Hack VC: Is Ethereum's modular approach wrong as Mainnet is 'sucked' by Layer 2?

Authors: Alex Pack, Alex Botte, Partner at Hack VC

Compiled by: Yangz, Techub News

Summary

Ether’s performance in this cycle is not as good as Bitcoin and Solana, and other Mainstream Tokens. At least in the eyes of opponents, the culprit is the modular strategic decision of Ether. But is this true?

In the short term, the answer is yes. We found that the transition of ETH workshop to a modular architecture has an impact on the price of ETH due to the drop in fees and Token consumption reduction.

If we add the Market Cap of Ethereum and its modular ecosystem together, the situation will change. In 2023, the value generated by the Token of Ethereum’s modular infrastructure is almost the same as the entire Solana, both are 500 billion US dollars. However, in 2024, the overall performance of these Tokens is not as good as Solana. In addition, the profits of these Tokens mainly go to the team and early investors, not ETH Tokenholder.

From a business strategy perspective, the modular transformation of Ethereum (ETH) is a reasonable way to maintain its dominant position in the ecosystem. The value of blockchain depends on the scale of its ecosystem. Although Ethereum’s market share has decreased from 100% to 75% in nine years, this share is still significant. We compared it with Amazon Web Services, a Web2 cloud computing company, whose share decreased from nearly 100% to 35% during the same period.

From a longer-term perspective, the biggest advantage of Ethereum’s modular approach is to enable the network to withstand technological advancements that may potentially render it obsolete in the future. Through L2, Ethereum has successfully navigated the first major ‘disaster’ of L1, laying a solid foundation for its long-term resilience (albeit with some trade-offs).

What’s the problem?

Compared to BTC and Solana, ETH has performed poorly in this round of market trends. Since 2023, ETH has pumped 121%, while BTC and SOL have pumped 290% and 1452% respectively. There have been many explanations for this phenomenon, with some attributing it to the irrationality of the market, the lagging technical roadmap and user experience of ETH’s ecosystem, and the competitive erosion of market share by rivals such as Solana. So, is ETH destined to become the AOL or Yahoo of the cryptocurrency field?

The main culprit for the poor performance of Ethereum is actually a very intentional strategic decision made by Ethereum nearly five years ago, which is to switch to a modular architecture, and subsequently Decentralization and split its infrastructure roadmap.

In this article, we will explore the modular approach of Ethereum, using data-driven analysis to assess how this strategy impacts the short-term performance of ETH, the market position of Ethereum, and its long-term prospects.

Strategic Shift of ETH Network towards Modular Architecture: How Crazy Is It?

In 2020, Vitalik and the Ethereum Foundation (EF) made a bold and controversial call to separate various parts of the Ethereum infrastructure stack. Ethereum will no longer handle all aspects of the platform (execution, settlement, data availability, ordering, etc.), but intentionally let other projects provide these services in a composable manner. Initially, they encouraged new Rollup protocols to handle execution on Ethereum L2 (see Vitalik’s paper ‘The Rollup-Centric Ethereum Roadmap’ in 2020), but now there are hundreds of different infrastructure protocols competing to provide what was once considered a L1-exclusive technology service.

To better understand how radical this idea is, imagine the situation in Web2. A Web2 service similar to Ethereum is Amazon Web Services (AWS), a leading cloud infrastructure platform for building centralized applications. Imagine if, when AWS was first launched 20 years ago, it decided to focus only on its flagship products, such as storage (S3) and computing (EC2), instead of the dozens of different services it now offers. AWS would have missed out on excellent revenue opportunities and would not have been able to market its expanding suite of services to customers. With a full range of product services, AWS could have created a ‘walled garden’ that would make it difficult for its customers to integrate with other infrastructure providers, effectively locking them in. And that’s exactly what happened. AWS now offers dozens of services, and customers find it difficult to break free from its ecosystem, resulting in a remarkable rise in revenue (from hundreds of millions of dollars in the early days to approximately $100 billion in annual revenue now).

However, in terms of market share, over time, AWS’s market share has been gradually taken away by other cloud computing providers. Competitors such as Microsoft Azure and Google Cloud are steadily expanding their market share every year, and AWS’s market share has dropped from the initial 100% to about 35% now.

What if AWS took a different approach? What if AWS acknowledged that other teams might be better suited to building certain services, opened up their APIs, prioritized composability, and encouraged interoperability rather than creating a lock-in environment? AWS could have allowed developers and startups to build complementary infrastructure, resulting in better, more professional infrastructure and a more developer-friendly ecosystem with a better overall experience. This wouldn’t bring in more revenue for AWS in the short term, but it would give AWS a larger market share and a more dynamic ecosystem than its competitors.

