The liquid staking sector stands out as one of the rare segments within the crypto industry that has displayed consistent growth throughout a challenging year and a half bear market. Conventional staking procedures demand complex software and hardware configurations, often requiring users to lock up assets for extended periods. The Ethereum community had to wait 862 days for the Shanghai/Capella upgrade before they could access their locked funds. Liquid staking protocols offer a solution to these technical complexities. Consequently, this facilitates seamless trading on decentralised exchanges, efficient collateral utilisation, and yield optimisation through lending protocols.
Lido’s Ascendancy within the Ethereum Ecosystem
The introduction of Ethereum’s staking withdrawal functionality in mid-April marked a pivotal moment for the liquid staking domain. Instead of triggering a mass exodus of funds, this upgrade instigated a surge in deposits, confirming the newfound confidence in the reduced risks and enhanced flexibility associated with staking. Within the Ethereum ecosystem, Lido stands as the dominant force in liquid staking, commanding a significant share of fees (approximately 74%) and deposits (around 79%).
Lido made history as the inaugural liquid staking project, debuting its product in December 2020. In the realm of liquid staking, success is substantially influenced by network effects that drive the adoption and liquidity of such derivative tokens. Lido’s first-mover advantage has, therefore, positioned it as the frontrunner in capturing around a third of the liquid staking market.
Liquid Staking Across Different Blockchains
In contrast to Ethereum, Solana’s withdrawals were available from day one, which means stakers did not have the same long-term trade off that Ethereum stakers had — to stake or use in DeFi — so the need for liquid staking was depressed. Further, it’s DeFi ecosystem remains modest in scale and liquidity, presenting limited attractive risk-adjusted avenues for yield generation or token swapping, for example, whilst staking to secure the network.
Cosmos has recently implemented a Liquid Staking Module that seeks to enhance the role of ATOM, Cosmos Hub’s native token, for users as the primary collateral across the entire network, whilst staking.
Users on Proof of Stake networks faced a trade-off between staking their assets and foregoing their use in DeFi, or not staking and incurring a loss of purchasing power due to higher inflation rates. Removing these trade-offs has the potential to foster the growth of DeFi sub-sectors in tandem with bolstering network security.
Enterprise Adoption of Liquid Staking
Liquid staking is poised to capture the attention of traditional financial institutions, primarily due to the alluring combined prospects of Ethereum yield and DeFi utility. However, the landscape is not without its challenges, specifically relating to regulatory compliance and counterparty risk assessments. While many liquid staking protocols target crypto-native users, initiatives such as Alluvial’s Liquid Collective aspire to collaborate with established staking providers such as Coinbase, offering enterprise-level liquid staking solutions tailored to institutional demands.
The Prospective Trajectory of Liquid Staking
The successful implementation of the Shapella (withdrawals) upgrade could potentially introduce heightened competition within the liquid staking market. This evolution might lead to reduced commission rates, thereby allocating a larger share of rewards to stakers. Although, so far, this trend has not materialised as of yet. Commission fees on ETH staking rewards currently range from 10% to 25%. Smaller market share liquid staking providers may opt to adjust their commission structures to enhance user attractiveness, while larger market share entities like Lido, Rocket Pool, or Coinbase may not find it necessary, given their established brand loyalty and dominance among both retail and institutional investors.
In the case of Lido specifically, our base-case scenario anticipates nearly US$30 billion staked, representing a twofold increase from current levels, with a projected 20% compound annual growth rate (CAGR) over the next five years, while maintaining a consistent market share. Our bullish outlook envisions a 27% CAGR and an increase in market share to 40%, while our bearish projection indicates a 13% CAGR and a market share decrease to 22%.
We derived the market shares by adding or subtracting 2% per year to bull and bear case scenarios. Our thesis is that competition will continue to heat up as those who are likely to reduce their commission rates could steal market share. However, we doubt they can realistically compete with Lido’s brand loyalty and first-mover advantage. On that basis, Lido should keep a sizable slice of the pie, potentially ranging between 22–40% market share (currently 31%) by 2027. The lower bound is also a voluntary self-imposed limit for the sake of Ethereum’s decentralisation, which has already been agreed to by some ofLido’s competitors, and of which the proposition is still on the table for Lido. Yet the upper bound ignores this capped imposition of market share. As the total value of ETH staked grows (2027’s terminal staking ratio we estimate to be 45%, alongside the average of proof of stake protocols) so could the liquid staking market, and hence Lido should follow suit based on its market share.
