Nansen Research: Arbitrum, the Future of Blockchain Scaling?

Written by: Yasmine Karimi, Nansen

Compiled by: Deep Tide

Introduction

In the history of cryptocurrency, there have been three instances where Ethereum network gas fees skyrocketed to astronomical figures: the bull market of 2017, the DeFi summer of 2020, and the NFT boom of summer 2021.

Ethereum gas fee fluctuations from 2015 to 2021

Whenever gas fees surge again, a discussion about the scalability of the Ethereum blockchain returns to the forefront, while many scramble to find the next competitive blockchain to invest in. In reality, we must face the fact that gas fees are just the tip of the iceberg. The reason gas fees are so high is that the current Ethereum has not been able to scale, meaning that the demand for transactions still exceeds the number that the Ethereum blockchain can actually handle at any given time.

You may have the impression that the debate on scalability is dominated by cryptocurrency planners and developers, making it difficult to understand why Ethereum faces scalability issues, what scalability actually means, and how this race for scalability affects your own interests and those of the cryptocurrency space. Below is an interpretation of the current situation.

A Beginner's Discussion on Scalability Issues

Blockchain is a model for processing transactions and recording them in blocks, created without the need for a trusted authority and can avoid double spending. Early blockchains, such as Bitcoin and Ethereum, handle and record these transactions based on their consensus model, which is proof of work.

In the proof of work model, when you initiate a transaction, it is placed in a pending transaction pool and propagated to all nodes in the network. Although it is spread to all nodes, only one miner will compute this transaction and verify it by adding it to a block along with other transactions, thereby earning the gas fee reward for mining.

First, transactions must be propagated across the network both before and after verification, which makes the processing time for transactions long. Secondly, the computational power required for digital calculations consumes a significant amount of electricity. Finally, the number of transactions that can be included in a block is limited, which creates competition among users and drives up gas fees—the minimum price miners are willing to accept for processing transactions—sometimes exceeding the value of the transaction itself. As more dApps utilizing blockchain technology for processing and storing transactions are built on the mainnet (currently about 3,000), this is becoming an increasing problem.

Thus, to address these issues, Ethereum must scale, which can be achieved by increasing the number of transactions the network can handle (measured in TPS, transactions per second) and the speed of transactions. To this end, several scaling solutions are under development, primarily Ethereum 2.0, alongside Layer 1 scaling solutions, sidechains, and Layer 2 scaling solutions. Layer 1 scaling solutions like Ethereum 2.0, Polkadot, and Solana fundamentally change the underlying consensus and chain model of Ethereum, while Layer 2 scaling solutions are built on top of the Ethereum mainnet and its protocols.

The stakes are high, and the risks are significant. The few blockchains that emerge victorious in this race will power the entire DeFi space and NFTs, sustain DAOs and virtual worlds, and support the entire creator economy and metaverse.

I will elaborate below on why I believe that Layer 2 scaling solutions like Arbitrum (a company backed by Marc Cuban, Polychain Capital, and Pantera Capital) will lead Ethereum's scalability for at least the next five years.

A Brief Overview of Ethereum Scalability Solutions

As mentioned, scaling refers to increasing transaction throughput (the number of transactions that can be processed) and improving transaction speed. Below is a brief introduction to the existing solutions currently aimed at achieving this goal:

Scalability solutions in 2021, created by @yasminekarimi_

There are two ways to scale blockchain ecosystems.

Layer 1 Scaling Solutions

Layer 1 solutions address the underlying protocol, which is the code of the mainnet blockchain itself, to enhance the blockchain's transaction capacity. They can be further divided into:

Protocol Improvements

Protocol improvements are changes made to the underlying protocol to increase transaction throughput, specifically by increasing the number of transactions that can fit into a block (sustainable only in the short term), reducing the time gap between block creations, or achieving a structural shift from proof of work consensus to proof of stake. Unlike the "proof of work" model, "proof of stake" selects validators based on the amount of cryptocurrency they have staked in the protocol. Since validators are chosen based on this, there is no longer a need for massive computational power, nor is there competition among miners that drives gas fees to astronomical levels. The verification time for transactions is significantly shorter because a single node does not have to invest as much processing power as PoS-based blockchains like Solana (30,000 TPS) and Polkadot (1,000 TPS). In comparison, Ethereum can only handle 16 TPS.

