Hack VC: Analysis of the gains and losses of Ethereum's modularization journey in Depth

Author: Alex Pack & Alex Botte

Compilation: DeepTechFlow

Execution Summary

Ethereum is underperforming compared to BTC and Solana. Critics argue that this is mainly due to Ethereum’s choice of modular strategy. Is this true?

In the short term, that is indeed the case. We found that the shift to a modular architecture by Ethereum led to the decline in ETH price, due to reduced fees and decreased TOKEN burn.

If we look at the total market capitalization of ETH and its modular ecosystem, the situation is different. In 2023, the value generated by the modular infrastructure tokens of ETH is equivalent to the total market capitalization of Solana, which is about 50 billion USD. However, in 2024, they performed overall worse than Solana. In addition, the profits of these tokens mainly flow to the teams and early investors, rather than ETH token holders.

From a business strategy perspective, the modular transformation of Ethereum (ETH) is to maintain its dominant position in the ecosystem. The value of blockchain lies in the scale of its ecosystem. Although Ethereum’s market share has dropped from 100% to 75% in the past nine years, this proportion is still quite considerable (compared to the leader in the Web2 cloud computing field, Amazon Web Services, whose market share has dropped from nearly 100% to 35%).

In the long run, the greatest advantage of Ethereum’s modular strategy is to enable the network to cope with future technological advancements and avoid obsolescence. Through its Layer 2, Ethereum has successfully overcome the first major challenge of Layer 1 blockchain, laying the foundation for its long-term resilience (despite some trade-offs).

Introduction: Where is the problem?

In this market cycle, the performance of Ethereum (ETH) is not as good as BTC and Solana. Since the beginning of 2023, ETH has pumped 121%, while BTC and SOL have pumped 290% and 1452% respectively. Why is this happening? There are many views that the market is not rational enough, the technical roadmap and user experience lag behind competitors, and the Ethereum ecosystem is being taken over by competitors such as Solana. Will Ethereum become the AOL or Yahoo! of the cryptocurrency field?

The main reason for this poor performance is a deliberate strategic decision made by Ethereum about five years ago: to adopt a modular architecture, while decentralizing and deconstructing its infrastructure development roadmap.

In this article, we will explore ETH’s modular strategy and evaluate the impact of this strategy on the short-term performance of ETH, the market position of ETH, and its long-term prospects through data analysis.

ETH Workshop’s Strategic Transformation to Modular Architecture: How Bold Is It Really?

In 2020, Vitalik and the Ethereum Foundation (EF) made a bold and controversial decision to deconstruct various components of the Ethereum infrastructure. Instead of handling all aspects of the platform, such as execution, settlement, data availability, and ordering, Ethereum now encourages other projects to provide these services in a composable manner. This process began with the promotion of new Rollup protocols as Layer 2 (L2) solutions for Ethereum’s execution (see Vitalik’s article ‘A Rollup-centric Ethereum Roadmap’ in 2020), and now there are hundreds of different infrastructure protocols competing to offer services that were once exclusive to Layer 1 (L1) technology.

To understand how radical this idea is, you can imagine a Web2 analogy. ETH is a similar example in Web2 to Amazon Web Services (AWS), which is a leading cloud infrastructure platform for building centralized applications. Imagine if AWS, when it first launched 20 years ago, focused only on its flagship products like storage (S3) and computing (EC2), instead of developing the dozens of different services it offers today. AWS might have missed out on the huge opportunity to increase customer revenue by expanding its suite of services. Additionally, by providing a comprehensive range of products and services, AWS could create a ‘walled garden’ that makes it difficult for customers to integrate with other infrastructure providers, thus locking them in. And that’s exactly what happened. AWS now offers dozens of services, and the stickiness of its ecosystem makes it hard for customers to leave, resulting in revenue rising from hundreds of millions of dollars in the early days to an expected annual revenue of $100 billion today.