In summary, the landscape of liquid staking, spearheaded by Ethereum and led by Lido, has successfully weathered the challenges of the most recent bear market. However, it has also encountered growth disparities on alternative blockchains such as Solana and Cosmos. The realm of corporate adoption has presented obstacles in the form of regulatory compliance but solutions such as Alluvial’s Liquid Collective aim to solve these challenges and make staking an attractive proposition for institutions. Last, our base case suggests a two-fold increase in the amount of Lido staked by 2027 given consistent market share and growing Ethereum staking rates.
The cross-chain and multi-chain paradigms are two divergent crypto architectures and thought pieces. The former seeks freedom from confinement within a singular blockchain ecosystem. This avenue, metaphorically speaking, is akin to sovereign nations with different kinds of laws, cultures, people and systems, connected by expansive oceans. Travelling across borders may be relatively unsafe, in some circumstances, as in the case of cross-chain crypto. But the multi-chain ecosystem is slightly different. Think of an economic union, perhaps, which has common policies on regulating products, capital and labour, and freedom of movement of goods and services. The most prominent multi-chain world, Ethereum’s ‘zone of sovereignty’, as declared by Vitalik, has a common settlement and data availability layer that allows value and messages to move more freely and safely.
The ongoing discourse between developers advocating for cross-chain and multi-chain approaches will ultimately succumb to the discernment of users, who prioritise security and interoperability. While the latter approach has been gaining momentum, both sides exhibit noteworthy innovations that are intensifying the future competitive landscape. Our research delves into the fundamental architectures, vulnerabilities, distinctive focuses, and consequently, the partisan trajectories these paradigms are taking to establish robust and secure interoperability. The achievement of secure interoperability is poised to unlock opportunities for developers to create applications that leverage unified liquidity and elevate user experiences through layered abstractions.
The current state of both paradigms Among the largest crypto breaches, the top four incidents were attributed to vulnerabilities in cross-chain bridges, accounting for two-thirds of the total value lost in major hacks. The act of transitioning between settlement layers, for instance, from Ethereum to Solana, involves depositing 10 ETH on a bridge to receive 10 Solana-wrapped-ETH (WETH) due to the incompatibility between the ERC standard and the Solana blockchain. Should a breach occur, the value of Solana-WETH could plummet, because it’s a derivative of the actual ERC-20 ETH token.
In contrast, confining interactions to the same settlement and data availability layer engenders heightened security assurances. Layer 2 (L2) solutions like Arbitrum and Optimism retain stability even in the face of a 51% attack on Ethereum. As such, Ethereum’s “zone of sovereignty,” referring to L2s that utilise Ethereum as their settlement and data layer, has not experienced a bridging incident.
The Cross-Chain Outlook The proliferation of cross-chain bridges and Ethereum-based L2s has ignited a marked divergence in focus and investment. Cross-chain development predominantly prioritises improving the security of interoperable features. Noteworthy innovations in this realm include Chainlink’s Cross-Chain Interoperability Protocol (CCIP), LayerZero bridges, and EigenLayer’s restaking capabilities. Celestia’s Cluster vision occupies an intermediary space between cross-chain and multi-chain systems, facilitating interaction between independent zones of sovereignty, called ‘Clusters’, by segmenting the blockchain into discrete components, thus isolating execution from data availability and settlement, which is referred to as modularity. Advancements such as Optimism’s “Law of Chains” underscore the progress within the Multi-Chain domain.
EigenLayer’s pioneering restaking mechanism involves multiple instances of staking ETH to fulfil functions beyond validating the Ethereum blockchain. This concept finds immediate application in decentralising bridges and L2s — pivotal components of the crypto infrastructure. Trusting restaked bridges and L2s offers enhanced security, as malicious actions would lead to the slashing and loss of ETH. The potential use cases for restaking extend to managing Miner Extractable Value (MEV), safeguarding other blockchains, and unexplored domains.
Nonetheless, embracing restaking introduces intricate challenges. The increased mandates placed upon validators raise complexities and risks, compelling adherence to additional rules for the protocols they secure. Restaked protocols may also leverage the Ethereum community for dispute resolution, thereby heightening the likelihood of community division and unintended network forks, presenting a trade-off between enhanced interoperability and security.
