- Centralised Exchanges
- Crypto Asset Volatility
- Crypto Correlations
- Crypto Governance
- Crypto in the Portfolio
- Crypto Valuations
- Investment Highlight
- Security and Privacy
- Social Media Influence
- Stable Coins
- Traditional Finance and Crypto
- Web 3.0
by Marc Woodward
High gas fees have had a severe impact on the retail adoption of the Ethereum blockchain and Ethereum based DeFi. The excessive cost to transact often causes retail investors to overlook the fundamentals of Ethereum in search of a quicker, cheaper and ‘easier’ option. While this has caused frustration for believers in Ethereum, you can’t blame these retail investors as they have been priced out of layer 1 Ethereum.
In this article we will explore the up and coming scaling solutions for the Ethereum blockchain and outline how we are positioning the portfolio to take advantage of the opportunities that will arise from these developments.
When it comes to tackling the problem of scaling, there have been various ideas tested and researched over the years and we believe that these solutions are on the brink of ushering in a new age for the Ethereum blockchain. Beyond these scaling solutions, we will explore other key developments that are contributing to ETH’s price strength.
For the purposes of this article we will not explore the scaling solutions known as ‘Plasma’ and ‘State Channels’. This is because these solutions lack the ability for users to perform complex transactions and will not result in DeFi scaling.
Rollups vs. Sidechains
Sidechains are a leading scaling solution for Ethereum, with chains such as Polygon (MATIC) exploding in value and activity recently due to increased adoption by top DeFi developers and projects. Sidechains are often looked down upon by Ethereum believers as they do not inherit the security of the Ethereum blockchain. Instead, they rely on their own security measures and employ their own consensus mechanisms to process transactions.
Many different sidechains like xDAI, Raiden Network and SKALE have been in development for years with many raising significant funding in the 2017 ICO bubble. The adoption of these chains by the Ethereum community has been extremely low due to their lack of security and decentralisation. The only sidechain solution to really take off has been Polygon, this has been driven by NFT projects such as Zed Run and trusted DeFi projects adopting the ‘Ethereum Virtual Machine’ (EVM) compatible chain.
‘Roll ups’ differ to side chains as they bring the security of the Ethereum mainchain to layer 2 while making transactions fast and inexpensive. Rollups are solutions that perform transaction execution outside the main Ethereum chain (layer 1), but post transaction data on layer 1. As transaction data is on layer 1, this allows rollups to be secured by layer 1. There are two leading types of Rollups that are aiming to gain the adoption of the Ethereum community, these are ‘Optimistic Rollups’ and ‘ZK-Rollups’ (or Zero Knowledge Roll ups).
90 Day TVL Growth of the xDai Chain.
Zero knowledge rollups use a smart contract to bundle hundreds of transfers off-chain and generate a cryptographic proof, known as a SNARK (succinct non-interactive argument of knowledge). This is known as a validity proof and is posted on layer 1.
The ZK-rollup smart contract maintains the state of all transfers on layer 2, and this state can only be updated with a validity proof. This means that ZK-rollups only need the validity proof, instead of all transaction data. With a ZK-rollup, validating a block is quicker and cheaper because less data is included.
There are already multiple projects using ZK Rollups but the adoption of these projects has been relatively unimpressive. The main decentralised exchanges using ZK Rollups are Loopring & ZKSwap. to analyse the current success of these exchanges we will look at the Total Value Locked (TVL) in the protocol. TVL is an important measure for decentralised exchanges as liquidity is the lifeblood of these projects.
Loopring is the oldest DeFi project to use ZK Rollups with their initial release occurring in December 2019. Since then, the protocol has managed to attract only US$213 million in TVL with 11.2% of that TVL being the protocol’s native token, LRC.
ZKSwap offers a better user experience and recent liquidity mining efforts has attracted US$385 million in TVL over the past 5 months. Much like Loopring, a reasonable amount of this TVL is the protocol’s native token, ZKS.
When we compare the adoption of Loopring and ZKSwap to the recent uptake in projects built on Polygon (MATIC), we can see that these projects are well on their way to being left behind. For example, after extending their product offering to support Polygon, SushiSwap has managed to acquire US$654 million in TVL in less than 2 weeks after launching mining incentives.
We believe that the DeFi adoption of ZK Rollup solutions will continue to be relatively low, especially when Optimistic Rollups are set to be adopted by multiple DeFi ‘Blue Chips’ in the near future. One reason for this is the significant developer work that needs to be done to migrate existing smart contracts to ZK Rollup. However, we do believe that ZK Rollups are better suited for Non Fungible Tokens and we are actively looking for infrastructure opportunities in this space.
1 Year TVL Growth of Loopring
Optimistic Rollups are the most exciting scalability solution when it comes to DeFi applications. While Polygon has amassed a reasonable DeFi TVL of US$13.73 billion (according to Defi Llama), we believe that the favoured solution in the long term will be one that inherits the security of layer 1 Ethereum.
