OKEx Research Institute: Ethereum midfield battle - the reality and illusion of Rollup

Since the birth of Ethereum, its low transaction processing capacity has caused frequent congestion in the Ethereum network and high gas fees, which has seriously restricted the development of the Ethereum ecosystem. For this reason, the Ethereum expansion problem has always been a concern of the market. Against the backdrop of the DeFi explosion, Layer 2 expansion solutions such as side chains, state channels, and Plasma cannot meet market requirements, and Rollup has become the darling of the times.

Of course, Rollup is not a pure Layer 2 solution, but more like a hybrid of Layer 1 and Layer 2: data is calculated and packaged and compressed off-chain, and then stored on-chain. In addition, in order to solve the authenticity and validity of data and ensure asset security, Rollup launched ZK-Rollup using "validity proof" and Optimistic Rollup using Plasma's "fraud proof".

In summary, ZK-Rollup and Optimistic Rollup each have their own advantages and disadvantages. ZK-Rollup is suitable for non-contractual fields such as payment and transaction, with low cost and fast speed; and Optimistic Rollup is currently suitable for smart contract application fields due to the existence of OVM; but with the introduction of Turing-complete EVM by ZK-Rollup projects, ZK-Rollup may replace Optimistic Rollup in the future.

However, the upper limit of Rollup's scalability depends on the upper limit of block Gas consumption, so it can only be Ethereum's short- to medium-term scalability solution to solve the urgent needs of the DeFi ecosystem. In the long run, to fundamentally solve Ethereum's scalability problem, it also depends on the smooth implementation of Ethereum 2.0 sharding technology.

However, it is worth noting that the Rollup protocol can capture value and is economically sustainable. It is foreseeable that the tokens issued by the Rollup project will have huge investment potential.

After nearly two years of dormancy, Ethereum’s Rollup expansion plan is finally on the eve of bearing fruit: in February this year, Optimism announced the completion of its Series A financing and will launch its mainnet in March; ZkSync from Matter Labs also launched its mainnet last year and will launch smart contracts that support Turing-completeness this year; in addition, another Rollup solution that has attracted industry attention - Arbitrum, will also launch its mainnet this year.

Table 1. Progress of the Rollup solution

Source: OKEx Research Institute

As Rollup spreads, the market is full of expectations and enthusiasm for it. However, in reality, many investors and Ethereum users do not have a clear understanding of Rollup, but they have reached a consensus in general: Rollup is important and is the future of Ethereum.

The first half of this sentence is correct, Rollup is indeed important for the current Ethereum; but the second half is inaccurate, Rollup is not the future of Ethereum. To be more precise, Rollup only represents Ethereum's short-term and medium-term expansion plan, and is Ethereum's mid-term battle to solve the network congestion problem. In the long run, to fundamentally solve the scalability problem of Ethereum, it also depends on the smooth implementation of Ethereum 2.0 sharding technology.

In order to correctly understand and predict the future of Rollup and seize the wealth opportunities therein, we also need to analyze the historical context, principles and mechanisms of Rollup.

1. Ethereum’s Scaling War and the Rise of Rollup

Since the birth of Ethereum, its inefficient performance has been constantly criticized by the market: the TPS (transaction processing capacity) of the Ethereum network is about 15 transactions per second, while the Visa network is 2,000 transactions per second, and during the Double Eleven shopping festival, Alipay reached 500,000 transactions per second. The low transaction processing capacity has caused the Ethereum network to be frequently blocked and the gas fee to rise, especially during the bull market in 2017 and the DeFi (decentralized finance) wave that has emerged since 2020. This phenomenon is particularly prominent, seriously restricting the further development of the Ethereum ecosystem.

Figure 1. Changes in the average number of transactions and gas consumption on the Yifang network per day

Source: Etherscan, OKEx Research Institute

Solving the congestion of blockchain networks and improving the scalability of public chains have gradually become the focus of the industry. Various blockchain expansion solutions have also emerged, mainly including two categories:

On-chain expansion solutions, also called Layer 1 solutions, mainly achieve expansion by increasing the transaction capacity of the blockchain itself. Common Layer 1 solutions include increasing block capacity (such as BCH using large blocks of 32M), segregated witness (BTC, separating digital signatures from transaction data, changing the original block structure to achieve expansion), and sharding technology (Ethereum 2.0, dividing the status and historical records of the main chain into different shards to achieve expansion).