Given the close alignment, LayerZero and Chainlink’s CCIP warrant collective consideration. Both protocols share a low-level nature and blockchain-agnostic designs, rendering them flexible in facilitating connections across various blockchains. Chainlink’s CCIP emerges as a potential competitor to LayerZero due to its reliance on decentralised oracle networks for security. Notably, both protocols can interface with any smart contract network through different attachments, named Endpoints and MRSCs respectively. LayerZero’s implementation lead is notable, yet CCIP can tap into Chainlink’s pre-established chain integrations.
The Multi-Chain Outlook The phenomenon of cross-chain activity exhibits an anti-network effect, where limited activity presents a relatively safe environment, while increased economic throughput escalates hack risks. However, the Multi-Chain world has its own problems. Whilst it’s witnessed improved interoperability between layers vertically, it has not done so horizontally (between L2s). Within Ethereum’s zone of sovereignty, scant inter-chain communication and connectivity between L2s has prevailed, largely attributed to lack of collaborative inclination. However, it is Celestia’s goal to solve this problem. Yet, others like Optimism have underpinned this combative and competitive dynamic.
Celestia’s modularity allows for intra-Cluster (i.e. a zone of sovereignty) and inter-Cluster interoperability through trust-minimised bridges and trusted bridges, respectively. The innovation is that Cluster’s sit on top of, and share a data availability and settlement layer which means that transactions executed can be verified with proofs of probabilistic sampling methods. Celestia aims to maximise intra-cluster interoperability so that the limits of each cluster is reached, before spinning up new clusters that rely on less secure inter-Cluster communication. Although, Celestia does provide trusted-bridges in the case of inter-Cluster transfers to encapsulate every corner of the broad bridging design space.
Source: Celestia Docs
Whereas, Optimism aims to expand its own ecosystems into smaller sub-ecosystems, engendering fragmentation. The ‘Law of Chains’ thesis establishes minimum standards encompassing platform expectations, security criteria, and user-service safeguards within the Superchain framework. Enhanced interoperability between OP Superchains (L3s) directly stems from this framework. The Law of Chains facilitates the development of cross-chain applications, operational across various OP chains, and streamlines the transfer of assets between these chains.
OP’s shared message-passing format within its tech stack streamlines communication across chains, obviating the need for custom adapters for each chain, named Endpoints and MRSCs, respectively for CCIP and Layer Zero. Moreover, when Superchains elect to share a Sequencer Set, atomic intra-chain composability is unlocked, eliminating the dependence on external validators and fostering a more seamless user experience. However, we think this feature may meet a dead-end because taking away a large revenue driver, in that of centralised Sequencers, for these L2s is too unattractive.
Predictions and conclusions We foresee both cross-chain and multi-chain paradigms amassing value. As the industry expands, the Multi-Chain model may struggle to accommodate the scale of increasing transactions. Consequently, capital migration across ecosystems could prompt users to traverse zones of sovereignty.
In summary, the realms of cross-chain and multi-chain ecosystems continue to redefine the trajectory of the industry. Evidently, cross-chain bridges have been the source of most breaches due to vulnerabilities associated with inter-blockchain money transfers. This pattern contributes to the significant value directed towards L2s, which, however, have made limited strides in enhancing interoperability among themselves. Instead, these platforms are primarily focused on scaling and cultivating network effects within their respective sub-ecosystems. This strategy might pose risks in a scenario of heightened adoption, potentially pushing users towards more interoperable ecosystem alternatives due to subpar inter-chain interoperability user experiences.
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2022 was a tumultuous year for crypto amidst a global decline in asset prices and leverage. Quite commonly, big-time fraudulent actors were exposed, and they were often tied up with the crypto’s darling (Aka Solana) in one way or another. 3Arrows Capital, Celsius, SBF/FTX/Alameda all contributed to significant sell pressure resulting in a 94% decline. Solana was subject to its own network instability, nearly digging its own grave. However, a steadfast community and die-hard developers have nailed down its major problems of spam and outages, consequently improving performance, scalability and user experience.
Architectural Trade-Offs Causing Problems
Outages were also a common theme for the blockchain. Around 75% of total outages occurred in 2022 alone. Unlike Ethereum, where gas fees became prohibitively expensive, Solana’s problems were caused by a combination of (1) extremely low gas fees, (2) the absence of a fee market (unlike in Ethereum or Bitcoin), leading to (3) lots of spam, especially in moments of intense market volatility or popular on-chain events such as NFT mints.
