Messari interprets the development of Layer 1 in the first quarter: Ethereum challengers accelerate growth

This article was published on Babit, author: Wilson Withiam, translated by: Pingfeng.

In the first quarter of 2021, there were two major stories in the world of Layer 1.

The first story is about Ethereum, which broke its historical high and confirmed the launch date of what may be its most important upgrade to date (EIP-1559). The total value locked (TVL) in the DeFi space grew by nearly 200%, reaching approximately $48 billion. It has become the most widely used blockchain and has accumulated enough momentum to enter the next round of upgrades.

The second story is about Ethereum's challengers. With the rise of the cryptocurrency market, the subsequent gold rush among retail investors once again pushed Ethereum to its limits, with average transaction fees (in USD) reaching new heights. Users, unable to bear the rising fees, turned their attention to alternatives outside of Ethereum, discovering an ecosystem that was once barren now showing signs of life. New Layer 1 applications on platforms like Binance Smart Chain (BSC) and Solana, as well as inter-chain solutions like Cosmos and Polkadot, accelerated growth in the first quarter, with no signs of slowing down.

While Ethereum benefited from the overall growth of the Layer 1 space, it continued to lose market dominance. In the first quarter, its market dominance fell to 51% and may decline further as newer, faster chains find their footing, and their token prices "skyrocket" (compared to Ethereum). Next year will be a decisive year for Ethereum as developers explore solutions like flash bots and rollups to scale the network. What is certain from the first quarter is that the long-awaited scaling war has officially begun.

Ethereum Challengers

From the current situation, this year is a revival year for "Ethereum killers." Most new Layer 1s raised significant funds between 2017 and 2019 but made little progress while Ethereum captured all the attention.

In the past six months, the relationship between Ethereum and its so-called challengers has undergone a subtle change, as Ethereum's high fees forced users to explore new platforms. Users flowing out of Ethereum made developers realize they could make a living elsewhere. Developers launched new applications with token incentives, attracting users seeking profits, thus triggering a speculative and developmental flywheel: a larger user base brings more revenue or better token prices for development teams, leading to more developers joining and creating high-yield applications.

The flywheel effect of token incentives is significant (both during the rise and the fall), which is why new, low-fee, high-performance Layer 1s are emerging so rapidly. Whether Ethereum challengers can succeed depends on their ability to differentiate their products from Ethereum and stand out.

There are two types of challengers: vertical integration (single-stack) and horizontal modular (inter-chain) networks.

Vertical Integration

Vertical integrated networks are fully functional, all-in-one tech stacks. Ethereum (in its current form) is a single-stack network that layers different network touchpoints on top of each other, but they all share the same state. These chains achieve synchronous interoperability (also known as composability) because they can handle transactions that call multiple contracts within a single block.

Binance Smart Chain (BSC) and Solana are two chains that use the single-stack model and have outperformed other top ten Layer 1s in the past quarter.

The rise of BSC is primarily due to its close ties with Binance and its EVM compatibility. It uses BNB as the native token for gas payments, which already has a broad user base and can be used across Binance's various product suites. When Binance launched BSC in September 2020, it also initiated a $100 million support fund to guide its development. This funding directly or indirectly contributed to BSC becoming the most successful applications to date—PancakeSwap (DEX) and Venus (lending platform). PancakeSwap competes with Uniswap in daily trading volume, while Venus has accumulated over $5 billion in TVL (approximately 2/3 of Compound's total TVL).

BSC is also compatible with Ethereum tools, which lowers the learning curve for most smart contract developers and helps accelerate application development. A key feature of BSC is its increased support for MetaMask, allowing users familiar with MetaMask to switch almost seamlessly between Ethereum and BSC.

When Ethereum's on-chain activity broke its maximum capacity in early January 2021, BSC's building blocks were already in place. As Ethereum's user experience deteriorated, BSC was able to provide a smaller but usable DeFi ecosystem at 4% of the cost and with a block time of 3 seconds. The results were clear: users flocked to BSC, and its on-chain activity multiplied in February. BNB became a part of the platform and DeFi liquidity pools, and the excitement around BSC led users to buy, deploy, and hold more BNB.

BSC currently has over $22 billion worth of tokens locked in more than 50 DeFi applications, with its TVL second only to Ethereum ($60.1 billion).

