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Although Bitcoin and Ethereum continue to dominate the Layer 1s (L1) in terms of network security, active users and market capitalization, they also face challenges, namely slow speed, limited throughput and high gas fees. This has created opportunities for a number of emerging chains. Those that have marketed themselves as faster and cheaper alternatives have attracted a significant share of new developers and decentralized applications (dApps), along with strong community engagement, which has in many cases driven impressive performance of their underlying governance tokens.
With an ever-expanding list of contenders – lovingly known as “ETH-killers” – it has become increasingly challenging to determine which chain will ultimately win out and dominate the space. What qualities make for a successful L1? Will there be room for multiple chains? How does one assess the relative value of these L1s? And, perhaps most interesting, what is the ultimate blockchain end-game?
In this piece, we outline our framework for assessing the value of this growing community of L1s and invite readers to share their thoughts on this topic.
L1s are native blockchains on which dApps exist: L1s can be thought of as the prime real estate of the crypto world, while dApps are the storefronts. There are currently 5-10 major L1s, most of which utilize the Proof of Stake (PoS) method of validation (see Appendix 1). Ethereum is one of the best-known L1s (soon to be PoS), whereas AAVE and SUSHI are examples of the tokens for the dApps that are built using the Ethereum chain. While valuations for L1 governance tokens are generally very challenging to assess, investors in these protocols are in the unique position of being able to own a piece of the underlying blockchain in a way that doesn’t exist in the traditional internet space.
The bar for success is incredibly high, limiting the number of platforms able to achieve critical mass. The leading L1s generally command far higher valuations vs typical underlying native dApps (for example decentralized exchanges or borrow/lend platforms, where competition is intense). This is because L1s ofer greater permanence, network efects, composability of underlying core dApps, and pure exposure to growth in the network.
Beyond optimizing for the scalability trilemma (see Appendix 2) – decentralization vs performance vs security - we pose the following as critical “key performance” factors in assessing the fundamentals of an L1, listed from most to least important: • Developer adoption – ease of use creates eficiencies and development speed, and not surprisingly, developer-friendly tools often attract founders from one particular L1 to another. This includes the choice of smart contract language (e.g., Solidity for Ethereum) and runtime environment. In the case of Solana, for example, the primary language is Rust, a relatively common programming language that eases developer adoption.
Below we assess ten platforms using these factors. In general, developers, users and investors have tended to place a premium on performance, particularly given gas costs and the limited throughput of the Ethereum network to date. While still in development, Eth2 is clearly in a good position relative to other L1s in terms of both performance and decentralization.
A good example of an L1 that positively incorporates many of the characteristics outlined above is Avalanche (AVAX). Avalanche is a PoS L1 with one of the highest throughput speeds (~4500 tps) and a transaction finality of sub 2 seconds. Avalanche allows any developer to create their own app-specific blockchains and supports multiple virtual machines, most importantly the Ethereum Virtual Machine, allowing for a high degree of decentralization and interoperability. The Avalanche foundation recently started Avalanche Rush, its $180m incentive program, that has onboarded leading DeFi projects Aave and Curve. This incentive program has helped attract capital to its core dApps, such as Trader Joe, a leading DEX and staking platform, which has grown its TVL from $20m in early August to over $2bn at present. Other core apps on Avalanche include BenQi (borrow/lend), YieldYak (yield farming autocompounder) and Snowball (auto-compounder and incubator). While Avalanche has average gas fees that are far lower than Ethereum, it also has far less demand for block space. In the last month there were a few days where gas prices spiked to $140 per transaction as a result of short-term spikes in demand for block space.
Similarly, on Solana, core apps such as Raydium, Marinade, Saber and Sunny are seeing strong initial momentum, supported by low gas fees and helpful products such as liquid staking (ie staked SOL earning a yield but tradeable in the form of mSOL) on Marinade. Solana is also experiencing an increase in NFT volumes, with monthly sales topping $140m in October from a standing start in August – albeit still far below the $1.7bn logged on Ethereum last month. Low fees on Solana are also supporting the burgeoning gaming ecosystem, which has become a major focus for investors. On that point, Solana Ventures, Lightspeed and FTX recently announced the launch of a $100m gaming fund.