The Pillars of Solana’s Resilience
Two things have carried Solana through the bear market. First, Solana has a very enthusiastic and dedicated community. With the second-highest Twitter following behind Ethereum, Solana’s differentiated architecture and purposeful trade-offs help give it an edge and foster tight-knit support in a dense industry of copycat blockchains. Second, and more importantly, Solana’s developer ecosystem is the fourth largest but second most active. This success is harder to achieve, considering it employs a non-EVM virtual machine for developers to build on. This means that teams cannot ‘copy-and-paste’ applications onto Solana if they want to move away from Ethereum or add support for another chain, as they can with others such as Polygon, Avalanche, and Optimism, for example. Solana’s success is because developers and teams appreciate its scalability.
Innovation Solving Problems
Solana’s isolated fee markets are a system that helps manage transactions fairly and efficiently. Solana introduced a way for users to prioritise their transactions by offering extra fees to validators to express the urgency of modifying a specific account’s state even if it has reached its limit. This reduces spam and improves efficiency because users can target and bid higher for specific account states instead of flooding the whole system with excessive bids, therefore, isolating congestion and fee spikes to separate parts of the network and preventing outages across the whole network.
Imagine Ethereum is a shopping centre filled with clothing stores, restaurants and nail salons but only has one checkout lane for all of them, and people can pay to cut in front of you in line if they’re in a rush. Solana is a normal shopping centre, but every store has its own isolated checkout. The end result will be that Solana is much more stable and performant as users can now price block space as a limited resource appropriately.
Whilst this will help with network outages and chain stability, it is imperfect. The mechanism relies on past demand rather than current demand. Therefore future volatility is unaccounted for, so this mechanism may not be able to modulate demand appropriately enough in high activity and fee volatility spikes.
Solana is actively addressing its challenges. Jito Labs introduced a solution called Jito-Solana to tackle the issue of spam transactions, which has been a key factor contributing to chain outages and instability. In the Solana ecosystem, sending transactions has been inexpensive, making it an attractive target for spam bots. However, Jito-Solana aims to address this problem by establishing a specialised off-chain marketplace for Maximal Extractable Value (MEV).
With Jito-Solana, users can now send transactions with tips directly to Solana validators, similar to how Ethereum operates. This new process creates a barrier for spam bots since the cost becomes prohibitively expensive for them to compete effectively. As more validators adopt Jito-Solana, the prevalence of spam transactions decreases and leads to improved profit distribution for validators by capturing MEV rewards. As a result, enhancing validators’ yields and overall profitability.
Solana has made notable advancements in performance and stability by introducing Firedancer, an independent validator client developed in C++, led by Jump Crypto. This marks a significant milestone in terms of validator client diversity, making Solana one of the very few blockchains, following Ethereum, to have multiple clients. The presence of multiple independent implementations serves as a safeguard against network disruptions caused by bugs.
By having more than one implementation, the risk of both clients being affected simultaneously is reduced. Even if one implementation encounters issues, the other remains unaffected, ensuring the overall resilience and reliability of the Solana network. Firedancer also has the potential to bring about substantial performance improvements, as it has already showcased live demonstrations achieving a throughput of 600,000 transactions per second (TPS). The end result is enhancing DeFi maturity by reducing latency times, bringing decentralised exchanges closer to centralised exchange parity, and opening up new application possibilities by enabling Web2 applications on-chain with 1M+TPS. This scalability would benefit high-throughput financial apps and consumer apps like social media.
On a slightly different thread, part of the reason why Solana has built a strong NFT foundation is because of how fast and cheap the network is. NFT compression adds to the already-pleasing user experience in the Solana ecosystem. This compression technology reduces the cost of on-chain storage for NFTs by making the NFTs much smaller, making it feasible for any commercial enterprise to store on-chain tickets and launch at scale. With compression, a 100x increase in the number of NFTs minted only results in an 8x increase in cost. This is equivalent to up to 1 million NFTs minted simultaneously for approximately 6SOL and 100 million NFTs for around 50SOL.