The off-chain expansion solution, also called the Layer2 solution, mainly executes most transactions off-chain through the second-layer protocol to reduce costs and improve efficiency. The current mainstream Layer2 solutions include state channels, side chains, and Plasma.

Figure 2. Main blockchain expansion plans

Source: OKEx Research Institute

In the early days of Ethereum, people generally believed that sidechain technology was the best solution to the blockchain expansion problem. The so-called sidechain is another independent blockchain parallel to the main chain. By transferring some transactions to the sidechain in a custodial manner, the main chain can be expanded. However, this brings two serious problems: first, the security of funds on the sidechain cannot be guaranteed. Once a hacker controls a sidechain, the funds on the sidechain can be stolen; second, the sidechain cannot guarantee the availability of data. As long as the hacker controls the sidechain, he can refuse to share the underlying transaction data, which will cause a major blow to the security of the main chain.

Figure 3. Principle of the side chain technology solution

Source: OKEx Research Institute

In order to solve the problems of side chains and achieve Ethereum expansion, Ethereum founder Vitalik launched a Layer 2 expansion solution called "Plasma" in 2017. The special feature of Plasma is that it has designed a fraud proof mechanism: Plasma sends specific underlying data to users for safekeeping, solving the problem of data availability; in addition, Plasma has an "exit period" design. Even if hackers gain control of the side chain and try to withdraw funds, any user can submit evidence to challenge within the "exit period". If the challenge is successful, no one can withdraw the assets, and the operator will be fined, thereby ensuring the authenticity, validity and accuracy of the data and solving the problem of fund security.

However, Plasma solves the problem of sidechains, but it creates new problems: first, users must go online once every two weeks to monitor the Plasma chain, otherwise if they miss the "exit period", hackers can withdraw their assets; second, users must save the underlying transaction data themselves to ensure the availability of the data, but this brings huge storage costs to users. Therefore, Plasma is not user-friendly and the experience is extremely poor. In the context of the big bear market in 2018, the Plasma solution, which was once highly anticipated by the Ethereum community, was gradually abandoned.

In fact, even without the big bull market in 2018, Plasma would have difficulty adapting to the development of the Ethereum ecosystem. Since 2019, DeFi has gradually emerged, and AMM represented by Uniswap has become a leader among them. For liquidity providers (LPs) on Uniswap, the assets stored in the trading pool are easy to change, and it is impossible to meet the requirements of the Plasma solution to challenge and verify LPs every time they trade. In fact, a large number of DeFi protocols can change the account status without the user's consent, so Plasma is doomed to decline in the DeFi era.

Figure 4. Evolution of Layer 2 scaling solutions

Source: OKEx Research Institute

Similarly, state channels also face the problems faced by sidechains and Plasma: state channels cannot represent objects that logically have no clear owner (such as Uniswap), and objects must all have clear asset owners.

Therefore, as DeFi becomes increasingly important to the Ethereum ecosystem, state channels, side chains, and Plasma cannot meet the actual needs of Ethereum. Rather than saying that Vitalik Buterin played a decisive role in promoting Rollup, it is better to say that the times chose Rollup. So what is so special about Rollup?

2. Rollup Principle Analysis

Before analyzing Rollup, let’s understand how Plasma expands: Off-chain, the Plasma operator aggregates the transactions waiting for batch processing to generate a Merkle Tree. Each leaf in the tree can represent the information of a transaction asset. If there is no transaction, the leaf value is 0. Subsequently, Plasma sends the root of the Merkle tree to the main chain, and sends the branches of the Merkle tree to the user for safekeeping.

Therefore, the main chain actually only saves the hash value of the Merkle root. Through the index of the Merkle root, the specific transaction information in the branch leaves can be found. However, this specific transaction information is stored by the user off-chain, thus saving a lot of space in the on-chain blocks and realizing the expansion of the main chain.

