Bitazza Deep Research Series: Blockchain Scaling
While the concept of Decentralized Finance (DeFi) was introduced by Nick Szabo back in 1995, it resurfaced the world in 2014 with the creation of smart contracts provided by the Ethereum blockchain. By summer 2020, the Compound protocol kickstarted its liquidity mining program, which rewarded users for participating in the borrowing and lending of assets with its native governance token called COMP. This phenomenon was later known as “yield farming”. This disruption of crypto business models led to projects adopting liquidity mining incentives for users, leading to an ever-increasing Total Value Locked (TVL) or inflows of capital into smart contracts from individual wallets. It was the first time in history that blockchain found a real use case beyond fundraising through Initial Coin Offerings (ICOs) with a TVL peaking at $154.93 billion on May 10, 2021. The yield farming frenzy saw both Ethereum’s market capitalization and gas price increasing significantly. At one point, the gas fee was as high as 1500 gwei for simple transactions due to network congestion, affecting all Decentralized Applications (DApps). The excessive fees prohibited regular users from participating in the emerging decentralized economies and led to the acceleration of discussions and implementations of scaling technologies. Despite achieving product market fit through DeFi, blockchains’ very existence is threatened by its ability to scale to the levels seen in traditional finance and Wall Street. Although it is clear that scaling is required for blockchains to handle the world’s computations, it is unclear what approach should be taken to achieve such an ambitious goal.
Figure 1. TVL growth in late 2020 and 2021. Data from DefiLlama.
The current upgrade on the Ethereum network, the Berlin upgrade, implements four proposals: EIP-2565, EIP-2929, EIP-2718 and EIP-2930. EIP stands for Ethereum Improvement Proposals, a mechanism that Ethereum uses to make improvements to the protocol. These proposals showed no significant changes to the current protocol; however, the announcement of the London upgrade on EIP-1559 will show a significant leap in transitioning to Ethereum 2.0 as the protocol will help address the ongoing scaling problems and make Ethereum’s monetary policy more deflationary. With the transition from Ethereum 1.0 to Ethereum 2.0, Ethereum will change its consensus mechanism from its original “proof of work” to the new “proof of stake” model. This will reduce energy consumption for the network, lower gas fees, and potentially process 10,000 transactions per second. However, a complete upgrade to Ethereum 2.0 takes significant time and thus leaves room for competitors, typically called “Ethereum killers”, to raise significant funds to develop and compete with the Ethereum network.
In the first quarter of 2021, Binance seized the opportunity to gain material market share by promoting the Binance Smart Chain (BSC), an Ethereum Virtual Machine (EVM) compatible blockchain on Cosmos’ Tendermint BFT and Cosmos SDK. This helps speed up the network as it is an independent blockchain that allows compatibility with Ethereum and attracts developers to build DApps on the ecosystem. In other words, migrating from Ethereum to BSC was almost as easy as copying and pasting existing code from one computer to another. This resulted in projects creating copies of popular Ethereum projects on BSC. For example, Uniswap’s decentralized exchange was copied onto BSC and rebranded as PancakeSwap. It then continued innovating on product offerings and incentive structures to become a dominant player on BSC. The copy and development mentality has become the driving force behind the proliferation of DApps and BSC’s explosive growth.
Figure 2. BSC ecosystem projects rivaling Ethereum.
Notwithstanding the impressive adoption numbers, BSC has been labeled as a centralized blockchain by Ethereans, citing the cap of 21 validator nodes as being too few. Running high-performance validator nodes requires significant computational resources, maintenance, and storage, a responsibility not suitable to the mass retail. BSC also requires the validator to hold a minimum of 10,000 BNB to be staked, which at its peak was around $7 million. Successfully trading off centralization for scale has become a wake-up call in the crypto communities as it seems that many users do not care about decentralization as much as ease of use and cost.
Other competitors that do not support EVM compatibility opted for a ground-up approach. In contrast to Ethereum’s reliance on a single virtual machine, the EVM, as its execution environment, Polkadot creates multiple heterogeneous parachains so that transactions can be processed across multiple locations. An entirely new development framework called Substrate sets Polkadot apart from Ethereum as the framework allows developers to create new blockchains with very little programming. Developers can now experiment with new blockchain configurations, such as storage, consensus mechanism, and different rules without waiting for them to be made available on Ethereum. The main challenge for Polkadot now is adoption as we have yet to see real traction and usage growth.
