Ethereum expansion is imminent, a brief analysis of Layer 2 development trends and public chain landscape

Original title: "Layer 2, Ethereum and the public chain landscape"
Written by: Blue Fox Notes

Over the past period of time, DeFi has shown us the congestion of Ethereum, and the gas fees are incredibly high. This is just a superficial phenomenon from the user experience level. Its deeper meaning is that different DeFi protocols are competing for Ethereum's block space, which is a zero-sum game.

When the blocks are full, the increase in transactions of any protocol means the decrease in transactions of other protocols. As newcomers increase, competition becomes more and more fierce, and finally some mining transaction fees reach hundreds of dollars. In the first few months of the popularity of DeFi, Ethereum's transaction fees have surpassed Bitcoin to rank first in the crypto circle. Even if DeFi cools down today, its annualized transaction fees are not far behind Bitcoin.

Crypto project annualized cost-benefit ranking, SOURCE: tokenterminal

When the market is hot, the competition in the entire DeFi market will be very fierce. Since the transaction throughput is fixed, the value of the DeFi market as a whole cannot continue to rise. This is because it will limit the transaction volume of the overall DeFi project, thus affecting its sustainability.

This naturally leads to the question of throughput and speed. People have proposed solutions such as Layer 2, sharding, and cross-chain, among which Layer 2 is one of the most mentioned directions. Let's make an assumption that if Ethereum is a giant in the future, then Layer 2 based on Ethereum will be an important development trend.

What kind of evolutionary trend will emerge in Layer 2? Will Layer 2 be a flourishing one or a single flower? If Layer 2 succeeds, what impact will it have on Ethereum and the public chain landscape?

Layer 2 Evolution Trend

First, let’s take a look at the path of Ethereum scalability in Vitalik’s eyes:

In this development roadmap, Layer 2 is an important direction. According to the records in Blue Fox Notes, there are many practical directions for Layer 2, including state channels, side chains, Plasma, Optimistic Rollups, validium, ZK Rollup, and so on.

All this looks very good. But there is a big problem here: Layer 2 itself is an isolated island. If different projects adopt different Layer 2 solutions, how can they communicate with each other? This will break the composability on Layer 1. If DeFi's Maker, Uniswap, Compound, Curve, Synthetix, etc. cannot be combined, then how can aggregation protocols help people get higher returns? How can DeFi innovation be promoted?

Without composability, DeFi loses its original meaning. Even if it achieves extremely high transaction throughput and extremely low fees, its value will be greatly reduced without interoperability.

This situation means that, in the end, only a few Layer 2s are meaningful, which is similar to the winner-takes-all network effect of the public chain. Because projects using the same Layer 2 technology are more likely to interoperate. This means that most of today's Layer 2 technologies will eventually be short-lived, so when investing in this track, it is very important to consider how to bet and when to exit.

If mainstream DeFi projects all adopt a certain Layer 2 technology, this Layer 2 technology may become the de facto Layer 2 technology, and other Layer 2s may gradually fade out of history (game-related Layer 2 may be an exception). This is similar to the public chain. Composability and liquidity itself force other projects to make choices. If projects such as Maker, Uniswap, Curve, Synthetix, Aave, Compound, etc. all adopt a certain Layer 2 technology, then other projects will have to stand in line. Even if these projects do not adopt the same Layer 2 solution at the beginning, they will eventually go on the same path over time. In the adoption of Layer 2 technology, the choice of DeFi Lego, which has a liquid foundation, is decisive.

Although there are many Layer 2 technologies, each with different trade-offs, the most important point is still security. If there are too many trade-offs in this regard, it will eventually become a transitional Layer 2 technology, or even no transitional opportunity.

Because no mainstream DeFi project will rashly adopt a certain Layer 2 technology and then lock itself in an isolated island. For the project, this only gains theoretical scalability, but may lose liquidity and composability, and thus lose its advantage, which will not be worth the loss.

From the current perspective, the ZK Rollup series of technologies has a high probability of success, and it has achieved a relatively good trade-off in terms of security and performance. Of course, ZK Rollup technology itself is currently just a basic technical facility, and it also has its shortcomings. At the same time, it is not clear how to capture value. As for itself, how much investment opportunities there are still needs to be observed.

But it is indeed good for the DeFi industry. The benefit is that as more DeFi projects adopt the same layer 2 technology, there is no need to worry too much about the island effect of layer 2, and interoperability can be gradually achieved on Layer 2.

If DeFi on Layer 2 still achieves the composability and security of Layer 1, since its transaction throughput is hundreds of times higher than today and its transaction fees are greatly reduced, the possibility of large-scale adoption of the protocol will greatly increase. With the increase in protocol transaction volume, the increase in revenue, and the increase in users, both the actual value and the premium will increase greatly. This will lead to a breakthrough in the DeFi industry to a deeper and broader level. If we make a simple and rough analogy, with today's throughput and speed, the current DeFi market value can reach about 10-15 billion US dollars, and in the future layer 2 can increase scalability by 100 times. Even if it increases by 10 times, it can carry a DeFi market value of more than 100 billion US dollars, which lays a solid foundation for the overall market value of DeFi in the future.

This is the direction that open finance should develop in the future.

Ethereum's Layer 2 and public chain landscape

Assuming that Ethereum's Layer 2 can break through the island effect, then DeFi projects will migrate to Layer 2, which will greatly alleviate the current congestion and fee dilemma and can provide hundreds of times of room for improvement.

When this point comes, there will be a certain amount of pressure on other public chains. When Ethereum's congestion cannot be resolved, other public chains can act as Ethereum's side chains to help Ethereum alleviate congestion pressure and gain a position in the entire DeFi development process.

But if Layer 2 can successfully solve the problem, then the value of other public chains to Ethereum itself will decrease, although they will still have great value.

In addition, if Layer 2 is successfully implemented, Ethereum will be able to siphon off more Bitcoin assets, further becoming a place to carry more assets.

As more protocols are built on Ethereum, ETH can capture greater value, which will lead to an increase in the overall market value of Ethereum, and the increase in the overall market value will make Ethereum more secure. Ethereum's greater security can make it a public chain that carries a larger amount of assets. If Layer 2 and sharding are sufficiently scalable, the amount of Bitcoin circulating on Ethereum in the future may reach 10%, 20%, or even more than 30%.

If this situation is formed, a super public chain pattern may be formed. Although other public chains are still valuable and will continue to exist, the super public chain will siphon the largest amount of assets, become the most concentrated place for DeFi activities, and become the king of public chains.

Of course, there is a premise here: that the Layer 2 and sharding solutions can be smoothly promoted. In addition, other public chains still have opportunities and still have the opportunity to become public chains worth tens of billions or hundreds of billions of dollars, but there will not be too many public chains above the trillion-dollar level, and there may be only one or two at most.