Delphi Digital: Web3 infrastructure will experience explosive growth in 2023
The biggest opportunity in cryptocurrency lies in our weakest areas.Written by: Delphi Digital
Compiled by: Deep Tide TechFlow
The collapse of FTX resulted in $9 billion in liabilities. Despite this, centralized exchanges continue to attract significant capital.
The biggest opportunities in cryptocurrency lie in our weakest areas; welcome to the year of infrastructure.
We will explore four main pillars:
Access Control
Interoperability
Scalability
Privacy
And the emerging verticals still at the center of blockchain operations: MEV.
Pillar 1: Access Control
Today, access control is static and binary. Users either have complete and exclusive control over their funds or they do not.
There are two solutions: smart contract wallets and MPC.
For smart contract wallets, the permissions of externally owned accounts and smart contract accounts are completely separate—this is designed for security.
Account abstraction (AA) merges the two and unlocks functionality. The main issues with AA are security, coordination, and breaking backward compatibility with existing applications. The solution here is L2 with native account abstraction: zkSync, StarkWare, and Fuel.
MPC (Multi-Party Computation) wallets are another solution. Two examples here are entropy and odsy. Through these, users' keys are split and shared between the chain's validators and the users.
Users sign their secret shares to form a valid signature. When any condition in the smart contract is met, users instruct the validators to sign the shares.
This opens up design space for programmable and dynamic access control, such as conditional payments, whitelists, etc. An interesting protocol in this design space is Lit Protocol.
Lit has a pair of private key-public key. When users mint NFTs on-chain, the generation and distribution of keys occur between Lit nodes. NFT holders can instruct nodes to sign transactions using the generated keys.
In summary, we believe that the combination of smart contract wallets with native account abstraction offers the safest, cleanest, and most flexible user experience for on-chain self-custody. However, they will take more time, and progress between one chain/VM and another will vary significantly.
Decentralized MPC solutions can provide a faster path to the goal. While they cannot offer the complete flexibility and security promised by account abstraction, the scope of their usability is unknown and can span across all chains and even extend to new use cases in Web2.
Pillar 2: Interoperability
The multi-chain world we live in today is a living proof that a single chain cannot meet everyone's needs. Therefore, cross-chain interoperability is at the core of scalability.
The security of cross-chain bridges remains a major pain point and fundamental issue in the industry, with losses from bridge hacks exceeding $2.5 billion in 2022.
Cross-chain bridge designs can be categorized into three types: third-party, light client, and Rollup cross-chain bridges. (Third-party cross-chain bridges are externally validated; while light clients and Rollup-based cross-chain bridges are locally validated.)
Externally validated cross-chain bridges are prime targets for hackers because teams do not collaborate with each other.
Locally validated cross-chain bridges can serve not only as a universal messaging protocol but also meet other fundamental needs and primitives, such as moving wallets, fast synchronization, and reducing reliance on centralized RPC services.
We believe that cross-chain bridges need standardization.
Locally validated cross-chain bridges are ecosystem-centric, allowing teams and developers from their respective communities to conduct large-scale audits. Their roadmaps revolve around developing standards within the ecosystem, considering the maximum mutual benefit for ecosystem participants. The most successful example in this regard is IBC. IBC has already made a significant impact, with 53 chains relying on IBC to communicate with each other.
The main challenge of bringing IBC to Ethereum is that the verification costs of light cross-chain bridges are very high. One solution here is zk-IBC.
Consensus proofs reduce the verification costs of proving consensus by validating headers off-chain without introducing new assumptions. Then, the prover generates a succinct validity proof that can be verified at low cost through Ethereum smart contracts.
Enhancing IBC bridges with zk-proofs can bring IBC to any smart contract blockchain. In the future, consensus from multiple chains can be aggregated into a single proof using zk-proof. This will effectively drive down the costs of cross-chain information further.
One trend we expect to see next year is cross-chain applications. Today, the application layer is multi-chain, but it is not yet cross-chain.
We see this happening in various ways:
?Chainlink CCIP is ready to help blue chips that already rely on it for price feedback to go multi-chain.
?THORChain is continuing to integrate with existing CEX & DEX.
?Axelar has a unique position as it supports Ethereum, other EVM chains, and IBC. So far, it has served as a direct hub between Ethereum and numerous Cosmos application chains, being a major contributor to Cosmos. Axelar has also been selected as the standard cross-chain bridge for Osmosis.
