Finding the Holy Grail of Cryptocurrency: CoinHu Founder Guru Analyzes the Potential of Productivity Platforms like Ethereum

This article is from Chain News, and the author is Gulu, the founder of KEY GROUP.

On February 20, 2021, the total circulating market value of Bitcoin reached $1 trillion, claiming the first Holy Grail. Congratulations to our cryptocurrency economy industry! Continuing from the previous text, a fundamental point in "The Search for the Holy Grail 2.0 (Part 1)" is:

Over the past 29 months, from the publication of "The Search for the Holy Grail" to today, the development speed of Bitcoin has surpassed that of smart contract platforms. Here, "development" includes both the increase in actual utility leading to productivity growth and the enhancement of attractiveness simply due to changes in people's perceptions. The focus of smart contract platforms is clearly on the former, while Bitcoin belongs to the latter. In other words, the speed of technological advancement represented by smart contract platforms like Ethereum is slower than that of Bitcoin, merely because of the speed of changes in people's perceptions brought about by the longer existence of Bitcoin.

The future is not a simple extension of history. The author believes that the technological advancement of productivity platforms will bring about a turning point within the next two years, entering a new phase of rapid development. At that time, the market value of the base tokens of productivity platforms will undergo significant changes in comparison to Bitcoin's market value. Although innovation is always difficult, the cryptocurrency industry has never lacked excellent innovations. In the field of underlying blockchain infrastructure, the representatives of innovation are these productivity platforms, with typical examples including Ethereum, Polkadot, Filecoin, Dfinity, etc. After several years of technological accumulation, many projects are on the brink of effectively solving key technical challenges. New network structures like Polkadot's productivity platform will also be launched soon and will test their "product-market fit" in the market. The author remains hopeful and highly attentive to this, but due to space limitations, this article will mainly elaborate on Ethereum as an example.

The Second Curve of Ethereum Growth

Let's first discuss the growth model of Ethereum as a productivity platform: the "Second Curve" model. In the book "The Second Curve: Crossing the S-Curve of Growth," author Charles Handy argues: "Any growth curve will slide past the peak of a parabola (the limit of growth). The secret to sustained growth is to start a new S-curve before the first one disappears."

Please wait a moment; you may ask: What is Ethereum's first curve? This is the author's opinion:

1. Smart contract platform
2. Pursuing the ultimate decentralization of the underlying blockchain mechanism through a proof-of-work (PoW) consensus mechanism to achieve reliable "trustlessness" and "permissionlessness."

Smart contracts are a creation of Ethereum, and this technology stack has indeed brought a second curve of growth to the entire public chain industry: from simple functions coupled with the consensus layer (such as Bitcoin transfers) to flexibly creating applications at the application layer through decoupling the consensus layer and application layer using smart contracts. This leap has propelled the cryptocurrency economy from the "Nokia phone era" to the "smartphone era," resulting in an astonishing ecological prosperity: ERC20 token creation, ICOs, DeFi, NFTs, DAOs, and so on.

The first curve of Ethereum's growth has clearly been very successful; however, this growth model has long encountered bottlenecks: Ethereum can currently only process about 1.2 million transactions per day on average. If a user executes one transaction every three days on average, then Ethereum can serve at most 3.6 million users. In fact, we can easily observe the "spillover" phenomenon in the Ethereum ecosystem: relatively low-value applications are forced to leave Ethereum for other productivity platforms. Initially, financial applications squeezed out non-financial applications (such as games), and now the situation is even more severe. Due to the high gas fees, even some non-top-tier financial applications are forced to seek alternatives.

The author believes that the second curve of Ethereum's future growth is to enhance the system's throughput, enabling Ethereum to support larger-scale economic activities and serve more cryptocurrency users.

In fact, as early as around 2017, members of the Ethereum community recognized the importance of throughput and have been working to address this issue. However, this problem is indeed very difficult, leading to the emergence of the "impossible triangle" theory in the industry: performance, security, and decentralization cannot all be achieved simultaneously.

This theory was once quite popular in the industry and had a considerable impact. Some productivity platforms quickly concluded based on this theory: since security is non-negotiable, performance can only be improved at the expense of decentralization. Such a conclusion is too hasty, especially on such a significant issue.

The author does not consider himself a fundamentalist and does not believe that making no concessions on decentralization is necessarily correct. Instead, we need to think from the perspective of the problems to be solved: if there are compromises, where are the boundaries? We cannot imagine a future $10 trillion economy operating on a system based on 21 consensus nodes; such a system would be incredibly fragile. Would it remind you of the recently blocked Suez Canal, with such low robustness that a small accident could paralyze the entire system? Moreover, accidents may be the least of our worries; spending $10 billion to attack a $10 trillion economy and gaining $100 billion in return is an incredibly tempting business. Kidnapping, missile attacks, cyber infiltration, power outages, etc., with 21 nodes, are you ready?

