharding;

• While this does not necessarily mean that L1 will become irrelevant, the value of L1 may depend on how long it takes for the Ethereum network to complete scaling.

Gas fees on the Ethereum network have been one of the biggest barriers to mass adoption of ETH and smart contract platforms in general, and this is the main reason why Layer 1 alternatives including Solana (SOL), Avalanche (AVAX), and Terra (LUNA) have attracted a lot of attention in 2021. However, most of the active application development on L1 networks still seems to happen on the Ethereum blockchain, and the total locked value of 214 projects on the Ethereum chain has reached $156 billion - this is almost twice the total locked value of the blockchains ranked 2-11 by locked value. In this case, a question arises: if Ethereum 2.0 can replace the current Ethereum network with faster and cheaper options, how valuable will those L1 alternatives - so-called "Ethereum killers" - ultimately be?

In our opinion, there is still room for some L1 blockchains in the crypto space and to coexist with Ethereum for at least a few reasons. First, while the official Ethereum 2.0 implementation timeline has been moved up to 2023 (when sharding will be complete), L1 networks will still be involved in the network during this transition period, aiming to solve the problems of Ethereum's long transaction processing times and high transaction costs. That said, at least for now, ETH-centric Layer 2 (L2) solutions can play a huge role in increasing throughput and reducing transaction fees.

Second, scalability is just one issue that affects the Ethereum network. Currently, users or investors may not be concerned about issues such as maximum extractable value (MEV), but as these ecosystems continue to develop, related issues may change the governance mechanism of L1 blockchain chains. In addition, more complex bridging algorithms and improvements in interoperability may promote greater composability between different L1 networks in the future.

For some L1 alternatives, we can still see Ethereum Mainnet taking a certain advantage before the Ethereum Mainnet merges with the Beacon Chain, so Ethereum 2.0 will not crowd out the development opportunities of other networks. That said, we think Ethereum Mainnet's performance in the first half of 2022 may be mainly affected by monetary policy - especially due to the transition to the Proof of Stake work-hour mechanism, which will gradually reduce the issuance of ETH to miners (and ETH sales by miners). In our view, these changes will not have an impact on the feasibility or cost efficiency of the blockchain.

However, we do believe that L2 scaling solutions, merging with the beacon chain, and sharding upgrades may limit the current development of L1 networks. For example, as Ethereum scalability improves, DApp users may no longer look for faster and cheaper Ethereum alternatives. Despite this, we believe that there will still be a large space for multiple chains to coexist in the short term, driven by cross-chain interoperability and the possible need for alternative consensus mechanisms.

Misconception: Ethereum 2.0 Timeline

In essence, Ethereum 2.0 is a "set of interconnected upgrades" on the Ethereum network that allow for network scalability without significantly sacrificing decentralization or security. Considering the speed of development of decentralized applications (dapps) on the Ethereum blockchain and the rapid growth of the entire ecosystem, we believe that if Ethereum 2.0 can provide lower fees and better network performance, it certainly has the potential to disrupt the L1 network.

But many market participants tend to conflate the upcoming Ethereum mainnet and beacon chain merger with the actual deployment of Ethereum 2.0 itself, which is an important misunderstanding. The reality is that the Ethereum mainnet and beacon chain merger will only transform Ethereum from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism, but on its own, it will do little to achieve higher transaction processing speeds, increase transaction throughput, and support lower gas fees. In fact, Ethereum network fees are mainly driven by the demand for block space, so if activity on the network picks up after the Ethereum mainnet and beacon chain merger, then fees on the underlying network (i.e. Ethereum mainnet) may actually continue to rise.

Monetary policy. Although there are some issues, the merger of the Ethereum mainnet and the beacon chain does not mean that the update is meaningless, because the change in the consensus mechanism may also bring related efficiency improvements, especially in terms of monetary policy. For example, the merger of the Ethereum mainnet and the beacon chain may mean that more ETH is staked and less ETH is created (given the shift from miners to validators), thereby reducing the supply on exchanges, and therefore driving prices up from a supply and demand perspective.