Sharding

Sharding divides the computational tasks and data space of a blockchain into multiple chains (Ethereum 2.0 has over 63). Sharding blockchain protocols naturally mean dividing the nodes of the initial network into smaller groups, with each group responsible for approving a unique subset of pending transactions and storing a subset of the global state. Nodes are assigned to shards through a cryptographic sorting mechanism implemented by verifiable random functions to avoid shard takeover attacks when a shard is composed of a majority of malicious nodes. Since transactions specific to a node are verified by it rather than the entire blockchain, there is no competition that leads to high fees, and transactions are faster, which in turn increases the number of transactions that can be processed in a second. According to Vitalik Buterin, sharding and the PoS consensus model should be able to achieve 100,000 TPS on Ethereum 2.0.

Layer 2 Scaling Solutions

Layer 1 scaling solutions change the blockchain's protocol, while Layer 2 scaling solutions are extensions of Layer 1 scaling solutions implemented through smart contracts built on-chain. By outsourcing the execution of transactions before reporting to Layer 1 scaling solutions, Layer 2 scaling solutions create additional space for transaction processing. There are many ways to achieve this.

Sidechains

First, you can transfer assets to sidechains with more favorable transaction fees and speeds (for example, the delegated proof of stake consensus mechanism used by xDai allows for 5-second TPS at a cost of $0.000021). Cross-chain transfers of assets are achieved through a two-way peg (2WP) protocol, which locks assets on the first chain and then creates a transaction on the second blockchain, with input information containing cryptographic proof that the lock is valid. A perfect example of this is Polygon.

Plasma

Secondly, Plasma (see the white paper by Joseph Poon and Vitalik Buterin) is a blockchain construction within blockchain systems. Assets are sent to a smart contract managing the Plasma chain, which executes the transactions. Only the hash of the block header is submitted to the root chain unless there is evidence of fraud; when fraud occurs, the block is rolled back, and the block creator is penalized. This "only when" scheme brings significant scalability because minimizing state updates to the root blockchain allows transactions to be faster.

State Channels

State channels refer to open-source protocols and smart contracts that allow participants to conduct x transactions off-chain but only submit two on-chain transactions to the Ethereum network. Users must create and pay for an Ethereum transaction when they first open the channel. When they are ready to close the channel, they must pay a fee to process the transaction on the Ethereum blockchain. This reduces the number of transactions that must be processed and stored, lowering gas fees to only the cost of opening and closing a channel. Major projects utilizing state channels on Ethereum include State Channels, Celer, Perun, and Raiden.

Rollups

Rollups expand the mainnet by aggregating transactions in a single "batch," using compression tools (such as scientific notation to reduce value length, measured in bytes) and verifying them off-chain, then storing state data on Layer 1 scaling solutions. Compression and batching lead to higher throughput, speeding up each transaction and minimizing costs.

Secondly, based on the verification method, rollups come in two different types. The way we verify is by checking whether the root of the post-batch processed state (i.e., account balances, contract codes, etc., which are "within rollups") is correct. In zk rollups, each batch of transactions generates a validity proof called a ZK-SNARK, while optimistic rollups like Arbitrum only perform proof calculations when a node suspects a transaction is fraudulent, further enhancing transaction speed and throughput.

As a user, how should I interact with Arbitrum rollup?