Another issue is that these 21 nodes would have the power to "live or die" over this $10 trillion economy, and it seems that no one within the blockchain system can limit this power. Who can stop them from "rent-seeking or plundering" from the economy? Who is the hacker, who is the good guy, whose funds can be confiscated, and after confiscation, who benefits? All of these will be dominated by these 21 nodes. Do you think a state machine that monopolizes violence can tolerate such competitors?

A reliable consensus mechanism and a sufficient number of decentralized consensus nodes are the cornerstones of the cryptocurrency economy. The prosperity of the cryptocurrency ecosystem relies on "trustlessness" and "permissionlessness." As for how much decentralization is enough, the author does not have a clear answer to this question, but we certainly do not need another high-performance Alipay data center.

The "impossible triangle" theory seems reasonable at first glance and has indeed gained quite a few followers. However, the premise of this theory is a single state machine and does not discuss the situation under multiple state machines, i.e., scale-out solutions. In fact, many outstanding teams in the industry are currently focusing on multi-state machine solutions, such as Rollup layer 2 networks, Ethereum 2.0's sharding system, Polkadot's multi-chain system, Dfinity, etc. In 2021, the outstanding innovators in the cryptocurrency industry will prove that reducing decentralization is not the only way to improve throughput.

Layer 2 Networks Based on Rollup

Layer 2 networks based on Rollup (hereinafter referred to as L2) are considered the most promising solution to the congestion of Ethereum's layer 1 network (hereinafter referred to as L1). The idea of L2 has existed for a long time, initially based on state channels, with typical representatives being Bitcoin's Lightning Network and Ethereum's Raiden Network; later, Ethereum's Plasma technology emerged. However, these solutions have not been widely adopted. So why will this time be different?

The state channel solution works like this: if user A and user B need to transact frequently, then A and B create a deposit contract on L1, and each deposits funds into that contract. After that, A and B privately establish a communication channel, where A and B can send each other signed transactions without limit and without gas fees, as there is no need to send every transaction to L1. Both parties must personally verify that each other's transactions are valid and store this transaction data themselves. Either party can publish the final state of all transactions accumulated to the deposit contract on L1 to initiate a settlement. The logic of the deposit contract has a pre-set waiting period for settlement to give the other party time to react and prevent one party from executing a settlement with an intermediate state rather than the true final state; if such fraudulent behavior is detected, the other party must send the true final state to the deposit contract to prevent theft and punish the thief. By connecting multiple state channels, a Lightning Network or Raiden Network can be formed.

The problem with state channels is that users must also assume the role of service providers, not just users. The services here include: 1) verifying the validity of transactions; 2) storing transaction data.

This clearly places too high a demand on users. Thus, the idea of Plasma emerged: users no longer need to assume the role of service providers, but rather these services are performed by third parties, who periodically publish the current state of L2 to L1 in hash form. The third party deposits a bond in the deposit contract on L1, which will be forfeited if they are proven to be fraudulent. Among the two services provided by the third party, the first service—verifying the validity of transactions—is difficult to falsify because each transaction carries the signature of the transaction sender, which cannot be forged; however, the second service—storing transaction data—is easier to manipulate. The biggest attack vulnerability of Plasma is related to the "Data Availability Problem."

The Rollup solution is specifically proposed to address the "Data Availability Problem." Currently, there are two types of Rollup solutions: Optimistic Rollup and ZK Rollup. The similarity between the two is that they both compress the transaction data on L2 and store it directly on L1; the difference lies in how they compress the transaction data on L2. Both solutions have the capability to increase Ethereum's throughput by at least 100 times while maintaining the security and decentralization of the Ethereum network.

It can be said that the Rollup scaling solution is the result of approximately four years of exploration by cryptocurrency researchers, having theoretically solved all known obstacles, and after about two years of engineering construction, it is finally set to be used on a large scale in 2021.

The author believes that the Rollup-based layer 2 network will bring about revolutionary changes to the entire cryptocurrency industry and provide strong infrastructure support for further rapid development in this industry. One can imagine that when Ethereum's daily throughput exceeds 100 million transactions, the ecosystem on Ethereum will be drastically different. The forms of applications on L1 will also change significantly; for example, applications on L1 typically prioritize saving gas and reducing the frequency of interactions with smart contracts as important design principles. A typical example is decentralized exchanges (DEX) based on Automated Market Makers (AMM); however, on L2 DEX, the product forms will be very different—not just in the DEX track, but the entire DeFi industry will start anew. Products that provide native services to users in the new L2 environment will thrive.

Ultra Sound Money

In addition to the Rollup L2 network bringing a second curve of growth to Ethereum, Ether (ETH) as an asset will undergo significant attribute changes: transforming from an inflationary functional token to an ultra sound money (Ultra Sound Money).