Figure 5. Plasma expansion principle

Source: Plasma White Paper, OKEx Research Institute

But as mentioned earlier, users saving specific transaction information off-chain compromises data availability and is not suitable for DeFi applications. To this end, the Ethereum community proposed a new solution: compressing transaction data and putting it on the chain, which is the Rollup solution.

Specifically, Rollup compresses transaction data into a Merkle tree and stores it on the chain; at the same time, the root of the Merkle tree (state root) is saved in the smart contract. The operator of Rollup can publish a batch of aggregated transactions (Batch), which is a compressed set of transactions and contains the previous state root and the new state root (the new Merkle tree root after processing the transaction). The smart contract will check and update the state root to achieve the transfer of assets.

Of course, from the above we can see that Rollup is not a pure Layer 2 solution, but more like a hybrid of Layer 1 and Layer 2: data is calculated and packaged off-chain, but stored on-chain. Therefore, it is more appropriate to call Rollup a semi-off-chain expansion or semi-layer 2 solution.

Figure 6. Rollup expansion principle

Source: Vitalik. An Incomplete Guide to Rollups, OKEx Research Institute

To use a vivid metaphor, now we need to save a lot of movies. Plasma is similar to storing movies on the computer and then saving only a directory file on the USB drive. According to the guidance of this directory file, we can easily find the location of any movie in the computer; while the Rollup method is to compress the movies first and then save them all to the USB drive. In this way, we can store more movies in the USB drive.

So how does Rollup achieve compression? --- Mainly by compressing the transaction parameters, including Nonce, Gasprice, Gas, To, Value, Signature, as shown in the following table:

Table 2. Rollup compression method

Source: Vitalik. An Incomplete Guide to Rollups, OKEx Research Institute

In the past, a transaction required 112 bytes of storage space, but now only 12 bytes are needed, and one byte costs about 16 Gas. On Ethereum, the upper limit of Gas is 12.5 million. We assume that Rollup needs to spend 500,000 Gas. Then, on Rollup, its transaction processing capacity is:

(Block Gas Consumption Upper Limit – Rollup Gas Consumption) / Gas Consumption per Byte / Number of Bytes per Transaction / Block Time = (12,500,000 – 500,000) / 16 / 12 /14 = 4464 transactions/second

Currently, a transfer on Ethereum consumes about 21,000 Gas, which means that if all of it is used for transfers, the maximum transaction processing capacity of Ethereum is: block Gas consumption limit / single transfer Gas consumption / block time = 12,500,000 / 21,000 / 13 = 45 transactions/second

This means that Rollup has increased Ethereum's TPS by 100 times in the transfer scenario. Similarly, according to Vitalik's calculations, in the ERC20 transfer and Uniswap application scenarios, Ethereum's TPS can be expanded by 100-400 times under the same conditions.

The previous analysis has been going smoothly, but we have overlooked an important issue similar to sidechain technology: how to prevent Rollup operators from falsifying data to steal assets? The Ethereum community has proposed two solutions: ZK-Rollup using "validity proof" and Optimistic Rollup using Plasma's "fraud proof".

3. ZK-Rollup VS Optimistic Rollup

First, let’s look at the ZK-Rollup solution for implementing validity proof. ZK-Rollup uses ZK-SNARK (zero-knowledge succinct non-interactive argument of knowledge) to ensure the security of transactions.

"Zero-knowledge proof (ZKP)" was proposed by S. Goldwasser, S. Micali and C. Rackoff in the early 1980s. It means that the prover can convince the verifier that a certain statement is correct without providing any useful information to the verifier.

A classic example: a circular corridor with a gap. The exit and entrance are very close (within eye distance), but there is a door somewhere in the middle of the corridor that can only be opened with a key. Alice wants to prove to Bob that she has the key to the door. Using zero-knowledge proof, Bob watches Alice enter the corridor from the entrance and then walk out of the corridor from the exit. At this time, Bob does not get any information about the key, but can fully prove that Alice has the key.