However, the result is that AWS’s market share has been gradually eroded by other cloud service providers, such as Microsoft Azure and Google Cloud, which have been steadily rising every year. The market share, which was initially close to 100%, has now fallen to about 35%.

What if AWS took a different approach? What if it acknowledged that other teams might perform better on certain services, chose to open its API, prioritized modularization and interoperability, rather than attempting to lock in users? AWS could have allowed developers and startups to build complementary infrastructure, creating more specialized services, and forming a more developer-friendly ecosystem to enhance the overall user experience. Although this may not increase AWS’s revenue in the short term, it could give AWS a larger market share and a more active ecosystem.

Nevertheless, for Amazon, this may not be cost-effective. As a publicly traded company, it needs to follow the current revenue, not a “more active ecosystem.” Therefore, deconstruction and modularization may not be appropriate for Amazon. However, for Ethereum, this may be reasonable, as Ethereum is a Decentralizationprotocol, not a company.

Decentralizationprotocol and Company

Decentralization protocol is similar to a company and will also generate usage fees, and even has ‘income’ to some extent. But does this mean that the value of the protocol should only be measured based on these income? The answer is no. Today, this is not the measure of value.

In the Web3 field, the value of the protocol depends more on the overall activity on its platform, as well as whether it has the most active developers and user ecosystem. Please see our analysis of Bitcoin, Ethereum, and Solana. There is a high correlation between Token prices and Metcalfe value (a measure of the number of network users), a relationship that has persisted for over a decade in the case of Bitcoin.

Why is the market so concerned about the activity of the ecosystem when pricing these Tokens? After all, the pricing of stocks is usually based on rise and returns. However, the theory of how blockchain adds value to its Tokens is still in its early stages and has not yet shown strong explanatory power in the real world. Therefore, it is more reasonable to evaluate the encryption network according to the network activity: including factors such as the number of users, assets, and activities.

Specifically, the price of Token should reflect the future value of its network (just as the stock price reflects the future value of a company, not the current value). This also leads to the second reason why ETH considers modularity: to ‘future-proof’ its product roadmap and increase the likelihood of ETH maintaining its dominant position in the long term.

In 2020, Vitalik wrote his article ‘Rollup-centric Roadmap’ when ETH 1.0 was in its early stage. As the first smart contract blockchain, Ethereum is expected to achieve multiple improvements in scalability, cost, security, and more in the blockchain. For pioneers, the biggest risk is the inability to adapt quickly to new technological changes and miss the next leap. For Ethereum, this means transitioning from PoW to PoS and achieving 100 times higher blockchain scalability. The Ethereum Foundation (EF) needs to cultivate an ecosystem that can scale and achieve significant technological advancements, otherwise it may become the Yahoo or AOL of its time!

In the Web3 world, Decentralization protocol replaces traditional companies. Ethereum believes that nurturing a strong and modular ecosystem is more valuable in the long run than having complete control over infrastructure, even if it means giving up control over infrastructure roadmaps and core service revenue.

Next, we will use data to explore the actual results of modular decision-making.

The Impact of Ethereum Modular Ecosystem on ETH

We analyze the impact of modularity on Ethereum from the following four aspects:

1. Short-term price (adverse impact)

2. Market Cap (beneficial to some)

3. Market Share (Impressive Performance)

4. Future Technology Roadmap (To be discussed)

1. Adverse Impact: Fees and Prices

In the short term, the modular strategy of Ethereum has had a significant negative impact on the price of ETH. Although ETH has rebounded significantly from the low point, its performance still lags behind BTC, some competitors such as SOL, and even at times falls behind the Nasdaq Composite Index. This is largely due to its modular strategy.

ETH Square’s modular strategy first affects the price of ETH through drop fees. In August 2021, ETH Workshop implemented the EIP-1559 proposal, where excess fees in the network will be “burned”, thereby reducing the supply of ETH. This is similar to a share buyback in the stock market, which should theoretically have a positive impact on the price and does work for a while.