However, this may not be worth it for Amazon because it is a public company that needs to optimize revenue, not a “more vibrant ecosystem”. For Amazon, splitting up and modularizing may not make sense. But for Ethereum, it may be reasonable because Ethereum is a decentralized protocol, not a company.

Decentralization protocol, not a company

Like a company, Decentralizationprotocol also has usage fees, or to some extent, can be called “income”. But does this mean that the value of the protocol should be based solely on these revenues? No, that’s not the case.

In Web3, the value of a protocol depends on the overall activity on its platform, which is determined by the most active builders and user ecosystem. Below is our analysis of the relationship between Token prices and Metcalfe’s value (an indicator measuring the number of users in the network) for BTC, Ethereum, and Solana. In all cases, Token prices are highly correlated with Metcalfe’s value, a relationship that has persisted for several years, and for BTC, more than a decade.

Why does the market follow the ecological activities so much when pricing these Tokens? Stocks are priced based on rise and profitability. At present, the theory of how blockchain accumulates value for its Tokens is still immature and has little explanatory power in the real world. Therefore, it is reasonable to value it based on the strength of the network, such as the number of users, assets, activity, etc.

More specifically, the price of a Token should actually reflect the future value of its network (just like stock prices reflect the future value of a company, not the present value). This brings up a second reason why Ethereum may want to modularize, as a ‘future guarantee’ to increase the possibility of Ethereum maintaining its dominant position in the long term.

In 2020, when Vitalik wrote ‘A rollup-centric roadmap’ document, ETHereum was in its 1.0 phase. ETHereum was the first smart contract blockchain in history, but it is obvious that there will be several orders of magnitude (OOM) improvements in the scalability, cost, and security of the blockchain in the future. The biggest risk for pioneers is that they adapt to new technological paradigms at a slower rate, thus missing the next OOM leap. For ETHereum, this means the transition from PoW to PoS and the transition to a blockchain that improves scalability by 100 times. ETHereum needs to cultivate an ecosystem that can scale and make significant technological progress, otherwise it may become the Yahoo or AOL of that era.

In the world of Web3, Decentralizationprotocol has replaced the position of companies. ETH believes that in the long run, nurturing a strong modular ecosystem is more valuable than controlling all infrastructure, even if it means giving up control of the infrastructure roadmap and core service revenue.

Now, let’s take a look at how this modular decision is implemented through data.

Modular Ethereum ecosystem and its impact on ETH

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

Short-term price (unfavorable)

Market Cap (to some extent, is advantageous)

Market share (advantageous)

Future Technology Roadmap (To Be Discussed)

Fees and prices: unfavorable

In the short term, the decision of Ethereum has had a significant impact on the price of ETH. Although starting from a low point, the price of Ethereum is still pumping significantly. However, in certain periods, the performance of Ethereum is not as good as many competitors such as BTC, SOL, and even the Nasdaq Composite Index.

This is undoubtedly largely due to its modular strategy.

The first way Ethereum’s modular strategy affects the price of ETH is by dropping fees. In August 2021, Ethereum introduced EIP-1559, which burns ETH when there is excess fee paid to the network, thus limiting the supply. This is somewhat equivalent to stock buybacks in the public stock market and puts positive pressure on the price. In fact, it did play a role for a period of time.

But with the introduction and development of L2 used for execution, and even alternative data availability (DA) layers like Celestia, the fees on Ethereum have decreased. By giving up core revenue-generating services, both the fees and revenue of Ethereum have decreased. This has had a significant impact on the price of ETH.

In the past three years, the correlation between Ethereum fees (in units of ETH) and ETH price has been statistically significant, with a weekly correlation of +48%. If the fees generated by Ethereum decrease by 1000 ETH in a week, the average depreciation of ETH price is $17.

Of course, these fees are not without a destination, they flow to new blockchain protocols, including L2 and DA layers, and so on. This also leads to the second reason why modularization strategies may harm the price of ETH, that is, most of these new blockchain protocols have their own native Tokens. Previously, investors only needed to buy one type of infrastructure Token to access all the exciting rises in the Ethereum ecosystem, and now they must choose from many different Tokens (CoinMarketCap lists 15 Tokens in its ‘modular’ category, with dozens of Tokens accepting venture capital in private markets).

The new category of modular infrastructure tokens may damage the price of ETH in two ways. Firstly, if we consider the blockchain as a company, it should be entirely value-added, and the total market capitalization of all ‘modular tokens’ will become the market capitalization of ETH. This is usually the case in the stock world. When a company splits, the old company’s market capitalization usually decreases as the new company’s market capitalization increases.