Both Ethereum and Polkadot approach scaling through a concept called sharding. This is a technique where the blockchain is split into multiple partitions so that transactions can be done in parallel. Sharding helps reduce the computational and storage load across the different partitions so that each node is not required to process every transaction on the blockchain. Nevertheless, there are significant drawbacks to this approach. DeFi’s success comes from composability or the ability of smart contracts to communicate with and build on top of each other. A yield farmer may deposit her ETH on Aave to take out a loan in USDT before depositing the USDT to a Curve pool in order to earn interest. This is only possible because Aave and Curve are available on the same shard, i.e. the Ethereum shard. If scaling causes Aave and Curve to end up on different shards, then the above transaction is not possible. Sharding is now one of the most actively researched topics in the blockchain community.
Figure 3. Illustration of blockchain sharding.
Solana, unlike Ethereum and Polkadot, aims to scale the blockchain without sharding. The unique Layer 1 utilizes proof of history to become the first major blockchain to introduce the element of time at the fundamental level. Each Solana validator node maintains its own clock instead of relying on all nodes to reach a global consensus on the passage of time. In addition to proof of history, Solana utilizes multiple key innovations to scale the blockchain while sticking to its no sharding principle. However, critics argue that in order to become a Solana validator node, one would have to use extremely high performance hardware and network capabilities. The ability to participate in the network is therefore severely limited, and goes against the ethos of inclusivity prevalent in the blockchain communities.
In August 2020, Sam Bankman-Fried, the founder of FTX and Alameda Research, announced his intention to build Serum, the first decentralized exchange to put orderbooks on-chain. With Solana’s high performance and scale, Serum aims to offer decentralized trading with 50,000 transactions per second with miniscule fees. As its ecosystem grew, Solana Labs recently announced a $314 million fundraising round led by top firms like Andreessen Horowitz, Polychain Capital, Alameda Research, Blockchange Ventures, CMS Holdings, and more. Despite the ambitious goals and having so many backers, Solana is relatively new and lacks the battle-tested developer tools and libraries available to Ethereum developers. This means that Solana developers need to rewrite much of the code from scratch, as well as work with cybersecurity experts and auditors to ensure that the code is reliable and secure enough to handle trillions of dollars on the blockchain.
As the scaling war wages on, Ethereum couldn’t just wait for Ethereum 2.0 to launch despite it being the long-term solution for on-chain scaling. Otherwise, it is likely that significant market share will be lost to an upcoming competitor. Short to medium term solutions are then put in place to ensure the majority of transactions are not siphoned away from the Ethereum ecosystem. Instead of waiting for on-chain scaling, there are several off-chain scaling solutions. This approach requires no modification of Ethereum as is, so it can be implemented and productionized today. These solutions are called Layer 2 solutions because they move transactions off the Ethereum main chain and on a different yet connected layer. Some Layer 2 solutions derive their security directly from the Ethereum base layer (e.g., rollups and state channels) and others involve new chains that derive their security separately from mainnet (e.g., sidechains and plasma chains).
|Layer 2||Non Layer 2|
|ZK-Rollups||Optimistic Rollups||State Channels||Sidechains||Plasma|
|Starkware||Offchain Labs Arbitrum Rollup||Kchannels||POA Network||Polygon Plasma|
|Matter Labs zkSync||Fuel Network||Perun||xDai||Gluon|
|Aztec 2.0||Cartesi||Raiden||Polygon PoS||Gazelle|
|Hermez Network||OMGX||State Channels||LeapDAO|
Table 1. Breakdown of Ethereum scaling solutions and respective teams.
Although there are many teams working on scaling Ethereum, no project has seen more adoption than Polygon (previously known as Matic Network). As of June 2021, there is over $7.5 billion in total value locked on its proof of stake sidechain. Its traction comes from its ability to attract top DeFi projects like Aave, SushiSwap, and Curve to build on its network. Coupled with strong liquidity mining rewards, traditional yield farmers started to migrate to Polygon. This shows that despite the massive drawdown in May 2021, investors are still actively searching for yield and are willing to deposit capital into newer projects with little track record.
Although its success comes from Plasma and PoS, Polygon is busy building a suite of scaling products for future adoption, including ZK-Rollups, Optimistic Rollup, Validium Chains, Sidechains, and Enterprise Chains. Polygon is also planning to expand their Polygon PoS security network to a stand-alone chain and a secured chain. A stand-alone chain will allow major enterprises to build their own secure networks with high security and flexibility. The secured chain will work as a pool of validators similar to Polkadot’s shared security. This will meet startups’ needs of building a secured network based on Polygon’s security pool. These additions will give incentives to its adopters and accelerate Polygon’s growth and scaling in these upgrades.