Money is the energy of human society; currency is the container for storing energy.

Currently, ETH as a base token is inefficient in capturing value and feeding back into the Ethereum ecosystem. In other words, ETH as a container of energy has been leaking energy. I have heard such opinions: I am optimistic about Ethereum's technology and ecosystem, but I don't think holding ETH is worthwhile. While I do not completely agree with this viewpoint, I clearly understand what the other party is thinking. Yes, this point is correct; ETH, as a currency without a total supply cap, lacks attractiveness as a store of value. Yes, as a store of value, ETH has been leaking oil. In contrast, although the Bitcoin network has a single function, Bitcoin as a stored asset has a clear cap of 21 million coins and is hailed as sound money. In the context of rampant currency issuance in the fiat world, it is highly attractive to those seeking to avoid depreciation.

The market size for value storage in the traditional world reaches $100 trillion, and Bitcoin has already captured 1% of this market. The value storage market is also the largest market in the current cryptocurrency industry. ETH will advance into the value storage market in the next two years, primarily through the adoption of EIP1559 and the proof-of-stake (PoS) mechanism.

The most significant change brought by EIP1559 is the division of the original gas fee into two parts: BaseFee and Tip, where BaseFee will be completely burned. BaseFee is expected to account for 50%-70% of the current gas fees on the Ethereum network. According to data from March 2021, Ethereum's daily gas fees are approximately 10,000 ETH. If we calculate based on 60%, then approximately 2.2 million ETH will be burned each year.

Currently, the issuance rate of ETH is 2 ETH per block, with an average block time of 13 seconds, resulting in an annual issuance of approximately 4.85 million ETH. Subtracting the 2.2 million ETH burned, the net annual issuance is about 2.65 million ETH, meaning the inflation rate decreases from 4.2% to 2.3%.

In other words, if only EIP1559 is adopted, ETH will still be an asset without a total supply cap, but the inflation rate will be reduced to 2.3%. However, after implementing PoS, the situation will undergo a qualitative change.

The PoS consensus mechanism has been a desire of the Ethereum community since its inception. As early as before Ethereum went live in July 2015, the community seriously considered adopting PoS as the consensus mechanism upon launch, but due to the maturity of technology at that time, Ethereum ultimately adopted PoW as a temporary transitional solution. Those at that time probably did not expect that this transitional solution would be used for over six years. The consensus mechanism maintains the operation of the blockchain economy, while it also consumes resources (money). Ethereum researcher Justin Drake compared the consensus mechanism to an engine (see Ultra Sound Money | Justin Drake). If PoW is a fuel engine, then PoS is a much more efficient electric motor. For a specific comparison between PoW and PoS, please refer to Vitalik's articles Proof of Stake FAQs and Why Proof of Stake. Both Justin and Vitalik's viewpoints are that compared to PoW, PoS will reduce the resources (money) consumed by an order of magnitude while providing the same level of security for the blockchain.

Ethereum will merge the current Ethereum network with the beacon chain in the Shanghai upgrade in 2022 and adopt PoS. PoS is currently running on the beacon chain, and the parameters set can be found here. The author expects that the merged Ethereum will have parameter settings similar to the current beacon chain on PoS. Assuming that eventually 10 million ETH participates in PoS, according to the settings, the inflation rate at that time will be approximately 0.44%, meaning an annual issuance of about 510,000 ETH to reward PoS nodes. Please note that this portion of the newly issued ETH is independent of the 2.2 million ETH burned due to EIP1559. In other words, after implementing PoS, Ethereum will net decrease by about 1.69 million ETH each year, resulting in an annual deflation of about 0.15%.

Thus, ETH will become a deflationary asset, a deflationary asset, a deflationary asset!

The author believes that once ETH enters the deflationary stage, it will have a conceptual impact on the entire cryptocurrency industry. At that time, people will compare ETH with BTC in the field of value storage. Compared to the rampant issuance of fiat currencies, if Bitcoin is sound money with a capped supply, then ETH may be regarded as ultra sound money with a deflationary supply, or it could also be called B-super coin. ^-^

Conclusion

The Rollup layer 2 network technology will bring a second curve of growth to Ethereum; the introduction of EIP1559 and the adoption of the PoS consensus mechanism will fundamentally change ETH's monetary policy, transforming it into ultra sound money. ETH will significantly enhance its ability to capture value and feed back into the Ethereum ecosystem.

The productivity platforms represented by Ethereum are, in the author's view, the next Holy Grail to reach a total market value of $1 trillion. This is not a question of whether it can be done, but merely a matter of time. Currently, Ethereum appears to have the greatest potential as the leading productivity platform, but other excellent new productivity platforms also have the opportunity to claim the title. Looking forward to witnessing the birth of the next Holy Grail with readers in the near future.