The Future of Ethereum: Finding Balance in the L2 Wave

Summary

The upcoming Ethereum Cancun/Deneb upgrade is expected to reduce the block space costs for Rollup operators, which may negatively impact Ethereum's revenue in the short term. As the interoperability between Rollup projects and other high-performance, low-cost chains increases, ETH may underperform. In the long run, if the modularity theory of blockchain is validated, the main source of revenue for layer one public chains will be from layer two Rollup service providers, rather than end users. Coupled with account abstraction in layer two chains, it is likely that the main holders of Ether in the future will be Rollup operators, rather than ordinary users.

Introduction

The cryptocurrency industry has long been seeking ways to maintain decentralization and security while scaling public chains. The recently launched Celestia represents a new solution, optimized as a public chain specifically for providing data availability for Rollups (DA). Ethereum is also working to reduce DA costs, with the next upgrade Cancun/Deneb expected to add 768kB of temporary data storage space, which is anticipated to reduce Rollup's DA costs by at least 10 times.

The modular theory of blockchain suggests that not all core functions should be executed by a single network, but rather that responsibilities should be outsourced to specialized infrastructure providers. With Ethereum implementing upgrades to support Layer 2 Rollups, the revenue share from Rollups may exceed that of direct L1 users. Currently, Rollups account for 12% of Ethereum's gas fees, up from 3% at the beginning of the year.

This report will explore the prospects of value accumulation from L2 to L1, while considering the impacts of reset and account abstraction. In the short term, the value of Ethereum may be negatively affected, but in the long run, as Rollup technology matures and Ethereum's DA capabilities improve, the value of Ethereum will perform excellently.

L2 Adoption in 2023

Since January, the trading activity of Ethereum L2 has more than doubled. In 2023, the daily average trading volume of L2 has seen the most significant growth. In terms of TVL, Optimism and Arbitrum have seen the largest decline in share, while Base and zkSync Era have experienced the most growth. Notably, Base launched by Coinbase has rapidly risen, with daily trading volumes sometimes exceeding those of Arbitrum and Optimism. Currently, Optimism, Base, and Arbitrum sorters have generated $140 million in revenue from user fees.

Cancun/Deneb Upgrade

The main change of the Cancun/Deneb upgrade is EIP 4844 ( Proto-danksharding, which creates dedicated block space for Rollup transactions. This will increase the data space of each block by 768 KB, and the block space fees for Rollup are expected to decrease by more than 10 times. In the short term, this may lead to a decline in Ethereum's revenue. Before the Rollup technology matures, it is unlikely that Ethereum will significantly benefit from EIP 4844.

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Short-term Technical Challenges

Rollup operators currently face three key areas of development:

1. Scalability: Rollups still face the issue of fee volatility, and developers are actively working to improve in this area.

2. Decentralization and Security: Mainly includes the implementation of effectiveness/fraud proofs, extended validation and sorting operator sets, removal of administrator privileges, etc.

3. Interoperability: Solving the seamless migration of assets from L1 to L2 and within the L2 ecosystem is key to driving user adoption.

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Advantages of Alternative DA Solutions

In the short term, Ethereum revenue will still mainly come from L1 transactions by end users. With L2 optimization, user adoption will increase. Companies that choose alternative DA layers like Celestia may achieve higher profits. Transaction fees for L2 users can be over 90% lower than Ethereum. The fees for Celestia are on average 80 times lower than Ethereum, but may rise as usage increases.

Overall, it is expected that after the Cancun/Deneb upgrade in 2024, Ethereum network revenue will decline. Most of the revenue will still come from end users rather than L2. If sorters use other DA solutions, their profit margins may increase in the short term.

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Long-term Outlook

In the long run, as blockchain applications are adopted on a large scale, Ethereum's revenue may rise, with L2 usage being 10 times or more than that of Ethereum. Lower L2 fees may bring new use cases and increase the overall demand for Ethereum's block space. At that time, Ethereum's main source of revenue will be the Rollup services as a settlement and DA layer.

In the coming years, the emergence of multiple optimized DA layers may accelerate the migration of L2 from Ethereum to other DA layers. This could challenge Ethereum's position as the primary Rollup base layer. However, as long as Ethereum maintains its advantage in user experience, it is likely to continue to dominate.

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Ethereum's Competitive Advantages

Although Ethereum dominated in security, value, decentralization, and network effects in 2023, competition from public chains like Celestia that specifically support Rollups will intensify. Ethereum is responding by enhancing its DA capabilities through the Cancun/Deneb upgrade.

However, it should be considered that Rollup may not provide users with the same level of decentralization, security, and interoperability as the underlying layer. In this case, even if Celestia performs better as a DA layer, Ethereum's advantage as the most decentralized general-purpose public chain may continue to attract users.

If most user activity remains on Ethereum, it will lead to high fees and a temporary surge in revenue. However, the lack of scalability will ultimately limit revenue growth and affect Ethereum's long-term value.

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Other Considerations

1. Account Abstraction: Implementing native account abstraction on L2 may change the user experience, allowing for more flexible fee payment methods. This could reduce the need for users to hold ETH directly.

2. Re-staking: Protocols like EigenLayer will allow the reuse of staked ETH to secure other protocols, potentially increasing the demand for ETH. EigenLayer is expected to launch EigenDA in the first half of 2024.

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Conclusion

In the short term, Ethereum may face a decrease in revenue, and the performance of ETH may be poor. However, in the long run, as Rollup technology matures, most user activity may migrate to L2. The native account abstraction on L2 will further reduce the demand for users to hold ETH directly. In the future, the main holders of ETH may be Rollup operators. The maturation of restaking solutions may create new sources of demand for ETH.

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