Solana is still in its growth phase. Low-cost transactions and fast data propagation across the network is Solana’s unique selling point. To incentivise validators, Solana employs an inflation rate that rewards them with enough block rewards to offset the low transaction fees paid by users. As a result, the network is unprofitable, marking losses of ~$153m per quarter over the last four quarters. Looking at the cumulative issuance-to-fees ratio over the last year (demonstrating how many dollars of issued token incentives for one dollar of fees), Solana’s security budget at 42 is far higher than others such as Tron (0.7), Ethereum (1.7), Polygon (5.6) and Bitcoin (26), and only marginally higher than Avalanche (39). With the development of fee markets and sending transaction tips to validators, this number should reduce as nominal fees increase and the pre-determined annual inflation rate decreases at 15% yearly until a stable rate of 1.5%.
In summary, Solana’s journey through the challenges of 2022 has exemplified its community’s resilience and commitment to innovation. Despite the significant decline in crypto asset prices and the prevalence of outages, Solana has managed to thrive. Its enthusiastic community and active developer ecosystem have provided a solid foundation for growth. Moreover, the platform’s implementation of isolated fee markets, the introduction of Jito-Solana to combat spam transactions, and the development of Firedancer as an independent validator client will further enhance its stability, performance and scalability.
Circling Back on Solana was originally published in CoinShares Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.
Exchanges mostly facilitate decentralised Finance (DeFi). Within the realm of exchanges, there exists a spectrum of (de)centralisation. On one end, we have the automated market makers (AMMs) pioneered by Hayden Adams, the founder of Uniswap, which embody decentralisation. On the other end, we have order books, which resemble the structure of traditional exchanges but are not as decentralised.
The overarching goal of these exchanges is to eliminate intermediaries and enable users to trade directly from their wallets in a non-custodial manner. Order books operate based on a trade execution model that matches buy orders (bids) with sell orders (asks). In contrast, the AMM model utilises pools of crypto tokens supplied by liquidity providers (LPs) to determine prices through an algorithm that adjusts based on the changing token ratio within the pool.
This research report aims to compare two major types of DEX models: order books and AMMs. The focus of the analysis will be on their respective volumes, fees, trader unit economics, and earnings. The data used for this analysis is derived from the top five DEXs of each type. However, it is important to note that the figures may be influenced by prominent platforms such as Uniswap and dYdX.
When examining the volumes of order books and AMMs on an annualised basis, it becomes apparent that order books have experienced a relatively minor decline and stagnant growth over the past two years. Conversely, AMMs have encountered an average decline of 34% during the same period. It is worth noting that Uniswap, the leading AMM platform, and dYdX, the leading order book platform, contribute to approximately 75% and 90% of their respective categories’ total volumes. This significant presence of these platforms has a substantial impact on the overall volume trends. It is interesting to highlight that dYdX is one of the few exchanges with a year-over-year volume increase.
However, when it comes to fees, the story diverges. Order books account for approximately 65% of AMM volumes but contribute only around 15% of the total fees generated. This discrepancy can be attributed to the fact that fees are considerably cheaper on Layer 2 solutions, where dYdX primarily operates, which bestows a significant portion of order book fees. On the other hand, AMMs predominantly operate on Layer 1 blockchains such as Ethereum, Binance, and Avalanche, with some utilisation of Ethereum Layer 2 solutions. These Layer 1 blockchains tend to have less scalability, higher dollar-denominated fees, higher volumes, and deeper liquidity, leading to increased fees.
We project order books to achieve approximately $6 million in profits by the end of this year, whereas AMMs collectively face a loss of $330 million. The trend observed here is that revenues, akin to operating profits in traditional financial markets, decreased at a lower rate for order books, while token incentives, similar to operating costs, decreased at a higher rate than AMMs. The business model of AMMs, where a significant portion of fees is directed to LPs rather than the protocol itself, makes it unlikely for them to become profitable with their current architecture and infrastructure. This is compounded by the fact that communities are worried about US regulations, such as in the case of Uniswap’s community mulling the fee switch proposal. Theoretically, Uniswap could have made around $19m in profit (see our investment case here), pushing the whole AMM category in the green. However, that is not the case.
The unit economics of order books and AMMs provide valuable insights into profitability and the value generated per user. From a net profit perspective and per-trader basis, order books emerge as the more profitable business model, showcasing higher lifetime value and earnings per user. This indicates that order books have been successful in generating more fees per user and maintaining better user retention rates compared to AMMs.