However, with the introduction and development of L2 execution layer and alternative data availability layers like Celestia, the fees of Ethereum started to decrease. As the core source of income was abandoned, the fees and revenue of Ethereum decreased, which had a significant impact on the price of ETH.

Over the past three years, there has been a significant statistical correlation (+48%) between the fees of Ethereum (in ETH) and the price of ETH. If the fees on the Ethereum blockchain decrease by 1,000 ETH in a week, the average price of ETH will decrease by $17.

Therefore, outsourcing the execution to L2 leads to a drop in fees on L1, which in turn reduces the destruction of ETH and causes the price to drop. At least in the short term, this is not good news.

However, these costs have not disappeared, but have flowed to new blockchain protocols, including L2 and DA layers. This also leads to the second impact that modular strategies may have on the price of ETH: most of these new blockchain protocols have their own Token. In the past, investors only needed to buy an infrastructure Token (ETH) to participate in all the rises of the Ethereum ecosystem. Now they need to choose from many different Tokens (CoinMarketCap lists 15 in the “modular” category, with more projects supported by venture capital in development).

The new modular infrastructure Token category may have affected the price of ETH in two ways. First, if the Block chain is considered as a company, theoretically, the total market capitalization of all ‘modular Tokens’ should vesting in the market capitalization of ETH. This is similar to the spin-off of companies in the stock market, where the market capitalization of the old company usually decreases, equivalent to the market capitalization of the new company.

However, the situation may be even more unfavorable for ETH. Many cryptocurrency traders are not particularly sophisticated investors, and they may feel overwhelmed when they need to buy dozens of tokens to participate in ‘all the innovations rising on the ETH platform’, and may even choose not to buy. This psychological burden, as well as the transaction cost of buying multiple tokens instead of a single token, may have a negative impact on the price of ETH and modular tokens.

2. Positive Side (for Some): The Story of Market Cap

Another way to evaluate the impact of Ethereum’s modular strategy on its success is to observe the change in its Market Cap. In 2023, the Market Cap of ETH rose by 1280 billion USD. In contrast, the Market Cap of Solana rose by 540 billion USD. Although the absolute rise of ETH is higher, Solana started from a lower base, so its price rose by 919%, while ETH rose by 91%.

However, if we consider the market capitalization of all new ‘modular’ Tokens developed through the Ethereum modular strategy, the picture is different. In 2023, the market capitalization of these Tokens rose by 51 billion US dollars, which is almost on par with Solana’s market capitalization rise.

What does this mean? One interpretation is that the Ethereum Foundation (EF) has created a modular infrastructure ecosystem for Ethereum that is equivalent in value to Solana through the transformation of modular strategies. In addition, it has created a Market Cap of $128 billion for itself, which is quite remarkable! Imagine how astonishing it would be to see the achievements of Ethereum compared to Microsoft or Apple, which have spent years and billions of dollars building their own developer ecosystems.

However, this trend did not continue in 2024. SOL and ETH continued to rise (although at a slower pace), while the overall market capitalization of modular blockchain declined. This may be due to weakened confidence in Ethereum’s modular strategy in the market in 2024, or it could be due to the pressure of token unlocking, or the market feeling overwhelmed by purchasing multiple tokens and choosing to invest in Solana’s technological ecosystem by only purchasing one token.

Let’s shift from PA and market feedback to actual fundamentals. Maybe the market judgment for 2024 is wrong, while the market judgment for 2023 is correct. Has Ethereum’s modular strategy helped or hindered it in becoming a leading blockchain ecosystem and mainstream Cryptocurrency?

3. Outstanding Performance: Ethereum Ecosystem and the Dominant Status of ETH

From the perspective of fundamentals and usage, the infrastructure related to Ethereum performs exceptionally well. Among similar projects, Ethereum and its L2 have the highest Total Value Locked (TVL) and fees. The TVL of Ethereum and its L2 is 11.5 times that of Solana, even considering only L2, its TVL exceeds Solana by 53%.

