Galaxy: Ethereum is facing "embattled", why is it still worth a heavy position?

By Christine Kim, VP of Research, Galaxy

Compilation: Chief Villager of Ivory Mountain, Carbon Chain Value

Summary

The upcoming Ethereum Cancun/Deneb upgrade is expected to reduce the fees paid by Rollup operators for the Block space, so it will adversely affect the revenue of Ethereum’s fee-derived protocol in the short term. ETH may underperform as a result, especially when Rollup projects built on Ethereum become increasingly interoperable with other more performant, relatively lower-cost settlement and data availability chains. In the long run, if the theory of Blockchain modularity proves correct, the main network fee driver for Layer 1 public chains like Ethereum and Celestia will be Layer 2 Rollup service providers, not end users. Because of this, coupled with the increasing adoption of account abstraction by layer 2 public chains, the main individuals who hold Ethereum to pay for the block space are expected to be rollup operators, not end users.

Introduction

An age-old problem in the Crypto Assets industry is how to maximize (or at least maintain) network Decentralization and security attributes while scaling public chains. The recent launch of Celestia represents the maturity of a new solution to the Unholy Trinity problem of public chain scaling. Celestia is the first public chain to be highly optimized to provide data availability (DA) for rollups. As a data availability layer, Celestia does not perform transaction-native functions. Instead, Celestia provides block space for rollups to temporarily publish batches of user transaction data. As a DA layer, Celestia employs strategies such as Data Availability Sampling (DAS) to dropBlock the cost of space, which Block is dedicated to the execution layer, such as Smart Contract rollups that publish data on behalf of on-chain users.

Ethereum is also working to drop the cost of block space for DA purposes, but at the cost of higher node requirements. Proto-Danksharding is the major code change for Ethereum’s next network upgrade. The upgrade, known as Cancun/Deneb, is expected to increase the EthereumNode’s temporary data storage space by 768kB. It is estimated that the additional block space for rollup transactions will drop Ethereum’s DA cost by at least 10 times.

At the heart of the modular theory associated with scaling public blockchains is that public blockchains should not be performed by a single network to perform all the core functions of a common public chain computation (i.e., monolithic or integrated Blockchain theory), but rather outsourcing responsibilities (such as execution or DA) to specialized infrastructure providers to enhance functionality and performance.

As Ethereum implements network upgrades to better support Layer 2 Rollups, a larger share of protocol revenue from Rollup Sequencers (i.e., entities that publish data from end users to the DA layer) is likely to be larger than direct L1 end users. Currently, Rollup accounts for 12% of all gas paid on Ethereum, up from 3% at the beginning of the year.

Gas used monthly to Settlement L2 Rollup transactions

This report will delve into the short- and long-term outlook for value accumulation from L2 Rollups to L1 public chains, taking into account the impact of reset and account abstraction. The activation of recent upgrades such as Cancun/Deneb, coupled with the increasing flexibility of L2 to migrate from using Ethereum as a settlement and DA layer, may negatively impact Ethereum’s value in the short term, but in the long term, Ethereum’s value will outperform as the Rollup technology matures and Ethereum’s DA capabilities improve.

This report is an extension of our previous report on Blockchain Modularity, The Significance of Blockchain Modularity, which introduces many of the terms and concepts related to modularity theory and provides additional insights into the fee generation and revenue drivers of tiered blockchains – which we recommend reading as a precursor to the discussion in this report.

L2 adoption in 2023

Ethereum L2 trading activity has more than tripled since January. In 2023, L2 has the highest both nominal and percentage growth in the total number of daily transactions.

Ethereum the sum of the daily average TPS of L2s and EthereumMainnet

In L2, Optimism and Arbitrum saw the largest declines in their total value share locked into Ethereum L2 in 2023, down 11% and 7%, respectively. Base and zkSyncEra saw the largest value growth, with the total value share locked in L2 increasing by 9% and 4%, respectively. (Note: The Total Value Locked metric is based on the USD value of the Token and does not necessarily represent a change in the notional value of the Token deposited into the protocol.) ）

The total value share locked in Ethereum L2

Notably, Crypto Assets exchange Coinbase’s Rollup, called Base, launched this year, has seen a rapid rise in adoption and popularity among L2 users. As of December 12, Base’s Total Value Locked (TVL) ranked third in L2. In terms of trading activity, Base’s daily trading volume is sometimes higher than the two most widely used L2 (in terms of TVL) Arbitrum and Optimism on Ethereum.