Solana's story is quite similar. The turning point was the arrival of Sam Bankman-Fried and the launch of Serum in August 2020. Unlike the popular AMM model on Ethereum, Serum features an order book model with an on-chain matching engine. Due to Solana's fast processing times (over 50,000 transactions per second) and low fees (0.001 USD for every 100 transactions), this on-chain order book is considered a more efficient capital model. In contrast, Ethereum's 15-second block time and unstable fees make order book DEXs seem inflexible and inefficient.

Almost all Solana applications are built on Serum, with its order book becoming an essential component of AMMs like Bonfida and Raydium, as well as lending protocols like Oxygen. Non-financial applications like Audius and Solible also plan to use Serum's matching engine on the backend to facilitate trading and distribution of NFTs or social tokens.

It wasn't until January, when Ethereum fees skyrocketed, that Solana's development began to accelerate. Since then, Solana's DeFi has grown from Serum and a handful of projects to nearly 40 applications, with a TVL now exceeding $750 million, although still far behind Ethereum, it has grown over 400% since early February.

BSC and Solana both benefit from their monolithic designs. Synchronous composability can be said to be Ethereum's defining feature. Integrating existing building blocks allows developers to innovate and create applications quickly. With the right integration or differentiation approach, some core components can give rise to new DeFi ecosystems.

The problem is that vertically integrated networks have historically struggled with scalability. A single chain has a large amount of data, and each application must adhere to the same transaction rules. The result is that node storage costs and network fees increase as on-chain traffic rises. Ethereum has reached its limits and must seek ways to offload the burden, reducing storage costs and fees but breaking the ties of synchronous composability.

BSC and Solana address this issue by reducing the number of validators and increasing the costs for validators. BSC sets its validator set to 21 to minimize the time required to reach consensus. Its consensus layer also relies on Binance Chain (another earlier independent blockchain of Binance), which has only 11 validators (as shown below), to minimize on-chain complexity. Solana's validator requirements are an order of magnitude higher than Ethereum's node costs. As the storage costs for validators will only increase over time, the facilities best suited to run Solana nodes are high-end data centers. These methods make the power dynamics of the network (how many entities control the network) difficult to decentralize.

In the end, will users care about centralization? Most have sacrificed privacy for convenience. Decentralization may be the same, as users driven by profits tend to lean towards centralized products. However, political decentralization has become the cornerstone of Ethereum DeFi, as almost every application strives to establish DAO-based governance systems. Transferring power to the community is a good protective strategy. As the cryptocurrency market adjusts, yields will gradually trend towards zero, and in the long run, user experiences across networks will converge. But those empowered and embracing decentralization communities will be more likely to ignore market fluctuations and actively contribute to project building.

If the controlling entities of a project do not overstep, decentralization may not actually matter. To protect the development of the community, centralized approaches are unsustainable. When decentralization is compromised, people will realize its importance.

Modularization

Unlike all-in-one networks, modular systems divide processing, consensus, or storage responsibilities among different independent chains. These chains typically build infrastructure using their respective ecosystem software frameworks or shared modular toolkits. Independent chains are either tailored for a specific application, providing a primary function, or serve as a more general platform for application development, like Ethereum.

Modular systems typically resemble a hub-and-spoke topology, where independent chains plug into a central hub or chain, facilitating cross-chain communication or assisting in network security. Because these systems allocate computational resources, no single chain can bear the operation of the entire ecosystem. This is achieved through parallelization for scalability.

Polkadot and Cosmos are two of the oldest and most well-known modular networks, but in the first quarter, Fantom and Avalanche stood out in price performance.

Fantom features an independent consensus layer and application execution layer. The consensus layer, called Lachesis, provides validator resources to support and secure multiple external execution layers. Fantom's first execution layer is an EVM-compatible platform called Opera FTM, launched in December 2019, but it only gained widespread attention in January 2021. Its recent resurgence is due to all-star DeFi developer and long-time advisor to Fantom, Andre Cronje, helping to establish and market Fantom's cross-chain solutions and technical capabilities.

Fantom launched a bridge to Ethereum in early March, prompting DeFi applications from the Yearn Ecosystem—Curve, SushiSwap, and Cream Finance—to deploy their contract versions on Opera FTM. Alameda Research and BlockTower Capital made headlines by purchasing large amounts of FTM tokens at the end of February and early March, respectively.

Avalanche is similar to Fantom, as it has multiple layers that execute core network functions (consensus, application execution, and token creation). Developers can also create customized execution layers called subnets, which have use-case-specific network parameters but can ensure transaction security by using a subset of Avalanche's validator group. Subnets can have overlapping validator groups but are modular in other respects.