New applications are now even starting cross-chain from the beginning. Ultimately, interoperability is at the core of scalability.
Pillar 3: Scalability
Scalability solutions take different forms at various levels of user demand.
Today, various blockchain architectures coexist to accommodate current user loads. These architectures can be categorized into four types.
We envision modular chains as the ultimate state architecture for blockchains to become mainstream.
Monolithic chains will not disappear, as we know their benefits, such as synchronous composability and permissionless innovation.
We hope that these two designs can coexist in the long term.
For general-purpose monoliths, we still believe Solana is the biggest competitor.
While we consider Solana to be a monolith, it is on the path to becoming a modular ecosystem as the Sealevel virtual machine becomes the standard for Rollups through Eclipse + Nitro.
Outside of Ethereum, the Solana Web3 developer package is the most widely adopted. Block times have significantly decreased. It has the most L1 transactions and the second-largest NFT ecosystem.
It has a new, independent validator client developed by Jump. FireDancer will help diversify clients on Solana and reduce the likelihood of network interruptions caused by client or execution layer errors.
The NFT minting/spam issues that previously caused Solana outages have not had the same level of impact on the chain. Theoretically, the new fee market will isolate peak network fees to the areas of Solana with the highest demand.
Overall, network stability is improving, TPS is significantly higher than other chains, DeFi protocols have new versions, and plans for launch are in place.
While general-purpose chains allow anyone to launch new applications permissionlessly, application chains determine which applications they will run through social coordination.
They lose the agility of permissionless innovation but gain sovereignty over their applications to provide a more reliable user experience.
For general-purpose chains, revenue often goes to the underlying Gas token. Nevertheless, application chains still account for less than 3% of the total cryptocurrency market cap.
For application chains, we think of Cosmos, as the Cosmos SDK is the best toolkit for building new chains from scratch.
Let’s take a look at eight interesting application chains in the Cosmos ecosystem:
? dYdX
? Osmosis
? SeiNetwork
? Injective
? Interchain Security
? Neutron
? Asset Issuance Chain
? Duality
dYdX
dYdX is a Dex application chain currently launched on StarkEx Eth L2 but will transition to Cosmos as an independent chain in 2023. The development of dYdX and its integration into the Cosmos ecosystem will benefit the growth of USDC on Cosmos.
Osmosis
Osmosis is the liquidity hub of Cosmos.
Superfluid staking allows the underlying OSMO in liquidity pools to be LP'd and staked simultaneously. Its latest upgrade added stable swap AMM, IBC rate limits, and multi-hop routing, with more to come in 2023.
SeiNetwork and Injective
SeiNetwork and Injective sit between pure "application chains" and general-purpose chains.
These chains establish order logic in the base layer while building permissioned applications on top. They serve as the infrastructure layer for perpetuals, options, and stablecoins.
Interchain Security
Interchain Security is an infrastructure that allows application chains to launch without guiding the entire validator set.
New chains simply rent security from ATOM validators and stakers in exchange for a proportion of tokens and fees generated on their chain.
Neutron
Neutron is a smart contract chain protected by Hub, providing a smart contract platform for Cosmos to experiment with new things/experimental ideas.
Lido is one of the first notable projects to launch, issuing their ATOM liquid staking derivatives on Neutron.
Asset Issuance Chain
Asset Issuance Chain is a chain protected by Hub for general asset issuance.
This chain is where Circle issues USDC, significantly boosting the amount of native USDC on Interchain, which has been lacking across Cosmos and IBC.
Duality
Duality is a DEX application chain designed to be a hybrid of AMM and CLOB.
It has the capability to create AMM pools that allow swaps at a constant price. It also allows liquidity to be placed at specific prices, similar to limit orders on an order book.
With the developments coming in 2023, the Cosmos ecosystem is poised to increase its market share.
Rollup
Now let’s continue discussing the Rollup-centric vision proposed by Ethereum.
In the past year, the adoption of L2 on Ethereum has been impressive. Their share of L1 Gas consumption has increased from less than 1% at the beginning of the year to 4%.
As L2 Gas consumption increases, its TPS is also rising. This year, L2 has already surpassed the Ethereum base layer in TPS.
In contrast to major EVM L1s like Avalanche and Polygon—who have lost significant liquidity since the beginning of the year…
Arbitrum and Optimism's TVL has been continuously increasing.
EIP4844 will be an important milestone for ETH L2 as it reduces the tx costs of Rollups.