As a user, the most likely scenario for you to interact with Arbitrum is when you use dApps, which are those you typically use on Ethereum and require transactions (e.g., Uniswap or Aave). More specifically, when you want to interact with Arbitrum, first add the Arbitrum One network extension to your MetaMask wallet and connect to it, then bridge your assets.

Why will Arbitrum lead Ethereum's scalability in the near future?

Arbitrum addresses the blockchain trilemma: scalability, decentralization, and security.

Simply scaling is not enough. While increasing its transaction throughput, the blockchain must retain the two fundamental attributes of blockchain technology: decentralization and security. This is known as the blockchain trilemma. As of now, the only Ethereum scaling solution that meets all three criteria is rollups like Arbitrum. The total number of transactions processed on Arbitrum has reached 3.56 million, with a peak daily transaction count of 268,000 on September 12, 2021.

Total daily transactions on Arbitrum over a period

In terms of processing capacity, Arbitrum should be able to achieve 40,000 TPS, with an average cost advantage of 5 times compared to using Ethereum's underlying scaling (currently Ethereum is $2 versus $10.38, see real-time Layer 2 scaling fees). Furthermore, Arbitrum is actively working to reduce fees by 90%-95%, meaning you could mint an NFT or transfer ETH for just a few cents. The total gas fees spent daily on Arbitrum have also consistently been lower than those on Ethereum. The noticeable spike on September 12 was due to the launch of a Layer 2 liquidity mining platform called ArbiNYAN.

Total daily gas fees paid on Arbitrum versus Ethereum

Arbitrum achieves this high throughput while gaining security from Layer 1 scaling consensus. In comparison, early Layer 1 scaling solutions like Ethereum and Bitcoin prioritized decentralization and security but sacrificed scalability, as evidenced by today's high gas fees. Similarly, other competitive Layer 1 scaling solutions like Solana and EOS sacrifice decentralization because only 200 and 21 nodes control their networks, respectively. In turn, centralization can also impact security, as it increases the chances of a 51% attack. Likewise, sidechains can introduce attack vectors in the mainnet because they rely on their own consensus and block validation models. Another example of limited security is protocol improvements, as blockchains with "larger blocks" are inherently harder to validate and may become more centralized, leading to reduced security. However, note that not all rollups are decentralized in their early stages, although most, if not all, are committed to gradual decentralization.

Arbitrum is the most EVM-compatible Layer 2 scaling solution to date

Arbitrum is currently the most EVM-compatible Layer 2 scaling solution. This makes it almost effortless for developers to migrate existing Ethereum applications to rollups, as they do not need to rewrite code. Arbitrum currently supports countless dApps and is the largest Ethereum Layer 2 network, with a total value locked in DeFi protocols exceeding $2.3 billion. In comparison, ZK-rollups and payment channels only support simple payments, exchanges, and other specific applications. Currently, it has a total of 2,361 verified contracts, averaging 12 new contracts added daily since September.

Daily verified address count on Arbitrum

As more dApps are integrated into the Arbitrum rollup, Arbitrum becomes not only very attractive to developers but also to users. The increase in the number of specific addresses using Arbitrum supports this assertion.

Total number of unique addresses on Arbitrum over a period

Among these addresses, smart money addresses seem to pay special attention to Arbitrum. As shown, 50% of ETH millionaires using Ethereum also use Arbitrum. For those who are not familiar with Nansen labels, ETH millionaires refer to addresses with a balance of at least $1 million in ETH.

Proportion of active smart money on Arbitrum

In simple terms, it builds on the king of the cryptocurrency realm—Ethereum

Another reason we believe that rollups like Arbitrum will dominate Ethereum's scalability in the coming years is that they are built on Ethereum, the king of the cryptocurrency realm. This gives them a first-mover advantage. First, in terms of usage, Ethereum remains the most popular blockchain protocol in the world, with over 3,000 dApps, DeFi, NFTs, DAOs, and virtual world ecosystems. Bitcoin is the only blockchain that can compare in this regard, but it lacks the capacity to support rollups.

