What is going on with Ethereum? Not only is its native token, Ether (ETH), underperforming as the current market rally gathers steam, but the whole Ethereum blockchain ecosystem appears to be facing problems of its own making.
It is not easy being the world’s first decentralised smart contract blockchain. The pioneer has claimed significant crypto and DeFi market share since launching in 2015. But as a first mover, Ethereum also faces the most severe headwinds as it forges a path through unchartered territory.
Unlike Bitcoin, which is content with its original simple design and function since conception, Ethereum must keep adapting. This is because Ethereum has been designed to handle far more complex tasks than Bitcoin. And as the decentralised ecosystem innovates and expands, the Ethereum base layer blockchain must keep up with activity growth.
But in solving one problem caused by increased activity, Ethereum appears to have steered itself into another potential bottleneck – ironically by the very protocols designed to fix the problem.
The latest state of affairs – Ethereum’s Layer 2 ecosystem
These protocols are known as Layer 2 (L2) protocols, which operate a large range of functions sitting on top of the Layer 1 (L1) Ethereum blockchain. Their demand became apparent after the CryptoKitty NFT craze back in 2017. These NFTs started clogging up Ethereum’s network with a sharp rise in activity, raising transaction fees to unsustainable levels.
Initially L2s such as Arbitrum, Base, Optimism and zkSync offered users a way around Ethereum’s high fees. But as these protocols grew in popularity, they also began experiencing their own bouts of congestion and high fees.
Ethereum’s Deneb-Cancun (Dencun) network upgrade in March of this year released the pressure by creating extra data storage space. This allows L2s to ‘roll up’ and process multiple transactions in chunks before sending them back to the Ethereum L1 for final settlement.
This has worked out splendidly for L2s, such as Arbitrum, Base, Optimism and zkSync, which can deal with more transactions at a faster pace, generating greater protocol revenues in the process. But this is also draining activity and fees away from Ethereum’s chain at an alarming rate.
The ongoing debate about whether L2s are parasitic to Ethereum continues to fuel conversations in the crypto community, questioning if they are helping or harming the network.
L2 Dominance vs Ethereum – Active Users
Source: Dune, 21co
The consequences
The survival of any dependent Layer 2 relies on the stability of its L1 host. As the final and trusted guarantor of property rights for all users in the decentralised ecosystem, the Ethereum blockchain is the bedrock of all L2 activity.
The good news is that Ethereum is still a long way from a critical tipping point. But many in the community agree that the current state-of-affairs is unbalanced and looks unsustainable.
Draining activity and fees away from Layer 1 makes it less profitable, and attractive, for validators and developers to operate on the Ethereum blockchain.
ETH investors are also feeling the pinch. Ethereum’s tokenomics keep inflation in check by permanently burning a portion of ETH with each transaction on the L1 blockchain. Fewer transactions increase the number of ETH in circulation, which by consequence leads to inflationary pressures.
In addition, the Ethereum ecosystem is now becoming fragmented as mismatched economic incentives drive a growing number of L2s into competition with their L1 host, as opposed to the desired symbiotic partnership.
DeFi giant Uniswap and centralised exchange Kraken have announced they are building their own L2 blockchains to bring user activity and transaction fees closer to home.
The growing cluster of L2s each have their own agenda, creating a tangle for investors and obstacles to seamlessly move assets between blockchains.
The opposition
For a few years, Ethereum was by far the most powerful smart contract platform in the market, allowing it to capture a market share dominance it still enjoys.
But the more recent emergence of L1 rival blockchains, such as Solana, Sui, BNB, Avalanche, Aptos and the soon to launch Monad, among others, are ready to take advantage of any weakness shown by Ethereum.
In terms of tokens, most eyes are fixed on Solana’s SOL as the most likely candidate to ‘flip’ ETH in terms of price and total market cap. Although the market cap between the two remains significant, many TradFi institutions choosing Solana for its scalability over Ethereum is a trend that could make it a real challenger if this continues.
The biggest worry for Ethereum would be for developers, projects and DeFi users to switch their activity to a rival L1 perceived to be more efficient and user-friendly – for instance, when the popular decentralised GPU rendering platform Render Network migrated to Solana late last year.
It is also possible that an L2 operating on Ethereum could pivot to a go-alone strategy, breaking free from the mothership if it gains enough traction.
However, the recent failure of many L2 blockchain airdrops to boost their communities and stimulate more activity suggests they are still some way off matching the strength of the Ethereum community of developers and users any time soon.
Providing tokens as a reward for meaningful work on blockchains backfired in some cases. Airdrops were exploited by opportunists who created multiple accounts to vacuum up as many tokens as possible before selling for a quick profit.
Can Ethereum bounce back?
As mentioned before, Ethereum is a constant work in progress, evolving to meet the changing demands of the industry. Ethereum’s strength of seeking consensus among its decentralised community can sometimes prove its Achilles heel in terms of speed and agility.
But there are plenty of signals of resolve among developers to patch up Ethereum’s current problems and improve efficiency. It is all a case of finding the right solution to maintain the balance between security, speed and decentralisation – in other words, working around the blockchain trilemma.
Several solutions have been put forward to both rebalance the distribution of fees between the L1 chain and the L2s it supports, and to increase interoperability between the fragmented L2 chains.
The proposals include leveraging advances in zero-knowledge proof (ZKP) technology to streamline the transaction process, to tweaking the system of assigning validators to secure the network and adjusting roll-ups to bring them closer to the L1 blockchain.
The fragmentation issue is also being addressed by the L2 Optimism, which has created a ‘Superchain’ network of chains, allowing L2 projects that build on top to coordinate bridging, decentralised governance, upgrades and communication.
Optimism’s OP Stack has already drawn in Coinbase’s Base and Kraken’s Ink blockchains plus Web3 projects from Sony and Samsung.
There are even talks that Ethereum might reintroduce sharding after Ethereum Foundation researcher Justin Drake teased a new proposal for the Beacon Chain roadmap at Devcon earlier this month, which could dramatically reduce the network’s reliance on Layer 2 solutions.
Concluding remarks
There is little doubt that Ethereum continues to maintain its dominance over L1 blockchains like Solana, even if these rivals are catching up.
Ethereum is for now the default public blockchain for many traditional finance projects, such as BlackRock’s BUIDL tokenised money market fund. However, BlackRock has just expanded its project to launch on other high-performance L1 blockchains (Aptos, Avalanche) and L2 solutions (Arbitrum, Optimism).
Competition is fierce, but competition is also good for the future health of decentralisation. Ethereum was created and built and is continuously developed by some of the brightest minds in blockchain. It seems inconceivable that the pioneering project will break down or be consumed by rivals any time soon.
But Ethereum is also being pushed hard by the twin challenges of rapid decentralised innovation and rival blockchains. Like any centralised company, Ethereum’s current dilemmas prove that it can never sit still and must continue to adapt to remain competitive.
ENDS
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