In the short term, investors clearly are attracted to the high expected upfront returns and low transaction costs. Longer term however, it remains to be seen how viable some of these core protocols will be once the incentive programs end and they are forced to compete head-on with the more established players such as Aave, an early “Blue chip” DeFi protocol which is already expanding from Ethereum into other L1s and L2s on multiple chains, and enabling cross chain collateral in their recent v3 update.
On a similar note, L1s will ultimately have to compete with Eth2 which is being introduced sometime in 2022. Eth2 is arguably the most promising solution to a fully performant, decentralized and secure blockchain, given it has already achieved significant user and developer adoption. Based on current network activity, Ethereum is also on track to be ~3% deflationary post Eth2 given the combined impact of EIP-1559 fee burn and lower net emissions, which is clearly very attractive from an investor perspective.
It was originally thought that the L1 ecosystem would ultimately be “winner takes all,” given powerful network effects and composability. More recently, however, sentiment has shifted towards the increased likelihood of a multi-chain ecosystem, enabled through increasingly sophisticated bridges built between various L1s. This has the potential to break the single-network effect, allowing a degree of specialization and a choice of speed over decentralization and safety, which leaves L1s such as Solana well suited to less “mission critical” use cases such as NFTs and gaming.
We see this oligopolistic multichain future (i.e., many chains but a handful of major players) as fairly likely, with a number of L1s showing sufficient early-stage momentum to create critical mass. These ecosystems are increasingly being supported by cross-chain bridges and multichain DEX protocols.
How do multichain bridges work? These bridges generally hold assets on one L1 (for example, USDT on Ethereum) and release a wrapped version on another (eg USDT.e on Avalanche). In other words, the user deposits funds into the bridge and the bridge then represents those funds on another chain. These funds can be withdrawn, but this often involves non-negligible wait times – ranging from minutes up to a week depending on the chain or layer 2 you are withdrawing from. Bridging a transaction also involves a fee to the bridge, along with gas fees, which at the moment can be fairly material on L1s such as Ethereum.
Cross-chain bridges such as Avalanche Bridge, Binance Bridge and Wormhole (the bridge between Solana, Ethereum and Cosmos), allow assets to move between L1 and L2, potentially unlocking far more composability within DeFi. For example, one could bridge UST from Terra onto Ethereum and add it to a pool on Curve, or bridge assets to Terra and deposit UST in Anchor to create a yield currently close to 20% APY. NFTs could be wrapped and traded on other chains in order to access new pools of buyers and sellers. As with centralized exchanges, assets on a multichain DEX could be aggregated as margin, allowing for far greater efficiency. Given ESG concerns toward bitcoin, investors could also trade wrapped BTC (WBTC) on Ethereum as an “eco-friendlier” alternative.
With the proliferation of L1 platforms, dApps are increasingly diversifying risk and hedging their bets by building on multiple chains. SushiSwap, for example, is currently deployed on 13 chains. Additionally with effective bridges and ever-improving interoperability, developers can expand their businesses into new, less competitive marketplaces on competing L1s. It may well be preferable to have an early-mover advantage in building an NFT marketplace on Avalanche for example, as opposed to competing with established incumbents on Ethereum. Bridging is therefore a critical enabler to the viability of L1 ecosystems outside the top 3-5 players and is incredibly important in the way we think about valuation, which we discuss below. Rather than winner takes all, bridges support the viability of L1s beyond the major platforms, reducing the fair valuation of the leading L1s to the relative benefit of the long tail. Methods to determine L1 valuations L1s are notoriously difficult to value, encompassing an overlapping hybrid of utility valuation, “store of money” valuation and more traditional yield or “burn” return approaches.
Although the above approaches offer a simple framework in theory, valuating L1s remains an incredibly complex task in practice. Further complexities arise from the differences between circulating versus fully diluted valuations and challenges stemming from community funds, which can either be canceled subject to governance votes or used to invest in and grow the network.
In reality, most L1s trade on momentum, loosely driven by progress in the key performance indicators discussed earlier (e.g., growth in dApps, TVL, developer and VC support) or improvements in deflationary dynamics (such as with ETH post EIP-1559 this August). Most L1s outside of Ethereum or Bitcoin are loosely viewed by the market as competitors to Ethereum and as such, are valued using Ethereum as a benchmark. On this basis, the Solana valuation at $120bn (fully diluted vs ETH at $500bn) implies that the market sees roughly 1/4 of the value in Solana or, put differently, sees a 25% chance Solana can achieve similar levels of success.
