Neo-Commodities: The Base Layer of the Web 3.0 Stack

While Ether is very likely to become the biggest winner in crypto, usurping gold in the process, its competing blockchain-based commodities will assume roles as digital silver, digital bronze, etc.. Like Ether, these neo-commodities will live their metaphors based on the usefulness of their corresponding blockchains [1]. It is still too early to publicly project which Ether competitors will become which commodity metaphors. It is also too early to determine how steep crypto’s Pareto distribution will be, but based on the network effects of both liquidity and security [2], the curve should be steep [3]. Nonetheless, these competing chains continue to ship technical updates to their protocols while simultaneously attempting to grow their communities.

However, it is much easier to deploy code than to develop communities on top of that code. Thus, most Ethereum competitors have struggled and/or failed to garner meaningful community adoption, but certain chains have successfully garnered adoption across specific industries or regions: Provenance has very quickly grown in the Home Equity Line of Credit (HELOC) market; Nodle, a future Polkadot parachain (Polkadot has yet to launch), is now processing over 1 million transactions per day in its Internet of Things (IoT) relay network; Icon’s loopchains are quickly becoming adopted across numerous verticals in South Korea. Even if Ether assumes 95% of the value of all blockchain-based commodities [4], based on the future market size of these neo-commodities [5], there still exists trillions of dollars on the table for Ether competitors. Some of these competitors may even pose a better risk-adjusted return than Ether itself.

Measuring a Blockchain’s Value: The Usefulness of its Smart Contracts

Smart contract usage thus far has been overwhelmingly dominated by contracts on Ethereum. Below are Ethereum’s most used smart contracts (The terms ‘smart contracts’ and ‘layer-two protocols’ are used interchangeably, as all layer-two protocols are a set of smart contracts. The blockchain itself is known as a layer-one protocol.).

Image 1: Ethereum and its most used smart contracts

User applications must write (such as sending a transaction) and read (such as receiving an update that a transaction has been received) information to and from Ethereum’s smart contracts. The process of reading and writing to smart contracts can be termed the ‘querying’. Thus, the full Ethereum stack currently looks as follows:

Image 2: Web 3.0 Stack, Ethereum Only

Other chains can attempt to copy the code from Ethereum’s most used smart contracts, but other chains cannot copy the liquidity locked inside Ethereum’s smart contracts. However, the liquidity of Ethereum’s smart contracts recently proved to be a double-edge sword: as Ethereum’s block space becomes increasingly demanded, Ethereum’s efficiency becomes hindered. There was no better example than this than the recent market crash on March 12, when Ethereum’s lack of mainstream scalability exacerbated the crash of Ether’s price: users were unable to quickly add additional collateral to their debt positions, causing their debt positions to become undercollateralized and consequently liquidated (further dropping Ether’s price and causing more liquidations).

Scaling Ethereum via Sub-Chains

In general, the decision (for a layer-two protocol to either have its own rollup, share a rollup with other layer-twos, or remain on the base layer) will follow marginal demand and marginal cost economics, as most free markets do: smart contracts will position themselves to best optimize that contract’s utility/demand across the cost of operating the contract. As rollups/sub-chains are deployed, Ethereum will begin to form a hub-spoke model, with rollups as spokes and Ethereum 1.0 mainchain as the central hub.

Image 3: Ethereum and its rollup sub-chains

Ethereum competitors will also have their own intra-blockchain standards, allowing for their own versions of the above hub-spoke model. However, these Ethereum competitors will increasingly need to interoperate with Ethereum, due to Ethereum’s increasing dominance of the decentralized finance sector; not interacting with Ethereum will significantly diminish the utility of these Ethereum competitors.

How Ethereum Competitors Will Enter

The costs of deploying and operating these light-clients are paid by the less secure chain’s users to the more secure chain’s validators (which will often be Ethereum’s validators). Thus, chains will only connect to a few other chains, for which the gains in utility/liquidity compensate for the cost of interoperability. Other than Ethereum, the chains that garner enough usage to render interoperability a worthwhile endeavor will be ones that optimize for specific industries and regions; these chains will be the most successful Ethereum competitors, with their native assets having the highest probability of becoming high-value digital commodities.

Industry Chains

There exist certain protocols that will be important to both factions of the broader Web 3.0 landscape [13]; the most important decentralized web protocols, both in the near and long term, will be those that also serve decentralized finance (This is not a coincidence, but merely a property of protocols: the best protocols can be used across a wide range of applications.).

Image 4: Web 3.0 landscape, broken into Decentralized Finance and the Decentralized Web

File Storage and Compute

Both decentralized finance applications and decentralized web applications will also rely on decentralized computation services. Decentralized computation is years behind decentralized storage due to secure enclave’s vulnerabilities and the current shortcomings of the math behind secure multi-party computation and fully homomorphic encryption. There are numerous chains focused on decentralized computation, and, although there is still no clear leader, it is likely that a chain optimized for decentralized computation follows a similar success story as Filecoin’s [15].