Rollups have two separate costs—execution on L2 + data on L1. EIP4844 increases the data capacity of ETH by an order of magnitude, reducing the data publishing costs for L2.
Today, data published by Rollups is permanently stored on L1. EIP-4844 relaxes the data requirements for Ethereum L1 and reduces Rollup fees by an order of magnitude.
An interesting project that can play a significant role for Ethereum is Eigen Layer.
EigenLayer can be seen as Ethereum's vision for inter-chain security. It will allow Ethereum validators to re-stake their ETH to provide additional services.
Validators will expose themselves to penalties for malicious behavior but will be able to earn rewards from the services they provide. EigenLayer can accelerate innovation at the protocol level.
The Rollup-centric vision proposed by Ethereum has been the greatest catalyst for the development of smart contract Rollups. Last year, Celestia expanded the definition of Rollups by introducing sovereign execution and/or settlement Rollups and the concept of Celestiums.
The definition of a modular blockchain is a blockchain that outsources at least one key function (execution, settlement, consensus, data availability) to another blockchain.
Celestia is expected to be the first truly modular blockchain network.
After the mainnet launches the foundational data availability layer, there will be some modular settlement and execution layers that launch user-facing applications. One of these projects is Fuel.
The Fuel team has been developing FuelVM from scratch to create a modular execution layer.
Fuel may have multiple instances, including a PoS sidechain to Ethereum, smart contract rollups on Ethereum, and sovereign Rollups on Celestia.
While these developments are exciting, it is important to note that rollups are still in their infancy: almost no Optimistic rollups have permissionless fraud proofs, and all rollups have security-critical upgradeability vows in their contracts, minimizing the trust assumptions of cross-chain bridges.
Pillar 4: Privacy
The openness of public blockchains is a double-edged sword. From the perspective of solvency and transparency, openness is a feature and one of the greatest advantages of blockchain.
The ability to audit protocols in real-time and check their solvency in seconds addresses the opacity issues we see in centralized institutions—this was a painful lesson in 2022.
A one-click audit of the full reserves of DeFi protocols is something CeFi can never achieve, no matter how robust the reserve proof process or how diligent and reputable the auditing firm.
However, a 100% transparent financial network comes at a cost. Keeping your history 100% on-chain not only exposes profitable trading strategies but can also be dangerous from a personal safety perspective.
Thus, there are various interesting privacy developments, including:
? Penumbra
? Aztec
? Aleo
Penumbra
Penumbra: As a fully private DEX, Penumbra acts as a shielded pool in the Cosmos/IBC ecosystem.
Their shielded swaps prevent certain MEV-like front-running and sandwich attacks, utilizing sealed bidding and batch execution to clear orders at a single price.
Penumbra's V1 AMM utilizes concentrated liquidity design, allowing market makers to deploy strategies privately without leaking them.
Aztec
Aztec Connect is unique compared to other rollups. It does not have its own smart contracts/dApps/liquidity but acts like a VPN to use Ethereum L1.
Ethereum protocols can integrate with the Connect SDK, allowing Aztec users to privately use their protocols from Aztec.
Aleo
Aleo is a default privacy smart contract platform.
Developers do not have to consider privacy issues when developing dApps on Aleo; they get it by default. They retain the ability to decide which aspects of their applications to display publicly.
Aleo's thoughtful aspect is its hybrid use of PoW/PoS; PoS for instant finality and PoW for scaling proof generation performance.
Aleo allocates part of the block rewards, decentralizing proof generation and opening it to an open network of SNARK provers.
We expect privacy to regain focus and become a major theme, with this battle being not only technical but also regulatory. Privacy is important.
MEV
The most important topic, and the last emerging vertical in our blockchain operations center: MEV.
We will cover MEV on ETH, Solana, Cosmos, MEV-Boost adoption, relays, builders, censorship issues, and Flashbots development.
Ethereum blocks can be built locally or externally.
Local block building is the default process, where validators receive public mempool transactions, package them into a block, and then broadcast this block to other validators in the network.
In external block building, validators outsource the block building process by running MEV-Boost, which is a "sidecar" software that allows validators to profit from MEV without any knowledge, complex systems, or relationships with builders.
MEV-Boost is merely an aggregator of relays, selecting the highest bidding (i.e., most profitable) blocks from the relays connected to validators. The main stakeholders in this supply chain are searchers, builders, and relayers.
Searchers: Run MEV strategies and send bundles (transaction sequences) to builders.