When Avalanche's first DeFi application, Pangolin, launched on February 9, 2021, on-chain activity accelerated. The network's native gas and staking token, AVAX, surged from around $15 to nearly $60 in the subsequent frenzy. A surge in user activity also triggered a bug in Avalanche's codebase, rendering its primary execution layer (C chain) unusable for an entire day. This series of events illustrates that the demand for a low-cost DeFi environment is very real. Pangolin now has over $200 million in liquidity, with daily trading volume around $15 million. Avalanche's DeFi ecosystem continues to grow, with complementary financial products like YetiSwap (exchange), Snowball (yield aggregator), Penguin Finance (asset management), and SushiSwap.

Non-essential layers and their tokens in modular systems will also benefit from improved developer experience, and in some cases, gain better defensibility (tokens tied to on-chain security models are hard to fork). The Cosmos ecosystem is a perfect example of these advantages, as each zone (independent chain) can be optimized for specific use cases, find product-market fit, and innovate quickly (adding new modules) to capitalize on specific trends.

For instance, Terra initially established its stablecoin creation system and generated organic user demand through the Chai app. As demand for Terra's UST stablecoin grew, it added a smart contract module to its infrastructure in December 2020, allowing Terra to launch a synthetic asset trading platform (Mirror Protocol) and a money market protocol (Anchor) in the following months. UST is the core asset within each protocol, and the emergence of these protocols facilitated the minting of UST. The price performance of LUNA in the first quarter indicates that Terra's DeFi ecosystem is rapidly developing, with UST being widely used. When Terra issues stablecoins, LUNA is burned, which is beneficial for price trends.

Modular networks still face some recent challenges. Although these systems do not restrict on-chain composability, inter-chain communication will be asynchronous by default. As mentioned earlier, seamless composability is often a prerequisite for rapid innovation. But as Paradigm pointed out, "synchronous interactions with all other applications will ultimately not be sustainable at scale." Most chains, even Ethereum, are addressing scalability issues through sharding. Future systems will consist of a mix of synchronous and asynchronous communication paths.

Another downside of modular networks is that their architecture is relatively new. Therefore, their ecosystems may either be underdeveloped or lack functionality. However, several modular systems are on the verge of significant developmental milestones.

Experienced networks like Cosmos and Polkadot have a lot of developer activity and are about to release their defining features. Cosmos Hub launched support for IBC connections in February and transitioned in March to enable cross-chain communication. This is the first in a series of planned upgrades aimed at improving the fundamentals of ATOM and the role of Cosmos Hub in the ecosystem.

Similarly, Kusama and Polkadot plan to launch support for parachains (individual chains connected to Kusama or Polkadot) at some point in 2021. Once online, KSM and DOT holders can lend their tokens to projects to help them secure parachain slots in exchange for token rewards. Stakers in both networks will also proportionally receive fees generated by the network to facilitate cross-chain communication.

So far, KSM and DOT have advocated for minting rights and have sought to grant voting rights to holders in their isolated networks. Parachains will transform these tokens into more powerful capital assets (collecting fees) while endowing them with currency-like characteristics (as collateral for parachain auction rewards). Users may bid for KSM in preparation for parachain auctions, which could occur in the coming months (or even sooner).

The success of modular systems will depend on the quality and scale of their sub-chain ecosystems. Cosmos and Polkadot have pioneered this, with over 200 and 130 projects, respectively, waiting to connect with each other. Greener modular networks like Fantom and Avalanche have only one primary execution environment. In each case, the chains are EVM-compatible, which is a great growth hack, but they will ultimately compete with other EVM-compatible Layer 1s (like BSC) and Layer 2 solutions. The diversity of ecosystems in product suites or market strategies will determine whether they succeed or remain mediocre.

Layer 2 Scaling Solutions

Layer 2 scaling solutions are undoubtedly part of Ethereum's development roadmap. They not only help bridge the gap between now and the launch of Eth2 but can also serve as accelerators for Eth2's scalability, theoretically increasing its processing capacity to around 100,000 transactions per second.

In general, these Layer 2 solutions accelerate transactions through off-chain means and then package them as a single transaction to submit to the base layer. By batching transactions, Layer 1 can significantly increase the number of transactions processed per block while theoretically providing similar security assurances at settlement. Off-chain transactions are essentially free and do not burden the underlying network with excess data and computation requests.