In Ethereum’s top three TVL L2s, the Base Sequencer generates about 20% of total revenue by sorting user transactions and converting them into blocks in batches. To date, Optimism, Base, and Arbitrum sequencers have generated $140 million in revenue from user fees.

Optimism, Base, and Arbitrum combined sequencer revenue

Looking ahead to 2024, with the activation of the Cancun/Deneb upgrade, the cost of bulk user transactions and completing transactions on the Ethereum will be significantly drop, increasing the profitability of the Rollup sequencer while dropEthereum fee revenue.

Cancun/Deneb (Cancun Upgrade)

The main code change in the Cancun/Deneb upgrade is Ethereum Improvement Proposal (EIP) 4844, also known as Proto-danksharding. Native Proto-danksharding creates a dedicated Block Space for Rollup transactions. These transactions, known as “blobs”, will be priced according to a fee-based market that is separate from the transactions of regular users, and transaction data will only be stored temporarily for about three weeks. By activating EIP 4844, 768 KB of data space will be added to each block for rollup transactions.

The Cancun/Deneb upgrade may reduce Ethereum’s fee revenue in the short term, as EIP 4844 will reduce the Block Space fee paid by Rollups to Ethereum by more than 10 times. In addition, due to the ongoing technical challenges of the Rollup technology in terms of lack of scalability, decentralization, and interoperability, it is likely that most of Ethereum’s fee revenue will continue to come from end users who execute transactions directly on Ethereum, rather than L2. Until the Rollup technology matures, Ethereum’s revenue is unlikely to benefit significantly from EIP 4844.

Short-term technical challenges

Below is an in-depth look at three key areas of growth that Rollup operators prioritized in 2023 and will continue to advance in 2024:

Scalability: Rollups are not immune to the impact of fee Fluctuation. As we highlighted in our previous report on Blockchain modularity, in June 2022, when Project Galxe’s Arbitrum Odyssey marketing plan sparked a lot of on-chain activity, Arbitrum (Ethereum’s leading rollup in total locked value) briefly had higher transaction fees than Ethereum. Since then, Arbitrum’s fees have dropped significantly, especially after the release of Nitro in August 2022.

Optimism’s Bedrock upgrade, completed in June 2023, also aims to improve the scalability of the network and drop gas fees. The scalability of rollups is an active development area that developers are focusing on improving.

Average Daily Transaction Fees for Optimism and Arbitrum (USD)

Decentralization and Security: Another area of Rollup development that developers focus on is Decentralization. All Crypto Assets on Ethereum are vulnerable to centralized attacks because they rely on a single node operator to sort or order transactions and generate blocks. To improve Decentralization and Security, the three core focus areas of Crypto Assets include (i) implementing validity/fraud proofs, (ii) expanding the set of operators used for verification and sorting, and (iii) removing admin privileges and assigning Rollup control through governance.

Optimism & Arbitrum: Security & Governance

Interoperability: One of the main reasons why Ethereum occupies the market share of universal public chains is its strong network effect. As more users join Ethereum, the liquidity of the assets that users interact with on Ethereum continues to increase, and the value of the network increases in a positive feedback loop. The decentralization of this liquidity is a barrier to Rollup adoption. The DeFi (Decentralized Finance) ecosystem benefits from the centralization of Liquidity and the composability of Dapps on a single protocol. Therefore, addressing the seamless migration of assets from L1 to L2, as well as within the L2 ecosystem, is an important area of development that will help drive the migration of end users from Ethereum to L2.

Benefits of alternative DA solutions

In the short term, Ethereum’s revenue will still be generated primarily by transactions initiated directly by end users on L1. User adoption of L2 will increase as the cost savings of transacting on L2 increase due to L2 scalability upgrades, and the decentralization and interoperability of Rollups improve. In addition, Crypto Assets companies that choose to use alternative Decentralization layers such as Celestia to improve cost-effectiveness can simply pass on some of the cost savings to Crypto Assets users for higher profits. In addition to Ethereum and Celestia, other L1-level public chains such as NEAR have also announced their intention to shift to better services for Rollups as a DA layer.

