Scaling: The Theme of 2023

Famously, “bitcoin can only perform 10 number of transactions per second”. After the common arguments of “it's got no intrinsic value”, “it's only used by criminals”, and “governments will crush it”, it's often the last remaining arrow in the quiver of no and nevercoiners. And in fairness to the critics, the transaction throughput has been a legitimate argument against crypto adoption and certainly an impediment to growth. However, one should never bet against human ingenuity, where there is a will there is a way, and in crypto there is always a will.

Blockchain Trilemma

The legitimacy of a blockchain is derived from the fact that anybody anywhere can simply replay all the transactions that have ever happened on the ledger and be assured of their validity. Clearly whilst this is ideal in practice, applying such a system at scale to handle as many transactions as the Visa or Mastercard network support, let alone all the transactions on the planet and any conceivable human-to-human, human-to-machine, and machine-to-machine transaction seems an impossible task.

One possible solution is to relax the requirement that everybody check everything – this could take the form of perhaps loosening the requirement that everybody ought to be able to download the whole blockchain, or maybe not everybody needs to be able to add blocks to the chain. In the past this type of a solution has been achieved via centralization. However, achieving scale through centralization seems to defeat the purpose of blockchains, which was to remove the reliance on corruptible intermediaries. For many years it seemed impossible to square the circle of creating a blockchain which is decentralized, scalable and secure from external attack. This became known as the Blockchain Trilemma.

As scalability limitations began to bite during the bull run of 2021, when Ethereum whales were paying several hundred dollars for simple swap transaction, ordinary users began to find themselves priced out of transacting on Ethereum and pushed towards alternative chains which compromised on one of the other two apexes of the trilemma triangle. One such project was Binance Smart Chain, where scalability in catering for demand for inclusion on the blockchain (blockspace) was achieved by essentially dispensing of any pretense towards decentralization. By reducing the number of blockchain nodes processing transactions to single digits, Binance was able to mimic an Ethereum like service at scale. Obviously having a large, centralized entity presiding over the chain is far from ideal, and in fact is antithetical to the ethos which created blockchain.

Over the years a number of projects have seized upon this weakness in Ethereum's scalability as an opportunity to ride on Ethereum's coattails and market themselves as Ethereum killers. Most of these projects ultimately became victims of their compromises and have since fallen by the wayside. Wisely, the Ethereum community opted to not compromise on its core principles and continued to research a wide variety of solutions to the scaling trilemma. Some of these solutions finally went live in 2022 but 2023 will be the year that these solutions finally bear fruit.

So why is this important? Although the benefits of more transactions per second and cheaper transactions are self-evident as an incremental improvement in blockchain technology, what is less obvious is the true potential that effective scaling might bring to bear in terms of utility for this technology. For blockchain tech to truly fulfil its role as a global settlement layer for all transactions, the cost of a transaction needs to be several orders of magnitude cheaper than it currently is. But beyond this, it could be theorized that when a transaction on a blockchain cost less than a thousandth of a cent - suddenly it unlocks a whole host of new possible transaction types which may be currently prohibited by cost. What exactly these transactions are is still a task for the imagination, however.

Scaling Ethereum

Alternatives such as the Lightening Network for scaling Bitcoin was a previous topic of discussion. However, research on scaling Ethereum is at the forefront of scaling blockchains in general, and its two main candidates are sharding and rollups. Sharding is essentially splintering the blockchain into separate blockchains, to reduce the burden on any one set of nodes, which would be synced up at a later point. Sharding was the original Ethereum expected direction and is still on the Ethereum roadmap. However, as always, necessity is the mother of invention, with a demand driven urgent need for scaling in the immediacy, researchers have discovered some ingenious alternatives, the most prominent being rollups.

Rollups are a major theme for 2023 so let's dig in.

Rollups are what are known as a "Layer 2" or L2 solution. We touched on this previously - the main idea being that instead of doing all the calculations for the execution of smart contracts on the main Ethereum chain, the calculations are done on another, potentially more centralized and efficient chain, and later written back to the Ethereum mainchain. The Ethereum chain now only needs proofs that the computations off chain were preformed correctly, rather than having to do all the computations itself, a subtle but critical difference. 