Builders: Aggregate transactions from searchers and other sources to build blocks.
Relayers: Receive blocks from builders and send them to proposers.
MEV-Boost allows validators to maximize their staking returns by selling their block space to an open, competitive block builder market.
This means consistently higher staking yields and greater execution layer rewards for large staking providers like Lido Finance.
MEV is inherent to blockchains, and it remains to be seen how profits will be shared.
A competitive builder market will lead to a more balanced distribution of MEV, as builders compete on execution guarantees, sharing profits with users, providing rebates for order flow, etc.
On the other hand, monopolies will allow a single builder to retain more of these profits for themselves, as users will have nowhere else to go.
Encouraging signs have already emerged as Flashbots' builder market share has dropped from 75% to 25%.
The builder market started out very concentrated but has become more diverse over time.
On the other hand, the relay market is still dominated by Flashbots, which is a concerning issue given the censorship regime of relays.
Due to Flashbots' dominance, the number of censored blocks has been increasing, as most MEV-Boost transactions (63% of payloads) go through Flashbots relays.
The adoption rate of MEV-Boost and the censorship/OFC compliance rate of the base layer are essentially 1:1.
Currently, about 67% of blocks comply with OFAC standards. This does not mean that censored transactions will not go through, but they will be delayed. The probability of 67% censorship rate/50% censorship transactions is about 24 seconds.
At 99% compliance, this will increase to greater than 13 minutes.
Flashbots' next (and more significant) announcement is their new application chain SUAVE.
The primary goal of SUAVE is to facilitate a competitive builder market—where builders bid in the open market and there are no exclusive PFOF agreements.
SUAVE has three main components:
1. Universal Preference Environment: Displays and aggregates transactions from all users and searchers into a centralized cryptographic mempool.
2. Best Execution Market: "Executors" listen to the SUAVE mempool and compete to provide users with the best execution.
- Decentralized Block Building: Builders utilize cryptographic preferences from the network to compete and build partial or complete blocks.
SUAVE not only aims to make the builder market more open and decentralized, but it also has the opportunity to create a decentralized block builder, where various builders independently build parts of blocks and combine them.
Speaking of Solana MEV, Jito Labs is the leader. Jito-Solana validators are a fork of Solana validators that allow packaging as a primitive.
Jito solves two major issues for Solana:
It facilitates an open market for MEV, optimally distributing profits to validators.
It reduces spam and improves network efficiency.
Jito essentially creates an off-chain fee market for a network that was not designed for it.
MEV on Solana is still in its infancy, but if Solana's overall vision is realized, there will be a massive economy facing unique challenges in the future.
Currently, there is no real MEV within the Cosmos ecosystem.
As an ecosystem primarily composed of application chains, Cosmos' MEV has two main distinctions from other ecosystems:
First, theoretically, application chains can internalize MEV. This means that token holders of these application chains can accumulate MEV directly for themselves instead of leaking it to another token. For example, MEV on Uniswap does not flow to UNI.
Second, Cosmos opens up a relatively undeveloped area: inter-chain MEV. While cross-chain "non-atomic" MEV exists in other ecosystems, it is naturally higher in Cosmos due to more inter-chain activity.
Application chains can still develop off-chain markets, where validators bypass internalized MEV and do not share with stakers. Some Cosmos chains have already begun governance/social coordination to attempt to prevent the development of these off-chain markets.
Finally, a promising idea from Cosmos Hub may still take a few years to materialize.
The Interchain Scheduler focuses on consumer chains and will become a futures market for block space.
MEV was initially a niche idea on Ethereum but has recently taken center stage as one of the most critical issues for blockchains to address.
At a high level, blockchains create economic activity, thereby creating MEV—this will be the primary value accumulation driver for every chain, just with different slicing methods.
MEV will always be inherent to blockchains; it is just the distribution method that has yet to be determined.
Conclusion
2022 may have been a rough year for the industry, with the negative externalities of MEV, cross-chain bridge exploits, and the FTX collapse taking center stage.
On the other hand, significant progress is being made in all major aspects of infrastructure, including user experience, scalability, interoperability, privacy, and censorship resistance.
Today's cryptocurrency infrastructure is not yet ready to handle mass adoption, but 2023 will still be a year of resurgence. We believe 2023 will be a year of returning to fundamentals, with renewed focus on the infrastructure layer.
Otherwise, how do we scale cryptocurrency to billions?