As shown in the figure below, users on L2 can spend more than 90% less transaction fees than users on Ethereum:

Year-to-date cumulative net deposits on Ethereum L2

By publishing user transaction data on Rollup to Celestia instead of Ethereum, Rollup operators can earn higher profit margins due to lower Transaction Fees on Celestia. On average, the fees on Celestia are several times lower than those on Ethereum, but this is largely due to the fact that the Celestia public chain was born earlier, launching on the Mainnet on October 31, 2023. The chart below depicts the fee ratio between Celestia and Ethereum, which is based on the average daily transaction fee (USD) for each protocol. Celestia’s daily transaction fees are on average 80 times cheaper than Ethereum. (Note: The data below shows all types of user Transaction Fee on Celestia and Ethereum, not just the Transaction Fee paid by the Rollup sequencer).

Ethereum vs Celestia average daily fee ratio

As a nascent public chain that has been online for less than two months, Celestia has not yet been widely used by L2 for DA like Ethereum. Most of the transaction activity on Celestia is not the confirmation of blob transactions, but the activities related to the staking and staking delegation of Celestia’s native assets. As blob trading activity increases on Celestia, Transaction Fees can Fluctuation and rise. However, because Celestia optimizes DA, which currently does not exist on Ethereum, it is unlikely that Rollup fees on Celestia will be higher than Ethereum, all else being equal.

In summary, we expect that with the launch of the Cancun/Deneb upgrade in 2024, the cost of Block space on Ethereum will drop, and the Ethereum network revenue will decline, or at least lower than it would have been without the Cancun/Deneb upgrade. In addition, due to ongoing challenges in Rollup’s scalability, decentralization, and interoperability, it is expected that the majority of Ethereum network revenue will still come from end users rather than L2. Finally, if the sequencer doesn’t pass on all the crypto cost savings to paying crypto users and instead uses other Rollup solutions like Celestia, Rollup’s profit margins are expected to increase in the short term.

Long-term outlook

In the long term, with the mass adoption of Blockchain-based applications and services, Ethereum’s revenue is likely to rise, and the rollup usage for transaction execution will be 10 times or even higher than Ethereum’s. Lower L2 fees can bring new use cases to Blockchain applications across multiple industries, including gaming, social media, entertainment, sports, and more. New use cases driving wider adoption of Blockchain-based applications, also known as Decentralization applications (Dapps), are expected to increase the overall demand for EthereumBlock space, thereby increasing the total revenue of Ethereum. In this case, Ethereum’s main source of revenue comes from the Rollup service as a settlement and DA layer. In addition, as competition for end-user activity intensifies, profit margins for Rollup sequencers are tightening.

In the coming years, the presence of multiple highly optimized DA layers is likely to accelerate Ethereum L2’s migration from publishing data exclusively to Ethereum to other DA layers that provide cheaper Block space. These new DA layers could eventually challenge Ethereum more directly, which could weaken Ethereum’s current position as the most widely used Rollup base layer. However, as discussed in the previous section, network effects are important, and Rollrp developers are working to improve interoperability and composability between Dapps launched on different Rollup protocols. To ensure that users and their liquidity can easily switch between different DA layers in the future, projects such as Caldera, Hyperlane, and Polymer are building tools that enable the Rollup protocol to run smoothly on multiple DA layers without impacting the user experience. As long as shared settlements and DA layers like Ethereum offer an advantage in terms of user experience, allowing users to migrate assets between different rollups and Dapps running on top of those rollups, then Ethereum is likely to continue to dominate as the most valuable DA layer.

Ethereum’s competitive advantage

Although Ethereum dominates the market in 2023 as a settlement and DA public chain with the highest security, value, decentralization, and network effects, competition from Celestia and other public chains that have been designed to support rollup activities from the very beginning will become increasingly fierce. While Celestia is smaller in number and just getting started than Ethereum, Ethereum’s dominance as a public DA chain that supports rollup transactions is likely to be weakened over time, although this is still a small possibility. To this end, Ethereum core developers are working to launch an upgraded version of Cancun/Deneb to enhance Ethereum’s DA functionality. However, when discussing the long-term impact of layer 2 rollups on Ethereum revenue, it is important to consider that Rollups will never be able to provide users with the same level of decentralization, security, and interoperability as the base layer.