Secondly, contrary to the belief that Ethereum 2.0 will render rollups obsolete, considering that Ethereum 2.0 will not be fully deployed for several years, rollups like Arbitrum should be the first de facto scaling solution. On the contrary, data sharding, which is the second phase of Ethereum 2.0, is primarily aimed at accelerating rollups. With rollups splitting storage states, sharding splitting transaction histories, and rollups registering themselves to specific shards, the scalability of rollups' throughput is exponential, potentially reaching 15 million TPS by 2030.

For these reasons, it is clear that rollups like Arbitrum will have a unique position to lead the wave of Ethereum scalability solutions in the near future.

Get ready for the arrival of Layer 2 scaling solution tokens

Unless you are a developer or an early investor, you can still gain exposure by purchasing the native tokens of the projects. While most rollups like Arbitrum do not yet have native tokens, we can expect that most rollups projects will eventually release them.

Some challenges currently facing rollups

The first challenge is that for optimistic rollups, the withdrawal period is long. Withdrawals may take up to 7 days because there needs to be a delay to allow time to publish evidence of fraud and cancel the withdrawal if a transaction is suspected of being fraudulent.

Secondly, the condition that ensures the security of optimistic rollups is that at least one node is honest and can identify fraudulent transactions.

In addition, while we can expect that moving assets and data through rollups will become increasingly easier, rollups are still in their early stages and lack interoperability. Nevertheless, there are interoperable solutions like Hop, Connext, cBridge, and Biconomy.

Finally, many believe that although Ethereum's liquidity is dispersed across different rollups due to users being incentivized to get the best price, over time, liquidity will accumulate on rollups like Arbitrum.

Rollups five years from now

Realistically, the potential of rollups is not limited to Ethereum in the long run. The future of scalability solutions is actually a more complex system composed of interdependent scaling solutions across multiple Layer 1 chains. In this complex future, we can still expect three main trends.

As mentioned, in the short term, rollups on Ethereum like Arbitrum will dominate the landscape of scaling solutions, then will be further strengthened by the deployment of Ethereum 2.0 and its sharding scheme. Layer 2 scaling solutions, including but not limited to rollups, will showcase their advancements and improve their performance, thus competing in execution with Layer 1 scaling solutions.

Next, as other competitive Layer 1 scaling solutions reach full capacity, they will increasingly begin to build rollups on top of their mainnet. In fact, most people still cannot grasp the potential of rollups; every Layer 1 scaling solution will need rollups. Ethereum is simply the first that has been preparing for it for quite some time (since 2015). For example, Tezos is adopting a rollup-centric roadmap. Similarly, NEAR, Celestia, and Polygon have also recently announced advanced zk-STARKs based on the scaling solution Polygon Maiden (derived from zk-Rollup).

In fact, given that the demand for Ethereum and blockchain is only one-directional, we can also expect that all scaling solutions will be equally effective and necessary to meet the growing demands of current and future market participants.

Conclusion

In summary, high gas fees are indeed just the tip of the iceberg. Ethereum has faced scalability issues since its inception, and the numerous scaling solutions currently available are all aimed at addressing this problem. Among them, Arbitrum rollups are not only the largest Ethereum Layer 2 network but also have the potential to dominate scaling solutions in the coming years. It has been proven that Arbitrum rollup can scale Ethereum without compromising the decentralization and security of the mainnet. As more users seeking the best possible prices turn to Arbitrum, more developers will build on it because it is the most EVM-compatible. Beyond Ethereum, rollups are also a paradigm that will be exported to other competitive Layer 1 scaling solutions and integrated into an increasingly complex array of scaling solutions.

For everyone in the cryptocurrency realm, Layer 2 scaling solutions like Arbitrum are not just an investment issue; they are the foundation of ongoing and future projects in the DeFi and NFT space, which will not only sustain DAOs and virtual worlds but also support the entire creator economy and metaverse.