But for ETH, the situation may be worse than this. Most cryptocurrency traders are not particularly sophisticated investors. When they face the scenario where they have to buy dozens of tokens to get all the cool rises on the ETH platform instead of just one token, they may be at a loss and simply not buy any tokens. This mental cost and the transaction cost of buying a basket of tokens instead of just one token may harm the price of ETH and modular tokens.

Market Cap: advantageous (to some extent)

Another way to estimate the impact of the modular roadmap of ETH on its success is to look at the absolute change in Market Cap over time. In 2023, ETH’s Market Cap increased by 1.28 trillion US dollars. In contrast, Solana’s Market Cap rose by 540 billion US dollars. Although the absolute number is higher, Solana’s rise base is much lower, which is why its price rose by 919%, while ETH only rose by 91%.

However, if we consider the market capitalization of all the new ‘modular’ tokens brought by Ethereum’s modular strategy, the situation will change. In 2023, this number rose by 51 billion US dollars, which is basically on par with Solana’s market capitalization rise.

What does this mean? One explanation is that with the shift in modular strategy, the ETH Foundation has created the same value for modular infrastructure ecosystem as Solana, not to mention the 128 billion US dollars of Market Cap value it has created for itself. Just imagine how envious Microsoft or Apple would be of Ethereum’s achievement, spending years and billions of dollars trying to build their own developer ecosystem around their products.

However, the situation in 2024 is not the same. SOL and ETH continue to rise (although the rise is not significant), while the market capitalization of modular blockchain is declining overall. This may be due to the market losing confidence in Ethereum’s modular strategy in 2024, or it may be due to the pressure from token unlocking, and of course, it may also be due to the psychological cost of purchasing a basket of tokens long Ethereum-related infrastructure. In contrast, they only need to purchase one token to go long on Solana’s technical ecosystem.

Let’s move from the information provided by PA and the market to the actual fundamentals themselves. Perhaps the market in 2024 is wrong, while the market in 2023 is correct. Has Ethereum’s modular strategy helped or hindered it in becoming a leading blockchain ecosystem and cryptocurrency?

The Ethereum ecosystem and the dominance of ETH: favorable

In terms of fundamentals and usage, the infrastructure that is consistent with Ethereum is performing exceptionally well. Among similar products, Ethereum and its L2s have the highest Total Value Locked (TVL) and fees, which are 11.5 times that of Solana, and L2 alone is 53% higher than Solana.

If we consider from the perspective of TVL market share, when Ethereum was launched in 2015, it had 100% market share. Despite the hundreds of L1 competitors, Ethereum and its modular ecosystem still maintain about 75% market share.

In 9 years, the market share has dropped from 100% to 75%, which is already quite impressive! Keep in mind that AWS has seen its market share drop to about 35% in roughly the same period of time.

But is ETH really benefiting from the dominant position of the “ETH ecosystem”? Or is it the case that the modular parts of ETH and its ecosystem are flourishing but not necessarily treating ETH itself as an asset? The fact is that ETH is a ubiquitous part of the broader ETH ecosystem. This is true even as ETH expands to L2. Most L2s use ETH to pay for gas, and ETH makes up at least 10 times the value of any other token in most L2 TVLs. Looking at the table below, we can see the dominant position of ETH assets in the Mainnet and L2 instances of the three largest decentralized finance applications in the ETH ecosystem.

Technical level: subject to discussion

From the perspective of the technical roadmap, the decision of ETH to modularize the L1 chain into independent components allows projects to specialize and optimize within their specific domains. As long as these components remain composable, DApp developers can build using existing best-in-class infrastructure, ensuring efficiency and scalability.

Another major advantage of modularization is to provide ‘future guarantee’ for protocols. Imagine, if a new technological innovation changes the rules of the game, only the protocol that adopts this innovation can survive. This situation has often occurred in the history of technology, for example, America Online missed the transition from dial-up internet to high-speed broadband internet, and its valuation fell from $200 billion to $4.5 billion. Yahoo, on the other hand, missed the transition to mobile internet due to the slow adoption of new search algorithms (such as Google’s PageRank), and its valuation fell from $125 billion to $5 billion.

However, if your technical roadmap is modular, as an L1, you don’t need to catch every new wave of technological innovation, your modular infrastructure partners can catch it for you.

