Is modularization a mistake? Taking a data-driven look at Ethereum's strategy

Authored by: Alex Pack, Alex Botte, Hack VC Partner.

Compiled by Yangz, Techub News

Summary

• The performance of ETH in this cycle is not as good as BTC and Solana, the Mainstream Tokens. At least in the eyes of the opponents, the culprit is the modular strategic decision of ETH. But is this true?
• In the short term, the answer is yes. We found that the shift to a modular architecture of the ETH workshop had an impact on the price of ETH due to the reduction of fee drops and token consumption.
• If we look at the Market Cap of Ethereum and its modular ecosystem combined, the situation changes. In 2023, the value generated by the modular infrastructure tokens of Ethereum is almost the same as that of the entire Solana, both around 50 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 belong to the team and early investors, not ETH token holders.
• 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 dropped from 100% to 75% in nine years, this share is still substantial. We compared it to Web2 cloud computing company Amazon Web Services, whose share dropped 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 render it obsolete in the future. Through L2, Ethereum has successfully weathered the first major ‘catastrophe’ 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, claiming that the market is irrational, the technical roadmap and user experience are lagging behind, and the market share of the ETH ecosystem is being taken away by competitors such as Solana. So, is ETH destined to become the AOL or Yahoo of the cryptocurrency field?

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

In this article, we will explore Ethereum’s modular approach and use data-driven analysis to evaluate how this strategy affects the short-term performance of ETH, Ethereum’s market position, and its long-term prospects.

How crazy is Ethereum’s shift towards modular architecture?

In 2020, Vitalik and the Ethereum Foundation (EF) made a bold and controversial call: to split up 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 allow other projects to provide these services in a composable manner. Initially, they encouraged new Rollup protocols to handle execution issues as Ethereum L2 (see Vitalik’s article “Rollup-Centric Ethereum Roadmap” in 2020), but now there are hundreds of different infrastructure protocols competing to provide technical services that were once considered the exclusive monopoly of L1.

To better understand how radical this idea is, imagine the situation in Web2. A Web2 service similar to ETH is Amazon Web Services (AWS), which is a leading cloud infrastructure platform for building centralized applications. Imagine if 20 years ago, when AWS was just launched, it decided to focus only on its flagship products like storage (S3) and computing (EC2), instead of the dozens of different services it offers now. AWS would have missed out on excellent revenue opportunities and would not be able to market its expanding suite of services to customers. With a full range of product services, AWS could create a ‘walled garden’ that makes 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 challenging to break away from its ecosystem. Its revenue has risen remarkably, 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 gradually been taken over by other cloud computing providers. Competitors such as Microsoft Azure and Google Cloud have been steadily expanding their market share each year, and AWS’s market share has dropped from the initial 100% to around 35% now.

What if AWS took a different approach? What if AWS recognized that other teams might be better equipped to build certain services and opened up its APIs, prioritized composability, and encouraged interoperability instead of creating a closed environment? AWS could have allowed developers and startups to build complementary infrastructure, resulting in better and more professional infrastructure, a more developer-friendly ecosystem, and an overall better experience. This may not bring in more revenue for AWS in the short term, but it could give AWS a larger market share and a more vibrant ecosystem compared to its competitors.

However, this may not be worth it for Amazon. As a listed company, it needs to optimize its revenue rather than “a more vibrant ecosystem.” For Amazon, splitting up and modularizing may not make sense. But for Ethereum, it may be reasonable, as Ethereum is a Decentralization protocol, not a company.

Decentralization protocol, not a company

Like a company, Decentralizationprotocol also incurs fees, or to some extent can be called ‘revenue.’ 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 the protocol depends on the overall activity on its platform, as well as the most active builders and user ecosystem. Below is our analysis of the relationship between the Token price and the Metcalfe value (a measure of the number of users in the network) of BTC, Ethereum, and Solana. In all cases, the Token price is highly correlated with the Metcalfe value, a relationship that has persisted for several years. In the case of Bitcoin, this relationship has lasted for more than a decade.

Why does the market follow ecological activities so much when pricing these tokens? Stocks are priced based on rises and profits. Currently, 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 user count, 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 leads to the second reason why Ethereum may want to modularize, which is to use modularity as a ‘future guarantee’ to increase the likelihood of Ethereum maintaining its dominant position in the long term.