Figure 7. Zero-knowledge proof example

Source: OKEx Research Institute

From the above, we can see that ZKP has computational asymmetry. In the ZK-Rollup solution, the Rollup operator invests a lot of resources to perform ZK-SNARK calculations and puts them in the aggregated transaction (batch), while the smart contract (verifier) ​​can quickly and cheaply prove the security of the transaction. Therefore, ZK-Rollup has many advantages: it can quickly and easily verify the authenticity and validity of data while protecting privacy; but its disadvantages are large computational complexity, high technical difficulty, and difficulty in supporting virtual machines.

In the previous Plasma solution, we have introduced its designed "fraud proof" mechanism, which can realize the authenticity, validity and accuracy of transaction data and ensure the security of assets. Optimistic Rollups uses this mechanism: this type of Rollup will track all historical state roots and the hash value of each batch. If anyone finds that the post-state root of a batch is incorrect, they can publish a proof to the blockchain to prove that the batch is calculated incorrectly. The smart contract will verify the proof and roll back the batch and its subsequent batches.

Optimistic chose Plasma's fraud proof mechanism, which means that there is a long "exit period" like Plasma (about one week), which greatly reduces the efficiency of fund utilization, but the good news is that as the DeFi ecosystem matures, there will be a large number of liquidity providers to provide funds for users during the "exit period", which can effectively solve the problem of fund utilization offset. In addition, most importantly, Optimistic Rollup also inherits Plasma's OVM, which means that smart contracts compatible with Ethereum EVM can be deployed on the Optimistic Rollup network, which is particularly important for DeFi.

Table 3. Performance comparison between ZK-Rollup and Optimistic Rollup

Source: Vitalik. An Incomplete Guide to Rollups, OKEx Research Institute

In summary, ZK-Rollup and Optimistic Rollup each have their own advantages and disadvantages. ZK-Rollup is suitable for non-contractual fields such as payment and transaction, with low cost and fast speed; and Optimistic Rollup is currently suitable for smart contract application fields due to the existence of OVM; but with the introduction of Turing-complete EVM by ZK-Rollup projects, ZK-Rollup may replace Optimistic Rollup in the future.

4. The future of Rollup and wealth opportunities

From the above we can see that compared with other Layer2 solutions, Rollup can better ensure data security and data availability. However, is Rollup really the future of Ethereum?

No, as can be seen from the Rollup expansion plan: the upper limit of the block gas consumption is the upper limit of the Rollup plan. This is similar to taking the subway during the morning rush hour. In order to fit more people in the subway car (block), we squeeze more people into the car (compression). However, no matter how much compression is done, there is an upper limit. In the future, with the continuous development of blockchain applications, will we be satisfied with only a maximum expansion of 100 times? So in the long run, the future of Ethereum expansion still depends on the smooth implementation of Ethereum 2.0 sharding technology.

However, according to the official plan of Ethereum, the realization of Ethereum 2.0 sharding may have to wait until 2030. But even now, due to the popularity of DeFi, Ethereum has long been overcrowded and gas fees are high. Layer 2 solutions such as state channels and Plasma a few years ago cannot meet the requirements of DeFi, and sharding technology is a distant goal. It is precisely because "the past cannot be changed, and the future cannot be chased", Rollup naturally becomes the best solution to deal with Ethereum's expansion plan in the short and medium term, and becomes the midfield relay towards Ethereum 2.0.

Of course, another reason why Vitalik promotes Rollup is that the Rollup protocol can capture value and is economically sustainable.

Let’s talk about the economic value first. Rollup can ease Ethereum’s congestion and reduce gas fees. Part of the cost savings can be converted into revenue for the Rollup protocol (such as fees and MEV), and it is economically sustainable.

So why can Rollup capture value? This is related to the particularity of Rollup: the data is placed on the main chain, and only the data calculation is performed off-chain. This hybrid solution between Layer1 and Layer2 makes Rollup a special Dapp application on the main chain. Therefore, the Rollup project can issue tokens based on the Rollup protocol on the main chain, and can capture the value of the protocol through tokens.

It is foreseeable that after the explosion of Rollup in the next few months, there will be many Rollup project tokens issued. The tokens of those projects that are willing to attach the economic value of the protocol to the tokens will have great investment potential.