Layer 2 solutions are good news for a network that saw average transaction fees rise over 600% at the beginning of the year. Ethereum users have gradually become suddenly attracted to these solutions.

After a sluggish start in 2020, the total value locked in Layer 2 increased by 606%, reaching $273.4 million by the end of the first quarter. This return rate does not even include the value in Ethereum plasma solutions like Polygon (which is more like a sidechain than a true Layer 2 network), Validium-based applications like Deversifi, or the newly added ZKSwap. By the end of this quarter, Ethereum users had locked assets worth $745.5 million in Layer 2, a figure that was below $100 million just four months prior.

Layer 2 decentralized exchanges also saw a surge in user activity. The total daily trading volume of all Layer 2 DEXs grew by nearly 3000% in the first quarter, driven by Loopring's liquidity mining program launched in January and Polygon's QuickSwap going live in February.

Although these numbers are far from those of Layer 1 DEXs, the trend is clear: projects are developing, and users are following suit.

Venture capital firms have also recognized the increasing demand and adoption of Layer 2 solutions among users. As a16z pointed out, "there's no doubt that scaling Ethereum is necessary to support the rapid growth of the network." This demand is why venture capital firms invested over $100 million in Layer 2 solutions in the first quarter, with notable investments including a $25 million Series A for Optimism and an astonishing $75 million Series B for StarkWare.

The only development hurdle faced by Layer 2 in the first quarter was Optimism delaying its launch from April to July (or later). This delay should be just a minor obstacle, as this year is expected to be a big year for scaling solutions. The public release of Optimism and its integration with Uniswap are two of the several major Layer 2 milestones anticipated in 2021. Other developments include the mainnet launch of Arbitrum's optimistic rollup, Matter Labs' zkSync 2.0 supporting Solidity smart contract development, and StarkWare's application support for STARK-driven ZK Rollups.

While Layer 2 scaling solutions are essential for Ethereum's next phase of development, there are still some lingering questions regarding their impact on the network and user experience.

• Layer 2 parasitic issues: Will Layer 2 negatively affect Ethereum's security and the value capture of ETH? Because they will shift activity and miner/validator fees away from the base layer.
• Disruption of composability: In the foreseeable future, Layer 2 will be isolated centers of composable activity, with cross-Layer 2 activities only occurring on an asynchronous basis. How will protocols relying on Ethereum's current composability standards respond when their underlying connection points (and liquidity) shift to different solutions?
• Cross-Layer 2 communication: Currently, cross-L2 communication requires multiple costly transactions, as they must be routed through Ethereum. When users want to withdraw assets back to the base layer, they may face a long waiting period. If Ethereum's DeFi is distributed across different Layer 2s, how will these transactions be handled to make it more convenient for users? Connext's Spacefold transaction track and using L1 liquidity for L2 applications are potential solutions, but the realm of L1-L2 and L2-L2 transactions is still vast.
• Recurring congestion issues: What happens if almost all protocols migrate to the same Layer 2 and trigger the same congestion issues Ethereum experiences during peak times?

Not every question will have a perfect answer. Most solutions may ultimately be compromises to tricky problems. But the demand for scalability is real. Where there is demand, there is opportunity, and so far, cryptocurrency developers have shown remarkable creativity in solving problems within the scope of cryptography and blockchain.

The Future of Multi-Chain

The clear demand for yield-generating protocols and an endless thirst for assets indicates that the crypto industry is indeed large enough to accommodate multiple blockchains. Layer 2s and Eth2 will alleviate Ethereum's scalability dilemma, but current scalability issues will also include bridging Layer 1s.

Those who define themselves as "x-chain cultists" do so because they refuse to accept data-driven arguments. Ethereum may become the center of the crypto economy, while Bitcoin leads as the reserve asset of cryptocurrencies. But now Layer 1s can offer better or even complementary services in specific areas, such as Flow positioning itself as a haven for NFTs, and THORChain connecting traditional blockchains. As the cryptocurrency industry evolves, more questions (which may be opportunities for optimists) will arise, and the technological components needed to solve these problems may emerge on newer Layer 1s.

Bitcoin set the wheels of history in motion. Ethereum expanded possibilities by adding functionality. Their successors will extend the user base from a crypto-native niche market to the mainstream. While over time, some network communities may fail to realize their potential, the number of viable chains will decrease, but the near-term future will be a multi-chain future.