Coinbase Report: The Real "Ethereum Killer" Might Be Ethereum Itself

Original Title: "Is ETH2.0 the real 'ETH Killer'?"

Original Author: David Duong, Head of Institutional Research at Coinbase

Translation: Odaily Planet Daily

Content Overview

● Layer 1 (L1) alternatives are becoming increasingly popular, primarily due to the high gas fees on the Ethereum network making DeFi-related transactions increasingly expensive;

● Ethereum is trying to address network scalability issues through Layer 2 solutions, as well as transitioning 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 its scaling.

Gas fees on the Ethereum network have been one of the biggest barriers to the widespread adoption of ETH and general smart contract platforms, which is also the main reason why Layer 1 alternatives like Solana (SOL), Avalanche (AVAX), and Terra (LUNA) gained significant attention in 2021.

However, most active application development on L1 networks still seems to occur on the Ethereum blockchain, with a total locked value of 156 billion dollars across 214 projects on Ethereum, which is nearly double the total locked value of blockchains ranked 2-11. In this context, a question arises: If Ethereum 2.0 can replace the current Ethereum network with a faster and cheaper option, how much value will those L1 alternatives—so-called "Ethereum killers"—ultimately have?

In our view, at least for several reasons, some L1 blockchains still have a space to exist in the crypto space and can coexist with Ethereum.

First, although the official timeline for Ethereum 2.0 implementation has been moved up to 2023 (when sharding will be completed), L1 networks will still intervene during this transition period, aiming to address the long transaction processing times and high transaction costs on Ethereum. That is to say, at least for now, ETH-centric Layer 2 (L2) solutions can play a significant role in increasing throughput and reducing transaction fees.

Second, scalability is just one issue affecting the Ethereum network. Currently, users or investors may not be concerned about issues like maximum extractable value (MEV), but as these ecosystems continue to evolve, related issues may change the governance mechanisms of L1 blockchains. Additionally, 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's mainnet holding certain advantages before the merge with the beacon chain, so Ethereum 2.0 will not crowd out other networks' development opportunities.

That said, we believe that the performance of Ethereum's mainnet in the first half of 2022 may be primarily influenced by monetary policy—especially as the transition to a proof-of-stake mechanism means that the issuance of ETH to miners (and miners' sales of ETH) will gradually decrease. In our view, these changes will not affect the viability or cost efficiency of the blockchain.

However, we do believe that L2 scaling solutions, the merge with the beacon chain, and sharding upgrades may limit the current development of L1 networks. For example, as Ethereum's scalability improves, DApp users may no longer seek faster and cheaper Ethereum alternatives. Nevertheless, we believe that, driven by cross-chain interoperability and the potential need for alternative consensus mechanisms, multi-chain ecosystems will still have significant coexistence space in the short term.

Misunderstanding: Ethereum 2.0 Timeline

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

However, many market participants tend to confuse the upcoming merge of Ethereum's mainnet with the beacon chain with the actual deployment of Ethereum 2.0 itself, which is a significant misunderstanding. The reality is that the merge of Ethereum's mainnet with the beacon chain will only transition Ethereum from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism, but in itself, it has minimal impact on achieving higher transaction processing speeds, increasing transaction throughput, and supporting lower gas fees.

In fact, Ethereum network fees are primarily driven by demand for block space, so if activity on the network rebounds after the merge of Ethereum's mainnet with the beacon chain, the fees on the underlying network (i.e., Ethereum's mainnet) could still continue to rise.

Monetary policy. While there are some issues, the merge of Ethereum's mainnet with the beacon chain does not mean that the update is meaningless, as the change in consensus mechanism may also bring related efficiency improvements, especially in terms of monetary policy. For example, the merge may mean that more ETH is staked while less ETH is created (considering the transition from miners to validators), thereby reducing the supply on exchanges and potentially driving prices up from a supply-demand perspective.

It is important to note that the speed of ETH issuance is also a crucial factor, as in the past, miners often had to sell ETH to fund their operational costs. Therefore, according to our estimates, using (fewer) validators could reduce ETH issuance by as much as 90%, and also reduce the amount of ETH sold on exchanges by at least 30-50%, because the Ethereum network after the merge requires less computational power than the proof-of-work (PoW) mechanism (i.e., lower operational costs mean less forced ETH sales). This situation became particularly evident after the launch of EIP-1559 in early August, as shown in the following figure, where the cash flow of Ethereum miners appears to be more directional.

Figure 1: Net ETH inflow/outflow of Ethereum miners' wallets, Source: Coinbase Analytics

However, while the merge of Ethereum's mainnet with the beacon chain can set a higher low price for ETH/USD, it is unlikely to bring significant improvements in performance metrics such as network transaction speed, scale, or cost. So how should these issues be addressed? The answer may lie in sharding the beacon chain, which is actually an upgrade that the Ethereum network planned to implement before the merge with the beacon chain but was ultimately postponed to 2023 for various reasons, one of which is that ETH-centric L2 solutions have performed well. Now, L2 has become the main focus that the Ethereum network must address for scaling.

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 on upgrading the underlying network. That is to say, in terms of attracting developers and capital, as well as hosting smart contract platforms, we believe that the growth and adoption of L2 solutions may be key to determining whether these so-called "ETH killers" can challenge Ethereum's dominance.

Historically, blockchain scaling solutions have typically opted for larger blocks and/or sharding, but with the emergence of L2, a faster and more economical transaction processing method has been discovered. The main solutions are Optimistic and Zero-knowledge (ZK) Rollups, which can bundle transactions together and process execution in a new environment (i.e., off-chain), then send the 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 sharding upgrades in 2023, it may enhance the impact on transaction execution speed by allowing Rollups to utilize more block space on Ethereum. In the long run, this is crucial for Ethereum's goal of scaling to billions of users and processing tens of thousands of transactions per second.

Figure 2: Average monthly fees on Ethereum, Source: Coinbase Analytics

However, in our view, L2 is still in its early stages, and they may not yet be ready to welcome a golden age, which is actually why they are seen as "L1 alternatives" that can continue to surge. For example, when transferring funds between Rollup and Ethereum's base layer and scanning for fraud, users may have to wait a long time on Optimistic Rollup, in some cases even up to a week, which may pose significant potential risks for institutional investors. On the other hand, ZK Rollups also have certain limitations in terms of supported transaction types.

Living in a Multi-Chain World

As the scalability challenges of Ethereum persist, we believe that the attractiveness of market L1 alternatives will largely depend on the speed of the emergence of Ethereum 2.0 and L2 solutions. That is to say, we may see continued growth of these so-called "L1 alternative networks" and cross-chain bridges in the first half of 2022. However, the opportunity window for L1 alternatives may begin to significantly narrow in the second half of 2022, as we expect improvements in ZK proof technology and broader adoption of Rollups.

However, this does not mean that L1 alternatives will quickly disappear. A multi-chain world is a very real existence, as we believe that solving the scalability trilemma is just the first step in the development of smart contract platform blockchains. First, regarding the trilemma, users may prioritize transaction speed, security, and decentralization issues and choose L1 based on these factors.

Second, other issues in the crypto industry are also beginning to emerge, such as maximum extractable value (MEV) and priority gas auction bots. MEV refers to the profits that miners and validators can extract from others because they can include, exclude, sort, and reorder transactions in a block, which may pose some issues for both proof-of-work and proof-of-stake networks. Issues like this may support the use of blockchains with alternative consensus mechanisms, such as proof of history (PoH), which do not rely on memory pools and may be more insulated from MEV.

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