In 2020, when Vitalik wrote ‘Rollup-centric roadmap’, Etherum was in the 1.0 stage. Ethereum is 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 more slowly, thus missing the next OOM leap. For Ethereum, this is the transition from PoW to PoS, as well as the transition to a blockchain that increases 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. Ethereum believes that in the long run, nurturing a strong modular ecosystem is more valuable than controlling all the infrastructure, even if it means giving up control of the infrastructure roadmap and core service revenue.

Next, let’s see how this modular decision is implemented through data.

Modular Ecosystem of Ethereum 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（某种程度上是有利的）
• Market Share (Beneficial)
• Future Technology Roadmap (subject to discussion)

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, the price of Ethereum has still pumped significantly, but at 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 largely undoubtedly due to its modular strategy.

The first way Ethereum’s modular strategy affects ETH prices is to drop fees. In August 2021, Ethereum introduced EIP-1559, which means that excess fees paid to the network will result in ETH being burned, thereby limiting supply. This is somewhat equivalent to stock buybacks in the public stock market, which puts positive pressure on prices. In fact, it did play a role for a while.

But with the introduction and development of L2 solutions for execution and 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.

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

Of course, these fees are not going nowhere; they flow into new blockchain protocols, including L2 and DA layers, and so on. This also leads to the second reason why a modular strategy could harm the price of ETH, namely, most of these new blockchain protocols have their own native tokens. In the past, investors only needed to buy one infrastructure token to access all the exciting rises happening in the ETH ecosystem. Now, they must choose from many different tokens (CoinMarketCap lists 15 tokens in its ‘modular’ category, and there are dozens of tokens accepting venture capital in private markets).

The new category of modular infrastructure Tokens may have damaged the price of ETH in two ways. First, if the blockchain is seen as a company, then it should be fully value-added, and the sum of the Market Caps of all ‘modular Tokens’ will become the Market Cap of ETH. This is usually the case in the stock world. When a company splits, the Market Cap of the old company usually decreases as the Market Cap of the new company increases.

But for ETH, the situation may be even worse. Most cryptocurrency traders are not particularly mature investors. When they are faced with the situation of having to buy dozens of tokens to get all the cool rises that will appear on the ‘ETH platform’ instead of just one token, they may be at a loss and simply not buy any tokens. This psychological cost and the transaction cost of buying a basket of tokens instead of just one token may harm the price of ETH platform and modular tokens.

Market Cap: advantageous (to some extent)

Another way to estimate the impact of Ethereum’s modular roadmap on its success is to look at the change in its absolute Market Cap over time. In 2023, Ethereum’s Market Cap increased by $128 billion. In contrast, Solana’s Market Cap rose by $54 billion. 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 Cap of all the new ‘modular’ Tokens brought by Ethereum’s modular strategy, the situation will change. In 2023, this number rose by $51 billion, roughly equal to Solana’s Market Cap rise.

What does this mean? One interpretation is that with the shift in modular strategy, the Ethereum Foundation has created the same value as Solana for a modular infrastructure ecosystem consistent with Ethereum. Not to mention the market capitalization value of $128 billion it has created for itself. Just imagine how envious Microsoft or Apple would be of this achievement by Ethereum, 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. This may be a loss of confidence in Ethereum’s modular strategy in the market in 2024, or it may be due to the pressure from token unlocking. Of course, it may also be that the market finds the psychological cost of purchasing a basket of tokens for Ethereum-related infrastructure unbearable, whereas they only need to purchase one token to go long on the Solana technical ecosystem.

Let’s move from PA and market-told information to the actual fundamentals themselves. Maybe the 2024 market is wrong while the 2023 market is right. Did Ethereum’s modular strategy help or hinder it in becoming a leading blockchain ecosystem and cryptocurrency?

Ethereum ecosystem and the dominance of ETH: advantageous

In terms of fundamentals and usage, the infrastructure that is consistent with Ethereum performs exceptionally well. Among similar products, the Total Value Locked (TVL) and fees of Ethereum and its L2s are the highest, 11.5 times that of Solana, and even 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 a 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 very good! Keep in mind that AWS’s market share dropped from about 100% to around 35% in roughly the same period.

However, does ETH really benefit from the dominant position of the ‘Ethereum ecosystem’? Or, is Ethereum and its modular parts thriving without considering ETH itself as an asset? It turns out that ETH is an integral part of the broader Ethereum ecosystem. This also applies when Ethereum expands to L2. Most L2s use ETH to pay for gas, and ETH in most L2 TVL is at least 10 times that of other tokens. By observing the table below, you can understand the dominant position of ETH assets in the mainnet and L2 instances of the three largest Decentralized Finance applications in the Ethereum ecosystem.