From the perspective of TVL market share:

Since its launch in 2015, the Ether community initially occupied 100% of the market share. Despite facing hundreds of competing L1 projects, the Ether community and its modular ecosystem still maintain approximately 75% of the market share. The performance of reducing market share from 100% to 75% over 9 years is quite remarkable! In contrast, AWS reduced its market share from 100% to about 35% in approximately the same time period.

So, does ETH really benefit from its dominant position in the “ETH ecosystem”? Or are the modular parts of the ETH ecosystem thriving without using ETH as an asset? In fact, ETH is an important component of the broad ETH ecosystem. As ETH expands to L2, ETH expands in sync. Most L2s use ETH as gas (network currency), and in most L2 TVLs, the amount of ETH is at least 10 times that of other tokens. Please refer to the table below for the dominant position of ETH in the three major Decentralized Finance applications in the ETH ecosystem, including Mainnet and L2 instances.

4. Worth discussing: Technology Development Story

From the perspective of the technology roadmap, the decision of Ethereum to modularize the L1 chain into independent components allows the project to specialize and optimize within its specific field. As long as these components remain composable, decentralized application (dApp) developers can use the best infrastructure for construction, ensuring efficiency and scalability.

Another major advantage of modularization is to make the protocol adaptable for the future. Imagine a new technological innovation that changes the game rules, only the protocols that adopt it can survive. This situation is not uncommon in technological history: AOL fell from a valuation of 200 billion dollars to 45 billion dollars for missing the transition from dial-up to high-speed broadband. Yahoo fell from a valuation of 125 billion dollars to 50 billion dollars for failing to adopt new search algorithms (such as Google’s PageRank) in a timely manner and missing the transition to the mobile end.

However, if your technical roadmap is modular, as an L1, you don’t need to personally chase every new technological innovation wave - your modular infrastructure partners can do this for you.

Does this strategy work? Let’s take a look at the actual construction of the infrastructure related to the Ethereum (ETH) network:

**ETH’s L2 layer is highly scalable and cost-effective. At least two innovative technologies have found success here: optimistic rollups, such as Arbitrum and Optimism, and zero-knowledge (zk)proof-based rollups, such as ZKSync, Scroll, Linea, and StarkNet. In addition, there are many other high-throughput, low-cost L2s. Driven by these two blockchain technologies, ETH has achieved an order of magnitude improvement in scalability, which is no easy task. Dozens, if not hundreds, of L1s launched after ETH Square still haven’t achieved version 2.0 with 100x scalability and cost improvements. With these L2s, ETH has managed to survive the blockchain’s “first mass phase-out event”: it has achieved a 100x increase in transactions per second (TPS).

New Block chain security model. Innovation in the Block Chain security space is critical to protocol’s survival – see how each of the major L1s moves from PoW to PoS these days. The “shared security” model pioneered by EigenLayer could be the next big change. Although there are similar shared security protocols in other ecosystems, such as Bitcoin’s Babylon and Solana’s Solayer, EigenLayer is the pioneer and largest in the ETH workshop.

New Virtual Machine (VM) and programming languages. One of the main criticisms of Ethereum (ETH) is its Ethereum Virtual Machine (EVM) and its programming language, Solidity. While coding in Solidity is relatively straightforward, it is a low-level programming language that is prone to errors and difficult to audit, which is one of the reasons why Ethereum smart contracts are frequently attacked. For non-modular blockchains, it is almost impossible to try multiple VMs or switch the initial VM, but Ethereum is different. The new wave of alternative VMs built as Layer 2 allows developers to code in other languages and does not rely on the EVM, but is still built within the Ethereum ecosystem. Examples include Movement Labs, which adopts the Move VM developed by Meta and promoted by leading L1 projects like Sui and Aptos; zk-VMs such as RiscZero and Succinct developed by A16Z’s research team; and teams that introduce Rust and Solana VMs into Ethereum, such as Eclipse.

