Ethereum is the second-largest cryptocurrency in circulation and focuses on enabling the creation of smart contracts. Though Ethereum’s rise in price was the dream of most holders, its unseen consequence to the network was that it skyrocketed transaction prices. In simple terms, the transaction fee is determined by (gas consumed * gas price), and, for a simple transaction, the amount of gas consumed is always 21,000 while the gas price is around 20. Those numbers are denominated in gwei or one-billionth of an Ethereum (0.000000001 eth). Considering Ethereum is priced at $3,000, we have a “basic fee” of $1.36 per transaction, a value that is usually closer to $40 for most transactions.
Ethereum derives its utility from the possibility of being used as a foundation for smart contracts and dApps being the first Turing complete blockchain. With the maintenance of prohibitive transaction prices within the network, a myriad of competitors appeared, delivering lower transaction fees and quicker execution times. Among those are Solana ($SOL), Cardano ($ADA), and Polkadot ($DOT). Though switching to another blockchain that offers lower transaction fees and quicker execution times might be the intuitive answer to the problems Ethereum is facing, we have to consider the economic costs of doing so. For developers within the Ethereum network, switching would mean starting from scratch. Rewriting the dApp from scratch poses itself as an unsurmountable challenge that would be too costly and time-consuming for most enterprises to endeavor.
To solve the problem of high transaction costs, the Ethereum Foundation has promised an update known as Ethereum 2.0, which implements proof of stake and sharding. The update to Ethereum 2.0 had its launch delayed for the fourth consecutive time in December 2021, pushing it to summer 2022. With the uncertainty looming over the timing of the update, new developers have increasingly opted for other networks to elaborate their projects on, and switching networks after the beginning of a project is a definite no-no. This does not immediately impact Ethereum’s market cap dominance, but as the projects grow, communities strengthen, and competitor blockchains access network effects, the delays might leave a definite scar. The graph below shows how the price of Ethereum and the number of active addresses has decoupled for the first time since 2016. Taking Metcalfe’s law, which states that the value of a network is proportional to the square of the number of nodes in a network, we could be led to believe that the price of Ethereum grew without solid foundations, showing its first signs of weakness in years.
Ethereum: Number of active addresses and price in log
Source: Glassnode
Date: 09/01/2022
Community solution
High transactions costs and continuous delays in the implementation of Ethereum 2.0 pose as a threat to all participants of the Ethereum network. The community itself understood the Ethereum Foundation was lagging in implementing a solution and took matters into their own hands, looking for alternatives to make the Ethereum network cheaper. It was in this scenario that we saw the creation and rise of Ethereum layer 2 solutions. Ethereum layer 2s are blockchains that work on top of another blockchain, in this case, the Ethereum blockchain. This means that transactions that happen within layer 2 are first recorded only within the layer 2 blockchain, which then summarizes (bundles) all transactions that occurred within a specified time, and, with a single transaction, adds them all to the main chain (layer 1). In an almost excessive simplification, by adding grouped transactions to layer 1, layer 2 can process transactions at incredible speeds with low costs. Layer 2 solutions have gained traction recently and now have over $ 20 billion market cap, with Polygon ($MATIC) leading the way and about $3 billion in total value locked, with Arbitrum leading the way. The graph below shows how the Market Cap of the leading Ethereum Layers 2 performed against Ethereum itself last year. Between January and May and after December 10, we can see a sharp decoupling. Note that, despite the similar graph movement, the market cap of leading Ethereum layer 2 solutions increased 6.7-fold while Ethereum increased only 2.5-fold since last year.
Comparison of Ethereum’s market cap and leading Ethereum layers 2 in logarithmic scale.
Source: CoinMarketCap
Date: 09/01/2022
Layer 2 impact on Ethereum itself
There are two almost opposite ways of looking at how layer 2 solutions impact Ethereum. First and foremost, layer 2 solutions can be considered to resolve the devastating bottleneck created by transaction prices while also enabling greater scalability and processing speeds. This view relies on layer 2 as a complementary mechanism to Ethereum’s utility, leaving the main network as a means of security while the second layer performs thousands of transactions per second. The opposite view of layer 2 solutions states that these solutions are fragmenting the network and “stealing value” from Ethereum. Investment and development that would otherwise go into Ethereum are going into layer 2 solutions, growing the ecosystem to the detriment of the main chain, and creating intrachain competition.
The unanswered question that remains is: what does that imply for Ethereum? As stated in the beginning, assuming Ethereum derives its value from utility and its utility is based on the number of wallets and/or transactions within the network, with the implementation of layer 2 solutions, Ethereum should see a stark decrease in transactions and, therefore, value. The reduction of transactions derives from the possibility of layer 2 solutions to process thousands of transactions before submitting a single summarized transaction to the main chain. In a hypothetical scenario where a layer 2 bundles 20 thousand transactions (they can bundle up to 80 thousand) into a single Ethereum transaction, there would have to be an exponential increase in adoption of layer 2 solutions for Ethereum to maintain its current transaction rate. With the decrease in transactions, Ethereum’s utility diminishes and, therefore, also should price. So, I would dare say, Layer 2 solutions are Ethereum’s savior because they will allow Ethereum to prosper despite its repeated failure to upgrade and solve its problems. But, with the adoption of Layer 2 solutions, Ethereum should see a stark decrease in the number of transactions and, as a consequence, price. This will happen as Ethereums main function rotates from the development of dApps and smart contracts, which submit thousands of transactions, to being the backbone of other platforms, which submit few bundled transactions.
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