Despite the lower fees, splitting Application LayerLiquidity with L2 Rollups is likely to anchor most of the user’s trading activity to Ethereum in the short and long term. In this case, even if Celestia outperforms Ethereum as a DA layer, Ethereum’s competitive advantage as the world’s most decentralized universal public chain may continue to win and attract new users. At that point, Ethereum’s revenue will continue to be extremely volatile and depend on the number of users directly interacting with the application on its base layer. Compared to cheaper L2 and alternative L1s, some users may execute transactions on Ethereum to take advantage of the network’s unmatched decentralization and security as a universal public chain.

As mentioned earlier, in the short term, most end-user activity stays on Ethereum rather than migrating to L2, which will lead to high fees and a temporary surge in network revenue. However, without scalability, Ethereum’s revenue will still be limited by limited transaction throughput, and revenue will remain unpredictable due to the lack of sufficient block space to meet new demand. The short-term revenue generated by user payments will eventually be dragged down by the network’s inability to support larger user activity, which will adversely affect the long-term value of Ethereum as a universal public chain.

The following chart depicts the Ethereum average daily Transaction FeeFluctuation in ETH:

Average daily transaction fee in ETH

In the first six years of Ethereum’s existence, Miner, who are EthereumBlock producers, voted en masse to increase the Block gas limit, effectively increasing the number of transactions that a single Block can hold by at least 12 times. In August 2021, Ethereum core developers performed a hard fork (a backwards incompatible network-wide upgrade) to increase the maximum block gas limit from 15 million times to 30 million times and transform the fee market to reduce fee Fluctuation.

The following chart illustrates how EthereumBlock gas limits have increased since the inception of Ethereum due to overwhelming user demand for Block space:

Ethereum’s daily total Block Space limit vs. used Block space

Despite these changes to Ethereum’s Block Gas limit over the years, fee Fluctuation and limited network scalability remain a long-standing problem, and a long-term solution is needed if Rollups prove unable to effectively inherit most of the end-user activity over the long term.

Other considerations

Regarding the long-term value accumulation from L2 to L1, there are two other factors worth discussing, namely the trend of activating native account abstraction on L2, and re-staking solutions on Ethereum.

Account Abstraction

If the L2Rollup sequencer eventually becomes the intermediary service provider that the end user relies on to interact with the public blockchain-based application, rather than directly interacting with the Ethereum, then in the future, it is also likely that the user will no longer hold the Ethereum directly, but will be able to pay Transaction Fee in Stable Coin or even fiat currency, depending on the design of the sequencer and the Rollup, which will then convert these payments into Ethereum on behalf of the user to pay EthereumTransaction Fee.

The increased flexibility and Programmability of how fees are paid on L2 is largely achieved through a technique called “account abstraction” that has not yet been implemented on Ethereum and may not be implemented in the near future. While account abstraction brings many benefits to the user experience, there is a lack of coordination among Ethereum core developers that does not prioritize the implementation of this technology over other, more pressing code changes, including raising the maximum effective balance of validators, Verkle trees, Ethereum Virtual Machine object format, proposer builder separation, and more.

While there is a proposal to implement account abstraction (ERC 4337) without changing the core Ethereum protocol, the proposal is unlikely to gain widespread adoption as it relies on Dapp developers updating their Smart Contracts and end users choosing to use alternative mempools. On the other hand, as an emerging technology, Rollups is the perfect testing ground for native account abstraction at the protocol level. Currently, rollups such as zkSync and Starkware have done just that, which means that accounts created by end users on these protocols automatically enhance Programmability and usability.

Native account abstraction on Rollups will change the user experience as users interact with Dapps, as account abstraction unlocks several new features for user transactions, including but not limited to:

Improve the user experience for repetitive or frequent transactions: For some on-chain games and Decentralized Finance applications, users need to submit multiple transactions. ACs can be programmed to automatically allow transactions with certain Dapps so that users can avoid repeatedly authorizing interaction with the same Smart Contract using a Private Key.

The ability to stop the flow of assets in the event of a hack attack: If a user’s account exceeds a certain withdrawal limit, there may be embedded logic to stop the flow of funds.