We believe the most likely outcome is that of a multichain future, with increasingly sophisticated bridges connecting a number of L1 ecosystems, some of which will be used for more general purposes, and some for specialized purposes.
At the dApp level, we see developers opting for a multichain approach, and we feel it makes sense for this to be embedded within the dApps themselves (e.g., staking and lending within Sushiswap enabled by wrapped assets and cross chain collateral across various L1s). We therefore expect the wider user experience to be increasingly L1 agnostic, with cross-chain complexity removed via userfriendly front-end applications such as MetaMask or aggregators such as 1Inch.
While we see full interoperability taking time from a technical perspective, this view leans toward a more open, less “walled garden” crypto ecosystem, with diminishing first-mover advantages and increasing intra L1 network effects. This ultimately suggests a relatively lower valuation accruing to incumbent L1s (compared to a ‘winner takes all’ outcome), which from an investment perspective suggests a convexity in newer L1s, particularly for those with strong early momentum.
The key risk to this view is the impact of Eth2 and further growth in Ethereum-centric layer 2 scalability solutions and whether a highly performant, low fee iteration of Ethereum will be sufficient to severely damage the viability of challenger L1s. Overall, we tend to think current challengers will have built sufficient critical mass by mid-2022 to be relevant and credible over the medium- to long-term. However, Eth2 and the launch of. Layer 2 scaling solutions like zk-rollups and optimistic rollups may well close this window of opportunity for challengers, which will mark an interesting inflection point for the ecosystem.
The original L1s were designed using Proof of Work (PoW) which meant that miners had to solve a random cryptographic puzzle in order to mine Bitcoin and Ether. Given the rise in competition, this eventually led to ever more sophisticated application-specific hardware and lowcost power being required to run economically viable mining operations. The logic of this PoW approach was to introduce the concept of economic security, designed to make an attack on the network so resource-intensive that it would be extremely expensive to attempt a 51% attack (the share required to control the network). One of the key design features is that it is more profitable to spend those resources to support the network than to attack it. Given the inefficiencies and eventual ESG concerns around this model, most of the leading blockchains are now Proof of Stake (with Ethereum transitioning sometime in 2022).
Proof of Stake networks essentially allocate votes and staking rewards in proportion to the value staked in validation nodes, with smaller token holders often able to delegate their tokens to particular validators, which generally take a small fee from the delegator’s staking rewards. In the Proof of Stake model, generally one would need to own 67% of staked tokens to control the network. Economic security in Proof of Stake is enforced by two mechanics - slashing and ownership of the asset.
In the case of nefarious activity, validators will have a percentage of staked assets taken away from them through “slashing” while the assets required to carry out the attack will be devalued by the market’s negative reaction to the attack.
The scalability trilemma, first proposed by Vitalik Buterin, posits that one can have at most two of the following three attributes – decentralization, performance and security.
Traditional blockchains including Bitcoin and Ethereum offer a high degree of decentralization and security but not scalability, given that every node must validate all transactions. High throughput chains like Solana achieve speed and security by sacrificing decentralization through high validator costs and relatively lower validator counts.
This trilemma has historically been re-enforced by the difficulty of maintaining large node counts as the speed of the network increases. In the case of Solana, although there are ~1000 validators at present, each node requires expensive high-performance hardware, leaving 70% of the network capacity in the hands of the largest 100 validators, thereby limiting decentralization. The network also supports parallel transaction execution and allows the production of new blocks before finality is achieved. This strategy is ideally suited to “non-mission critical” activities such as gaming, NFTs, and perhaps retail yield farming, but clearly has limitations for industrial-level applications. In fact, in September the network suffered an outage for 12 hours as an extreme spike in network activity proved too great for the validators running lower-end hardware. It is important to note that Solana launched its “mainnet beta” in March 2020 and so is still a relatively new chain, hence some of these issues may well be solved over time.
More recent developments, such as multi-chain ecosystems, offer decentralization and speed but are considered less secure given the vulnerability to an attacker achieving a consensus node majority in one of the individual chains. What solutions are available to deal with the Trilemma?
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