Optimistic Rollups use a sidechain (Optimism) in order to complete the complex smart contract computation that would usually be completed on layer 1, the result is then sent back to layer 1 and recorded on the blockchain. Since this computation is the most slow and expensive part of a transaction, using Optimism greatly reduces the demand for Ethereum layer 1.
Optimistic Rollups are called ‘Optimistic’ because they assume that all transactions are ‘innocent until proven guilty’. Meaning that after a transaction is made there is a time period where fraudulent transactions must be identified by users or bots. If someone notices a fraudulent transaction, the rollup will execute a fraud-proof and run the transaction’s computation, using the available state data. This means you may have longer wait times for final transaction confirmation than a ZK-rollup, because it could be challenged. This also means that getting your assets off Optimism could take up to a week to allow enough time for the transaction to be challenged. Although this sounds like a major pain point, it is likely that liquidity bridges will form between layer 1 and Optimism.
Optimism is set to fully launch in July 2021 with Synthetix being the poster child for the launch and Uniswap following soon after. With these two heavy weights of DeFi, EVM compatibility (making migration for existing protocols easy) and a community looking to break free from high gas fees, we anticipate that Optimism will experience a rush of liquidity and adoption over the second half of 2021. Apollo Capital’s portfolio is extremely well positioned to capture this value with our core positions consisting of many of the Ethereum DeFi ‘Blue Chips’ that are likely to adopt the scaling solution, including Synthetix and Uniswap.
While the focus near-term for Ethereum has moved to rollups such as Optimistic Rollups and ZK Rollups, Ethereum 2.0 includes a scaling solution for the base layer called shard chains.
The idea with sharding is to spread the load over 64 new chains. Towards the end of 2021 it is expected that the current chain will merge with the PoS Beacon chain. At that point Ethereum will fully transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS). In 2022 we could see the launch of sharding that will bring further scaling to Ethereum. At this point, the details of sharding are still being worked out by Ethereum developers.
Polygon’s PoS chain has seen a dramatic increase in TVL during 2021. Polygon is sometimes referred to as a pegged chain as it uses Ethereum mainchain for checkpointing.
It is likely that trusted Ethereum DeFi projects such as Curve, AAVE, mStable, Sushiswap and 1inch have expanded onto Polygon in response to the rapid rise of the Binance Smart Chain. Since Polygon is EVM compatible it takes relatively little effort for the developers of these projects to launch on Polygon. Polygon’s broader vision is to support a multi-chain Ethereum ecosystem that includes ZK Rollups, Optimistic Rollups together with Polygon’s own PoS chain.
We believe that Polygon’s native token, MATIC, will continue to accrue value and the network will continue to gain traction among quality Ethereum developers and projects. We are positioned to capture value in MATIC as well as the ‘Blue Chip’ projects that have adopted the chain.
1 Year TVL Growth of Polygon Network (Formerly Matic)
As Ethereum has experienced network congestion and increasing fees, this has led to users adopting other blockchains with much lower fees. Perhaps the best example of this is Binance Smart Chain (BSC) which has seen a surge in usage and TVL during the past 6-9 months. BSC currently has over $41bln in TVL with Uniswap fork PancakeSwap having over half of that at $9.83bn. Other alternative blockchains seeing traction include Solana ($1.36bn TVL), Terra ($3.17bn TVL) and Avalanche ($382M TVL). Polkadot is another chain that we believe will experience traction when it launches with its full capability later in the year.
So far the EVM compatibility, meaning developers can easily migrate smart contracts from Ethereum, has been a clear competitive advantage for the likes of BSC and Avalanche. EVM compatibility also makes user acquisition easier as the same infrastructure in terms of key management and wallets can be used.
Other Ethereum Developments – EIP-1559
Ethereum is scheduled to receive a highly anticipated upgrade called “EIP-1559” in July. The successful introduction of this “Ethereum Improvement Proposal” will significantly change the network fee mechanism and reduce the amount of new ETH issued in that the base transaction fees will be “burned” rather than added to the circulating supply. Network miners will still be compensated in the form of an inclusion fee (or a “tip”). From an investment perspective, the effect of this upgrade will be to increase the scarcity of ETH and could drive the price higher over time as there will be a stronger bond between the activity on Ethereum and the price of ETH.
Despite the gas fees, Ethereum’s adoption over the past year has been nothing short of incredible. DeFi is proving to be the killer use case for smart contracts and non fungible tokens are bringing the financially agnostic masses into the ecosystem. The scaling solutions outlined above will drive the Ethereum blockchain into a new era of economic utility, Apollo Capital is well positioned to capture this value. While we are big believers in Ethereum, we maintain the view that multiple chains will have a place in the new blockchain based financial system that is being built.