Support social recovery private key: User accounts are also designed to rely on the user’s private key and other social recovery devices to transfer funds. If a user loses their private Secret Key, the account can be programmed to regenerate a new Secret Key using two-thirds or three-fifths of other social recovery devices.

Re-staking

Another consideration related to Ethereum’s Rollup appreciation over the next five years is the maturation of re-accounting protocols such as EigenLayer. As explained in Galaxy Perspectives’ article on restaking, EigenLayer will enable end users to repurpose their staked ETH to ensure the security of other protocols and Dapps, increasing yields. As of December 2023, EigenLayer developers are testing the re-staking workflow for EigenDA, an additional DA layer secured by staked ETH to which Rollup programs will be able to publish data instead of directly to Ethereum. Validator Node Operators who choose to re-stake via EigenLayer will be subject to additional slashing conditions (penalties) when validating transactions on Ethereum and EigenDA, but in return, they will also receive higher yields from staking on both protocols instead of one. The EigenLayer team expects to launch EigenDA on the Mainnet in the first half of 2024. Thereafter, EigenLayer will add new protocols that validator node operators can restake outside of EigenDA.

EigenLayer re-staking workflow diagram

It can take several years for re-staking protocols like EigenLayer to mature and become widely adopted on Ethereum. The first active validation services (AVS) on EigenLayer will be available to Node Operators via re-staking, which will initially be carefully planned and real-world tested. EigenLayer developers intentionally limit the amount of ETH and liquid staking tokens that can be deposited into the protocol. At present, the EigenLayer team has set the initial ETH deposit limit for EigenDA AVS liquidity re-staking at 117,000 ETH. By December 18, 2023, this cap will increase to about 200,000 ETH. In addition, on December 18, EigenLayer will begin accepting deposits from six new liquid staking Tokens: osETH, swETH, oETH, EthX, WEBETH, and AnkrETH.

As of December 14, 2023, the amount of staked ETH deposits in Liquidity Provider Token, including rETH, stETH, and cbETH, as well as native ETHToken, is less than 1% of the total amount of EthereumETH deposits. Over time, the EigenLayer team will gradually increase the ability to deposit ETH to EigenDA and other AVSs to ensure that the economic security of Ethereum and related AVSs is not compromised until the protocol is fully tested. The full development roadmap for EigenLayer can take years and there will be some unexpected bugs, especially as the AVS pool grows.

To the extent that re-staking becomes a reliable and scalable activity on Ethereum, similar to the liquidity staking activity that has become very common through the Lido protocol, then Rollups are expected to benefit by repurposing staking Ethereum to provide additional security for operations such as sorting. In addition, Ethereum’s staking yield is expected to increase even as more validator node operators lower issuance over time, which could increase demand for Ethereum, not just Rollup sequencers, but also Decentralized Finance applications and foundations. Even if the utility of ETH for executing transactions on Ethereum decreases and Rollup applications increase, re-staking activity still has the potential to generate significant yields, which may encourage individuals and entities outside of Rollup operators to buy and stake ETH.

Conclusion

Ethereum’s revenue will benefit from being able to sustain larger trading activity through L2, although in the short term, the network may face reduced revenue due to a lack of rollup adoption and the cost of implementing upgrades to subsidize rollups. With the looming upgrade supposed to reduce rather than increase fee payments, ETH is likely to underperform in the near term, at least as far as investors value Ethereum based on its fee-derived protocol revenue.

Rollup technology is an emerging technology that faces some technical challenges and application hurdles in the short term. Over time, as the scalability, decentralization, security, and interoperability of Rollup technology improves, most of the end-user activity is likely to migrate from Ethereum to L2. When this happens, the competition between L2s for subscribers will intensify, and the profit margins of rollup operators may decrease.

In the long run, technologies such as native account abstraction on L2s will further reduce the need for end users to hold ETH directly. More likely, with the existence of liquidity solutions and the maturity of re-staking solutions such as EigenLayer, end-users and Decentralized Finance protocols will hold ETH’s Token Representatives and their cumulative earnings. The main holders of native ETH are likely to be Rollup operators, who use Tokens to buy Block space on Ethereum on behalf of end users. Further areas of research related to L2’s L1 value accumulation include the impact of MEV on modular Blockchain ecosystems, and the evolution of Zero-Knowledge Proof on Rollup design, its bridging, and economics.