Rollups come in two different forms, optimistic and zero knowledge, depending on how the legitimacy of the transactions in the rollup are enforced by the layer one blockchain. Consider the example of a game of chess being played on a blockchain between two participants for a cash prize. In theory the blockchain could verify the legitimacy of every move, but this is unnecessary. Instead imagine each player puts up a bond as a guarantee of good behavior. The game proceeds as a series of transactions and concludes when both players sign a transaction attesting to the game's winner. The base layer blockchain pays the winner. In the event of a dispute, the layer 1 (L1) blockchain has all the transactions and can go to the trouble of calculating who actually won, or somebody may present a proof to that effect. Fraudulent claims should rarely arise as the original good behavior bond is at risk. This is the basis of Optimistic Rollups - they optimistically assume that transactions are all legitimate unless a fraud proof is submitted to the smart contract at the base of the rollup. If such a proof is presented, the fraudulent batch of transactions are rewound.

The second form of rollup is zero knowledge (zk) rollup. Now each batch of transactions computed off chain is submitted to the main chain with a cryptographic proof proving the correctness of all transactions within the batch. This relies on the magic of zero knowledge cryptography, which effectively compresses the transactions and allows for rapid verification without the need to actually run all the computations.

Of the two option, zk rollups are seen as the superior technology and are expected to eventually dominate the rollup space. However, implementing zk rollups is still fraught with difficulty, requiring an understanding of esoteric mathematics and programming languages for creating smart contracts differing from those used on Ethereum, slowing adoption.

To date, thanks to their simplicity and speed to market, two competing optimistic rollups, Arbitrum and Optimism, have been quick to gather market share. All combined, layer 2 finally flipped Ethereum in number of transactions per second during Q4 2022.

Source: l2Beat.com. Light blue is Ethereum transactions/second. Red is all L2 transactions/second

These efficiency gains are very apparent considering that this effective doubling of the capacity of the network was achieved at only 4% of the total computational load on Ethereum, an increase from 1% at the start of 2022.

From an investment perspective, it is interesting to note the damage L2's are already starting to wreck the scaling via alt-L1 narrative. TVL or Total Value Locked is a useful metric as a proxy for adoption of any given chain. It measures the amount of wealth existing on a chain (often transferred from other chains) typically being utilized in some DeFi protocol on chain.  Major L1s such as Avalanche and Solana have lost significant TVL since the start of 2022, whereas Optimism and Arbitrum have gained.

Source: Defi Llama

Data Performance Improvements Planned

Currently the costliest aspect of rollups is posting data back to L1. This year expects to see one of the most exciting, proposed upgrades to the Ethereum codebase EIP 4844 (EIP standing for Ethereum Improvement Proposal), which aims to reduce this cost by increasing the data capacity of Ethereum by an order of magnitude. Since optimistic rollups only have a challenge period of 2 weeks where the presentation of a fraud proof could revert rollup transactions, storing intermediary data past the two-week period is unnecessary. EIP 4844 introduces a new data temporary storage convention to Ethereum. This EIP is the first steppingstone towards so-called Danksharding, where each node is no longer required to hold all of the chain’s data. A later upgrade will add Danksharding where data availability sampling will allow each node to store only a portion of the total data.

Following these updates, optimistic rollups will have made significant steps towards scalability and potential mass adoption. It remains to be seen if zk-rollups, which are a theoretically superior scaling solution from a technology perspective, offer enough of an improvement to beat the first mover advantage of their simpler optimistic alternative. The power of zk technology is clearly evident in how it has found application in tackling the two major obstacles holding back mass adoption – scalability and privacy.

Over the course of 2023 we may begin to see how these various scaling solutions are performing against one another and what direction developers, users and applications are beginning to favor. It’s a fascinating space and one which we will be paying close attention throughout the year.