Finance-Only

Other finance-driven chains have successfully optimized themselves for trade finance. E&Y’s Baseline protocol, a collaboration with Fortune 50s that already heavily leverages the Ethereum mainchain, is newly launched but already shows significant promise in the sector [16]. Citi Bank’s trade finance chain, komgo (a fork of Ethereum), also shows significant promise.

Regional Chains

Icon’s loopchains (Icon’s version of sub-chains) have garnered adoption from leading municipalities , financial services companies, and public universities across South Korea. With South Korea’s GDP at ~$1.5trn, if Icon is able to secure even a fraction of the country’s economy, it will be worth at least tens of billions, if not hundreds of billions. At a current valuation of ~$100mn, depending on your projections for Icon’s adoption within Korea, its risk-adjusted return could surpass Ether’s.

Conflux is a Chinese chain led by some of the top Chinese computer scientists. The chain has officially partnered with the city of Shanghai to incubate projects that improve Shanghai’s transportation, finance, and healthcare sectors. If successful, one could imagine other Chinese cities implementing Conflux’s solutions developed for Shanghai. However, due to the general opacity of the Chinese economy and the high likelihood that the current Chinese regime will not publicly endorse public blockchain technology (instead focusing on private blockchain technology), it is difficult to evaluate the risk-reward ratio of an investment in Conflux.

Both Icon and Conflux are attempting to expand beyond the regions they dominate. However, they will likely stumble outside of their regions, as Ethereum continues to amass the majority of independent developers due to the chain’s increasingly compounding network effects. Ethereum has garnered more third-party adoption even inside Korea and China than both Icon and Conflux (Ethereum’s founder, Vitalik Buterin, learned Mandarin in three months several years ago to grow Ethereum in the region.).

Regional chains are successful for the same reason that industry chains are: these chains have heightened competency in attracting institutions, due to the strong institutional relationships of their founders, and consequently can customize their chains specifically for their client institutions.

A Lack of Direction Hurts Even the Most Technically Innovative

No future parachains (Polkadot’s version of sub-chains) have garnered significant enterprise or community adoption. Currently, only one of Polkadot’s parachains promises to achieve adoption due to its innovative solution to bringing IoT devices online, Nodle Inc. [17]. However, even if Nodle becomes a dominant player in the global IoT market (becoming worth tens, if not hundreds of billions of dollars), Polkadot’s other parachains would need to see significant adoption for Nodle to stay in the Polkadot network. If other parachains have little adoption, there is no need for Nodle to pay rent to Polkadot’s validators to be part of the broader Polkadot network; it would be more cost effective for Nodle to simply secure their own chain with only their own validators.

While Polkadot is the number one Ethereum competitor for third-party developers (due to the reputation of its founder, Ethereum’s former CTO, and the technical prowess of the rest of the team), its failure to focus on one specific industry may be its ultimate reason for failing. It cannot usurp Ethereum as market leader [18], and may be stuck in the middle where its technology is wonderful but its adoption is scarce. At its current $1.2 bn valuation, if one believed that it was 10% as likely as Ether to become digital gold, its risk-adjusted returns would be equal to Ether’s. However, it is likely that Polkadot has less than a 10% probability of usurping Ethereum. No matter how strong an Ethereum competitor is technically, a blockchain is only worth as much as the community on top of it [19].

The Network of Chains

Image 5: Network of Blockchains (pre-Eth 2.0)

Ethereum is in the process of upgrading from Ethereum 1.0 to Ethereum 2.0 [20]. Ethereum 2.0 has three well-established phases: Phase 0, Phase 1, and Phase 2, each of which will incrementally change our projected network

Ethereum 2.0 Phase 0

Image 6: Network of Blockchains (Eth 2.0 Phase 0)

Ethereum 2.0 Phase 1

Image 7: Network of Blockchains (Eth 2.0 Phase 1)

Ethereum 2.0 Phase 2

As Ethereum evolves, a robust hub and spoke model will increasingly take shape, with a central hub in Ethereum securing the entire system. This system will underpin digital finance and, later on, the decentralized web (Although a decentralized computation chain was not drawn, due to a lack of a clear winner. Numerous chains were left out for simplicity’s sake.).

Image 8: Network of Blockchains (Eth 2.0 Phase 2)

Conclusion

Endnotes

[2] Liquidity begets liquidity: the chain with the liquidity in its lending pools, money markets, automated market makers, peer-to-peer exchanges, etc. will continue to grow its liquidity in these areas, while chains without liquidity in those areas will see little to no growth. Security also begets security: the chain with the greatest security (measured through capital staked in Proof of Stake, hash rate in Proof of Work, and file storage in Proof of SpaceTime) will attract more developers and enterprises, generating more fees for its miners and consequently increasing security.

[3],[4] Google assumes 90% of the market capitalization of search engines. Blockchains will follow a similar, if not more steep, pattern, due to [2].

[5] The market size of blockchain-based commodities will likely be tens of trillions of dollars, as these neo-commodities both replace and grow the market for physical commodities (~20 trillion).