Technical level: to be discussed

From a technical roadmap perspective, the decision of modularizing the L1 chain into independent components by Ethereum 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 modularity is to provide a “future guarantee” for protocols. Just imagine, if a new technological innovation changes the rules of the game, only the protocol that adopts this innovation can survive. This situation often occurs in the history of technology, for example, AOL missed the transition from dial-up internet to high-speed broadband internet, and its valuation fell from 200 billion USD to 4.5 billion USD. Yahoo also 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 USD to 5 billion USD.

However, if your technical roadmap is modular, as an L1, you don’t have 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 already been built to match ETH Square:

L2 with the best scalability and execution cost among its peers. At least two novel technical approaches have been successful in this regard, namely optimistic Rollup represented by Arbitrum and Optimism, and Rollup based on Zero-Knowledge Proof represented by ZKSync, Scroll, Linea, and StarkNet. In addition, there are more high-throughput, low-cost L2 solutions. It is not easy to cultivate two Block technologies that bring scalability and cost improvements of OOM to the ETH network. Dozens (if not hundreds) of L1 solutions launched after ETH have yet to introduce a 2.0 version with hundredfold scalability and cost improvements. With these L2 solutions, ETH has survived the “first major extinction event” of Blockchains, successfully scaling to hundreds of TPS.

• New Block chain security mode. Innovations in block chain 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 Babylon for BTC and Solayer for Solana, EigenLayer for Ethereum is the pioneer.
• New Virtual Machine (VM) and programming languages. One of the biggest criticisms of Ethereum is its Virtual Machine (EVM) and its programming language, Solidity. Solidity is a low-level programming language that, although easy to code, is 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 using multiple Virtual Machines or replacing the initial Virtual Machine with another one, but it 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, but still being able to build within the Ethereum ecosystem. Examples in this regard include Movement Labs, which is adopting Move VM built by Meta and promoted by Sui and Aptos; zk-VM, such as RiscZero and Succinct, implemented by the a16z research team; and teams introducing Rust and Solana VM into Ethereum, such as Eclipse.
• New scalability methods. Like other internet infrastructure or artificial intelligence, we can expect OOM scalability improvements every few years. Even now, Solana has waited for several years for the next major improvement, called Firedancer, developed by a team (Jump Trading). In addition, there are some new highly scalable technologies in development, such as parallel architectures from L1 teams like Monad, SEI, and Pharos. If Solana cannot keep up, these technologies may pose a threat to its survival, but Ether will not. It only needs to incorporate these technological advancements through new L2. This is precisely the approach being attempted by new projects like MegaETH and Rise.

These modular infrastructure partners help Ethereum integrate the biggest technological innovations in Crypto Assets into its ecosystem, avoiding disaster and innovating together with its competitors.

However, this also comes at a cost. As Composability Kyle pointed out, when Ethereum adopts a modular architecture, it adds a lot of complexity to the user experience. Ordinary users will find it easier to use a single-chain like Solana, because they don’t have to deal with Cross-Chain Interaction and interoperability issues.

Summary

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

• The modular ecosystem has voiced strong ‘opinions’. In 2023, the market gives the same rise to modular infrastructure Tokens as ETH, and the rise given to Solana, but this is not the case in 2024.
• At least in the short term, the modularization strategy has caused 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. In the 9 years since the establishment of Ethereum, its market share has dropped from 100% to 75%, while its Web2 competitor AWS has seen its market share decrease to around 35%. In the world of Decentralizationprotocol, the scale of the ecosystem and the dominant position of Tokens are more important than costs.
• If we consider the modularization strategy in the long term, as well as ETH’s need to defend against potential technological improvements that could turn it into the AOL or Yahoo of the Cryptocurrency field in the future, then ETH’s performance is also quite good. With L2, ETH has already survived the first “great extinction event” of the L1 chain.

Of course, all this comes at a cost. The modularity of Ethereum, compared to a bundled single chain, is worse, which damages the user experience.

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

In the long run, Ethereum may become a stronger participant by investing in nurturing a broader ecosystem. It will not lose ground like AWS in the cloud computing market, nor will it lose everything like Yahoo and AOL in the internet platform war. It is laying the foundation for the next wave of blockchain innovation to adapt, expand, and thrive. 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.