It is important to note that the speed of ETH issuance is also an important factor, because in the past miners often had to sell ETH to obtain funds to cover the operating costs of their equipment. Therefore, according to our estimates, using (fewer) validators can reduce the issuance of ETH by up to 90%, and can also reduce the amount of ETH sold on exchanges by at least 30-50%, because the Ethereum network requires less computing power after the merger of the Ethereum mainnet and the beacon chain compared to the proof-of-work (PoW) mechanism (i.e.: lower operating expenses mean less forced ETH sales). This situation is particularly evident after the launch of EIP-1559 in early August, as can be seen from the figure below, the flow of funds for Ethereum miners seems to be more directional.

Figure 1: Net ETH inflow/outflow from Ethereum miner wallets, Source: Coinbase Analytics

However, while the merger of the Ethereum mainnet and the beacon chain could set a higher low price for ETH/USD, it is unlikely to improve much in terms of performance indicators such as network transaction speed, scale or cost. So, how can these problems be solved? The answer may be to shard the beacon chain. Sharding is actually an upgrade that the Ethereum network planned to implement before the merger of the Ethereum mainnet and the beacon chain, but it was eventually postponed to 2023 for various reasons. One of the reasons is that the ETH-centric L2 solution has achieved good results, but now, L2 has become the main focus issue that the Ethereum network must face in order to expand.

L2: The key to Ethereum network expansion

In our view, the long-term viability of the Ethereum blockchain currently depends more on L2 scaling solutions than upgrading the base network. That said, in terms of attracting developers and capital, as well as hosting smart contract platforms, we believe the growth and adoption of L2 solutions may be the key to determining whether these so-called “ETH killers” can challenge Ethereum’s dominance.

Historically, scaling solutions for blockchains have typically chosen larger blocks and/or sharding, but with the advent of L2, there is a faster and more economical way to process transactions. Chief among these are Optimistic and Zero-knowledge (ZK) Rollups, which bundle transactions together and process them in a new environment (i.e., off-chain), then send updated transaction data back to Ethereum. Coinbase has previously discussed these solutions in depth, which can be viewed here.

Rollups can significantly reduce transaction fees, but if Ethereum implements a sharding upgrade in 2023, it may intensify the impact on transaction execution speed by allowing Rollups to utilize more block space on Ethereum. In the long run, this is critical for the Ethereum network to achieve its goal of scaling to billions of users and processing tens of thousands of transactions per second.

Figure 2: Average monthly fees on Ethereum chain, source: Coinbase Analytics

However, in our opinion, L2 is still in its early stages, and they may not be ready for prime time, which is why they continue to proliferate as “L1 alternatives.” For example, when transferring funds between Rollup and Ethereum’s base layer and scanning for fraud, users may have to wait longer on Optimistic rollup, in some cases even up to a week, which may pose a greater potential risk to institutional investors. On the other hand, ZK Rollups also have certain limitations in terms of the types of transactions that can be supported.

Living in a multi-chain world

As Ethereum’s scalability challenges persist, we believe the attractiveness of L1 alternatives in the market will depend primarily on how quickly Ethereum 2.0 and L2 solutions emerge. That said, we may see continued growth in these so-called “L1 alternative networks” and cross-chain bridges in the first half of 2022. However, the window of opportunity for L1 alternatives may begin to shrink significantly in the second half of 2022 as we expect ZK proof technology to improve and Rollups to gain wider use.

However, this does not mean that L1 alternatives will disappear anytime soon. The multi-chain world is a very real possibility, as we believe that solving the scalability trilemma is only the first step in the development of blockchains for smart contract platforms. First, in terms of the trilemma, users may place more emphasis on transaction speed, security, and decentralization, and choose L1 based on these factors.

Secondly, other issues in the crypto industry are beginning to emerge, such as Maximum Extractable Value (MEV) and priority gas auction bots. MEV refers to the profit that miners and validators can extract from others because they are able to include, exclude, order, and reorder transactions in a block, which has the potential to cause some problems for both proof-of-work and proof-of-stake networks. Issues like this may support blockchains that use other consensus mechanisms, such as Proof of History (PoH), which do not rely on memory pools and may therefore be more insulated from MEV.

Third, we are moving away from the concept of facilitating composability by locking into one specific network. With the development of L1 cross-chain bridges, as well as L1-L2 cross-chain bridges, assets are allowed to move across networks in search of higher yields or different liquidity pools. As interoperability and more complex bridges become more common, we can see the L1 ecosystem continue to grow, as some DApp developers may not want to compete in a crowded market. In fact, we may even see some specific L1 blockchains emerge that focus on specific use cases, such as gaming or social media.