So, has this strategy of ETH Square worked? Let’s take a look at the infrastructure that has been actually built to match ETH Square:

L2 with best-in-class scalability and execution costs. At least two novel technical approaches have been successful here: optimistic rollups, represented by Arbitrum and Optimism, and Zero-Knowledge Proof-based rollups, represented by ZKSync, Scroll, Linea, and StarkNet. In addition, there are many more high-throughput, low-cost L2s. Cultivating two Block Chain technologies that bring scalability and OOM improvements to the ETH workshop is no easy task. The dozens, if not hundreds, of L1s that were launched after ETH have yet to launch version 2.0 with 100x scalability and cost improvements. With these L2s, ETH has survived the “first mass extinction event” of the Block chain, successfully scaling to a hundredfold volume per second (TPS).

New Blockchain security mode. Innovations in Blockchain security are crucial for the survival of a protocol. Just look at how every mainstream L1 is using PoS instead of PoW today. EigenLayer’s pioneering ‘shared security’ mode may be the next major shift. Although other ecosystems have also introduced other shared security protocols, such as BTC’s Babylon and Solana’s Solayer, Ethereum’s EigenLayer is the pioneer.

New Virtual Machine (VM) and programming languages. One of the biggest criticisms of Ethereum (ETH) is its Virtual Machine (EVM) and its programming language, Solidity. Solidity is a low-level programming language that is easy to code but prone to vulnerabilities and difficult to audit, which is one of the reasons why smart contracts based on Ethereum have been targeted by hackers. For non-modular blockchains, it is almost impossible to attempt to use multiple Virtual Machines or replace the initial Virtual Machine with another one, but this is not the case for Ethereum. A new wave of alternative Virtual Machines is being built in the form of L2, allowing developers to code in alternative languages without using the EVM, while still being able to build within the Ethereum ecosystem. Examples in this regard include Movement Labs, which is adopting the Move VM built by Meta and promoted by Sui and Aptos; zk-VM, such as RiscZero and Succinct, as well as implementations built by the a16z research team; and teams introducing Rust and Solana VM into Ethereum, such as Eclipse.

New scalability approaches. Just like other internet infrastructures or artificial intelligence, we can expect scalability improvements like OOM every few years. Even now, Solana has been waiting for the next major improvement, called Firedancer, built by a team (Jump Trading), for several years. In addition, there are some new highly scalable technologies under development, such as parallel architectures from L1 teams like Monad, Sei, and Pharos. If Solana fails to keep up, these technologies may pose a threat to its survival, but Ethereum won’t, as it can simply incorporate these technological advancements through new L2. This is exactly the approach that new projects like MegaETH and Rise are attempting.

These modular infrastructure partners help Ethereum integrate the biggest technological innovations in Crypto Assets into its own ecosystem, avoiding catastrophic consequences and fostering collaborative innovation with its competitors.

However, this comes at a cost. As Composability Kyle pointed out, Ethereum’s adoption of a modular architecture has added a lot of complexity to the user experience. Regular users will find it easier to get started with a single-chain platform like Solana, as they don’t have to deal with cross-chain interaction and interoperability issues.

Summary

So, in summary, what does Ethereum’s modular strategy bring?

The modular ecosystem has issued a strong ‘opinion’. In 2023, the market gave the rise of modular infrastructure Token consistent with ETH, and the rise given to Solana was the same, but the situation in 2024 is not the same.

At least in the short term, the modular strategy has resulted in less cost damage to the price of ETH.

But if we consider the modular approach from a business strategy perspective, things start to make more sense. Over the past 9 years, Ethereum’s market share has dropped from 100% to 75%, while its Web2 competitor AWS has seen its market share decline to around 35%. In the world of decentralized protocols, the scale of the ecosystem and the dominance of tokens are more important than costs.

If we consider the modular strategy from a long-term perspective, as well as the fact that Ethereum (ETH) needs to withstand potential technological improvements that could turn it into the AOL or Yahoo of the cryptocurrency field, then ETH’s performance is quite impressive. With L2, ETH has already survived the first ‘mass extinction event’ of the L1 chain.

Of course, all of this comes at a cost. The modularity of Ethereum, as opposed to a bundled single chain, compromises user experience.

As for the actual ETH price, it is unclear when (if ever) the benefits of modularity will outweigh the cost of loss and competition with the infrastructure tokens that are in line with modular Ethereum. Of course, this is good news for the early investors and teams behind these new modular tokens, as they can take a share from the ETH market capitalization. However, in many cases, modular tokens are launched with unicorn valuations, which means the distribution of these economic benefits is uneven.

In the long run, Ethereum may become a stronger player by investing in cultivating a broader ecosystem. It will not lose ground like AWS in the cloud computing market, or lose everything like Yahoo and AOL in the internet platform war. It is laying the foundation for adapting, expanding, and prospering in the next wave of blockchain innovation. In an industry driven by network effects, Ethereum’s modular strategy may be the key to maintaining its dominant position as a Smart Contract platform.