[6] There are exceptions to the rule: Bitcoin, due to first-mover advantages, is still the market leader, despite only allowing for the transfer of the Bitcoin currency. While Bitcoin currently has a ~7x higher market capitalization than Ethereum, Bitcoin is and, barring significant changes to the Bitcoin community’s culture and roadmap, will continue to be only exceptional at storing and moving only the bitcoin currency. The Bitcoin community acknowledges that this is currently a very small market. They understand that Bitcoin’s long-term security is dependent on bitcoin transactions not becoming a very small market. However, massive consumer behavior changes (from paying in fiat currencies into paying with digital gold) is a low probability outcome, and Bitcoin’s future security is dependent on it: if transaction demand does not increase on Bitcoin, Bitcoin will be forced to raise its price per transaction significantly to pay miners, which will likely further reduce transaction demand, creating a spiral that ultimately leads to Bitcoin collapsing.

[7] Consequently, finance conducted on blockchains (often termed decentralized finance) allows for orders of magnitude improvements in the efficiency and openness of financial transactions (Openness meaning anyone, not just the half of the world with bank accounts, can partake in this new system.). Decentralized finance grew 67% this past year. Before the recent Ether price crash, its annual growth rate was 300%. The open-source nature of blockchain protocols and their smart contracts allows for faster feature growth than close-sourced systems; contributors globally need not ask for any permission to build on or access these systems, similar to how no one needs to ask YouTube if they can post a video. The ability for fast feature growth has played a large role in decentralized finance’s fast user growth.

[8] The current version of Ethereum, Eth 1.0, will become a sub-chain of Ethereum after sharding is implemented in Ethereum 2.0 Phase 1, although rollups are the most near-term/relevant form of Ethereum-based sub-chains. Some rollups may have their own token that their validators must stake, while others will allow their validators to stake Ether.

[9] Rollups will be able to communicate within two to three blocks due to credit markets.

[10] For example, money markets (which are over-collateralized loans) do not require strict composability with under-collateralized loans, and thus these two layer-two protocols could exist more efficiently on separate rollups within Ethereum. They would still hold weak composability, meaning they could communicate within three blocks (~39 seconds, still multiple orders of magnitude improvement over the current financial system).

[11] Use cases with meaningful adoption that require strict composability of layer-two protocols will either share a rollup or remain on the Eth 1.0 base layer, thus allowing users to still have frictionless access to that use case. Additionally, certain layer-two protocols may add specific features from other layer-two protocols, so as not to lose that use case as they transition to a rollup-driven architecture. For example, it would not be surprising to see numerous layer-two protocols implement flash loans, due to the ease of deploying this feature and the utility flash loans provide to their use case. Lastly, certain primitives that are useful across all rollups, such as Fully Collateralized On-Chain Stablecoins (FCOSs), will likely remain on the Ethereum 1.0 base layer; remaining on the base layer minimizes the friction for other layer-two protocols, both on rollups and on the base layer, to access the primitive.

[12] Ethereum will likely either allow competing chains to conform to similar standards as Ethereum’s sub-chains, or piggy-back off the open-source work of more focused interoperability protocols, namely Polkadot and Cosmos, implementing some version of their standards.

[13] For example, digital wallets will store a user’s private transaction history in a decentralized file system and then use a decentralized compute service to assess that user’s credit history.

[14] Filecoin is an incentive layer, for the storage and retrieval of files, built on top of IPFS, which is the protocol for how files are actually stored in the network.

[15] Eventually, the advent of decentralized storage and decentralized computation will not only further the adoption of decentralized finance, but will also unbundle the cloud monopolies of today (Amazon Web Services, Google Cloud, Microsoft Azure, etc.), whose primary services are storing data and allowing computation on that data.

[16] Of the Ethereum competitors described thus far, Baseline is the only one that currently interoperates with Ethereum.

[17] Nodle is a San Francisco based startup that allows for the efficient and frictionless relay of currently trapped IoT data.

[18] Polkadot’s primary design improvement was to allow developers to easily create ‘parathreads/parachains’ (similar to layer-two solutions on Ethereum) with customized state transition functions, which, a year ago, would have been a massive design improvement over Ethereum. However, this incremental design improvement by Polkadot has already been matched by layer-two developers on Ethereum. Ethereum’s layer-two developers are already launching chains secured by Ethereum but using a different virtual machine than the EVM (instead using a virtual machine more optimized for their specific application). This was Polkadot’s greatest design enhancement, and Ethereum’s community was able to launch it before Polkadot, despite Polkadot being able to hypothetically move faster and break more things. The compounding nature of Ethereum’s developer community will make it nearly impossible for Polkadot and chains like it to assume any significant market share among third-party developers.

[19] This is largely due to the open-source nature of blockchain code; there are no defensible patents.

[20] Ethereum 2.0 will scale Ethereum enough to allow for the network underpin a majority of the world’s value transfers.

Partner at Bizantine Capital