Figure 4. Polygon ecosystem map.
Offchain Labs is another promising team consisting of industry leading academics from Princeton University, Ed Felten, Steven Goldfeder, and Harry Kalodner. After working on the problem since 2018, the team has just recently launched its Arbitrum Rollups mainnet beta, allowing developers to build and test before Arbitrum One is launched. This is the first time an actual rollup solution will become used in production, a true Layer 2 solution. A rollup is an off-chain aggregator of transactions utilizing an Ethereum smart contract. This means that transactions are bundled outside the blockchain, making the process much more scalable. Arbitrum uses a special form of rollup called optimistic rollup, which assumes that transactions are valid by default and only runs computation in the event of a challenge called a fraud proof. In other words, as long as there is one honest node amongst the many validators, fraudulent transactions will be challenged and voided. This is a novel approach in solving for scaling while still utilizing the Ethereum base layer for security. There are over 250 projects built on Arbitrum, and huge decentralized finance protocols (namely Uniwap and Sushiswap) will provide huge contributions to its ecosystem and securing Arbitrum’s standing in its Layer 2 solution while also giving themselves more transactions due to lower gas fees and faster transactions without Ethereum network congestion. Meanwhile with its busy framework, the team are promising sidechain and channel solutions that are launching very soon.
Figure 5. Example projects building on Arbitrum Layer 2.
Subsequently, Optimism, another promising team building Optimistic Rollups, has been getting a lot of public attention recently with its successful hackathon testnet and their public announcement of its mainnet launching this July. Likewise, Optimism is also integrating with top protocols like Uniswap and Synthetix. In mid-2021, we will be able to see huge growth in TVL in both projects as Optimism mainnet is launched.
One drawback of Optimistic Rollups is that it makes an assumption that at least one honest node is required for a fraud proof to be submitted. Critics argue that ZK-Rollups are more sophisticated and offer more benefits like privacy in the long term. Two teams that have gained public interest recently are zkSync and Starkware. zkSync provides a Layer 2 scaling solution that operates on Zero Knowledge Succinct Non-interactive Argument of Knowledge (zk-SNARK) technology previously used by Zcoin and JP Morgan. With their current upgrade in February 2021, the current protocol is able to handle over 2000 TPS in 1/100 of the cost from Layer 1. Their solution goes further than normal ZK-Rollups as they add smart contract capability on ZK-Rollups. Currently, the protocol in testnet for zkEVM developers is only able to be written on Zinc VM as Zinc programming language is similar to Solidity (the programming language of Ethereum); however, zkSync is planning to rollout together with Solidity on their mainnet launch of zkEVM in August. This will help developers in transitioning from Ethereum Layer 1.
StarkWare as a Layer 2 ZK-Rollup solution promises scalability and privacy on their protocol running base of Zero-Knowledge Succinct Transparent Argument of Knowledge (zk-STARK). StarkWare operates on a 3 layer protocol: StarkEx, Cairo, and StarkNet. StarkEx is an engine where all on-chain StarkEx Contract (where all smart contract orders are executed or denied), Cairo enables StarkEx’s backend off-chain verification backend operates then sends it to StarkEx Contract, and StarkNet is the end product where it groups StarkEx and Cairo into one decentralized application. Separately, StarkEx and Cairo are running on a centralized mainnet. Top DeFi protocols like dYdX and Deversifi or even top NFTs Layer 2 protocol like Immutable are StarkWare adopters.
Though many interesting solutions for Ethereum scaling have risen in 2020 and 2021, we still see room for growth in both Layer 1 solutions. Binance will continue touching more sectors by releasing more DApps and Polkadot will give us a glimpse of its full main-chain release altogether with parachain auction this summer. And, even more so in the Layer 2 solutions namely Matic, when its enterprise chain is released or Arbitrum and Optimism when their mainnets are fully launched. These solutions will be further enhanced when Ethereum 2.0 is completely live giving Layer 2 an extensive upgrade on the protocol level. In the next few years, we will see massive technology developments. Which solutions will come up on top and which projects will be the most successful? The future is uncertain, but one thing is certain: it is that teams across the globe are tackling blockchain scaling very seriously as more transactions move from traditional sectors to blockchains, and that means users will enjoy the benefits of higher throughput, faster and cheaper transactions, and overall better user experience.
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