New Scalability Strategies. Similar to internet infrastructure or AI, scalability upgrades of an order of magnitude are expected every few years. Even now, Solana has been waiting for years for the next major improvement, Firedancer, developed by the Jump Trading team. In addition, new highly scalable technologies are under development, such as the parallel architectures of L1 teams such as Monad, SEI, and Pharos. If Solana cannot keep up, these technologies could pose a survival threat, but Ethereum, on the other hand, can easily integrate these technological advances through new L2s. This is also the strategy being attempted by new projects such as MegaETH and Rise. These modular infrastructure partners help Ethereum incorporate significant technological innovations in the encryption field into its own ecosystem, avoid being eliminated, and innovate together with competitors.

However, this also comes with compromises. As mentioned earlier, as long as the components remain composable, modular technology architecture can function well. As our fren ‘Composable Kyle’ mentioned, Ethereum (ETH) increases the complexity of user experience when adopting a modular architecture. Regular users find it easier to use a single structure chain like Solana because they don’t have to deal with issues such as cross-chain bridges and interoperability.

In the long run

So, where will all this lead us?

The modular ecosystem has sparked widespread discussion. The market’s expectations for rise of modular infrastructure tokens related to Ethereum in 2023 are the same as Solana’s, but the situation is different in 2024.

At least in the short term, modular strategies have indeed had a negative impact on the price of ETH, mainly because this has led to a decrease in fees and burns.

If we look at the modular approach from a business strategy perspective, we will find its rationality. In the past 9 years, Ethereum’s market share has dropped from 100% to 75%, while in comparison, Amazon Web Services, the Web2 counterpart, has seen its market share drop to about 35% during the same period. In the world of Decentralizationprotocol, the scale of the ecosystem and the dominance of Token are more important than fees, which is good news for Ethereum.

From a long-term perspective, Ethereum’s modular strategy and its future technology upgrade protection to avoid becoming the AOL or Yahoo! of the cryptocurrency industry have also performed well. Through L2, Ethereum has successfully overcome the first ‘extinction event’ of the L1 blockchain.

However, this also brings compromises. The modularized Ethereum after the ETH block is not as high in composability as a single chain, which has a certain impact on user experience.

It is currently unclear when the advantages of modularity can offset the reduction in costs and the impact on ETH prices from competition with modular Ethereum-related infrastructure Tokens. For early investors and teams of these new modular Tokens, it is certainly a good thing to get a share from the Market Cap of ETH, but the launch of modular Tokens based on unicorn valuation suggests that the distribution of these economic benefits is not balanced.*

In the long run, Ethereum (ETH) may become stronger due to its investment in promoting the development of a broader ecosystem. Unlike AWS, which has lost some market share in the cloud computing market, or Yahoo! and AOL, which have almost been wiped out in the competition among internet platforms, Ethereum is laying the foundation for adaptation, expansion, and success in the next wave of blockchain innovation. In this industry that relies on network effects for success, Ethereum’s modular strategy may be the key to maintaining its dominant position in the smart contract platform.

Acknowledgement

Special thanks to Kyle Samani (Multicoin), Steven Goldfeder (Arbitrum), Smokey (Berachain), Rushi Manche (Movement Labs), Vijay Chetty (Eclipse), Sean Brown, and Chris Maree (Hack VC) for reviewing the draft, arguments, and data of this article.

Endnote

*We need to state here that we may be biased to some extent as our venture capital firm Hack VC was an early investor in many of the modular infrastructure tokens associated with ETH Square, as mentioned in the footnote above. Therefore, in some cases, we are also those who profit from the ETH Square Market Cap, which may be detrimental to ETH Token holders in the short term.

Source: Deep Tide TechFlow