In summary, AMMs exhibit greater decentralisation and benefit from deeper liquidity and higher volumes, partly driven by their first-mover advantage and the trust traders place in battle-tested, safer, slower Layer 1 blockchains. While these DEXs command high fees from users, their inefficient business models, where LPs require significant compensation, result in minimal redirection of fees to the protocol, leading to sustained unprofitability. On the other hand, order book models prioritise speed and cost-effectiveness, which are more challenging to achieve on-chain. Nevertheless, the efficiency of these models makes the unit economics per trader more attractive. This year’s emerging profitability trends are further bolstered by the fact that order book volumes are catching up to AMMs, with notable contributions from platforms like dYdX.
This short essay explores touted but unrealistic examples of how blockchain and AI could intersect, such as forcing together two distinct computational domains with unique demands (AI and crypto), ‘putting AI on-chain’, ‘self-editing blockchains’ and trusting institutions handling personal biometric data on a blockchain with novel privacy techniques. Overall, highlighting the limitations and challenges of such intersections. It also examines the main area of synergy between decentralised systems and AI, mostly through cryptographic guardrails underpinning AI development in the realm of deep fakes and digital media.
The compute needed for blockchain, Bitcoin, and AI can differ greatly. For an energy-intensive, global monetary network like Bitcoin, mining requires specialised ASICs (Application-Specific Integrated Circuits), which are specifically designed and built to solve the SHA-256 hashing function with maximum efficiency. This results in significantly higher hash rates (the number of calculations performed per second) compared to general-purpose processors like CPUs (Central Processing Units) or GPUs (Graphics Processing Units).
When referring to much less energy-intensive Proof-of-Stake blockchains, CPUs work fine. Similarly, AI tasks, such as training and inference on large neural networks, require high-performance computing, which rely on GPUs. AI involves running various types of mathematical computations, such as matrix multiplications and non-linear operations. NVIDIA’s Tensor Cores, for example, are highly optimised for these types of computations. They have many processing cores and high memory bandwidth, enabling them to perform matrix operations efficiently and process large amounts of data simultaneously. As a result, the architecture and design of Bitcoin ASICs are not suitable for AI workloads, and they lack the necessary hardware components and features required for efficient AI computations.
There are some technological improvements, though. Decentralised networks of computing power can offer users an opportunity to volunteer idle GPUs to help relieve some computational hurdles and restrictions. This can reduce costs and is already being done for other computationally intensive work like video rendering, spearheaded by Render, for example.
A Comparison of the AI vs Mining Model Unit Economics
The AI model exhibits slightly superior underlying unit economics regarding return on investment (ROI) and payback metrics. Despite its higher initial capital expenditure (capex), each GPU deployed in the AI strategy generates higher revenue than each miner. Increased capex and higher barriers to entry with constructing advanced facilities, maintaining delicate GPUs, and specialised labour may render this strategy less feasible for miners with lower capex and opex budgets. This intricate combination of factors accentuates the significance of carefully considering the potential upside and challenges of adopting the AI approach.
The price of bitcoin and the cost of electricity can hugely affect profitability. At current numbers, increasing the bitcoin price to $30k increases ROI to just over 71% and decreases payback to c.16 months for Miners. Whilst we price the cost of electricity at an already attractive 0.04$/kwh, halving the electricity cost to 0.02$/kWh (albeit almost unheard of in the industry) has a similar outcome. Reducing the cost of electricity has less impact on ROI and payback than the price of bitcoin.
Delegitimising Unreasonable Use-Cases
Now, many egregious and unrealistic examples of how blockchain and AI could intersect should be uncovered. Without mentioning which shops have talked their book, here are some examples.
‘Putting AI models on-chain’ to customise applications for each user and crawl data across networks is prohibited because of cost, scarce computing, and differing hardware. As unit economics become increasingly important for on-chain services, much of the AI interaction must be off-chain, perhaps in the blockchain’s applications.
‘Self-editing blockchains’ have been argued to help outcompete Web2 counterparts by developing intelligence to self-optimise and self-administrate security. This proposal inherently opposes the ethos of decentralisation and social consensus, where there is supposed to be the distribution of power and control across a network of nodes, where no single entity has complete authority, and where there is broad agreement among network participants on the validity of transactions and the state of the blockchain.
Perhaps the worst is the motion to replace the private key (akin to your bank password) with biometric authentication on the blockchain. The argument is that private key management remains one of the largest frictions in Web3 UX. One potential solution to address the abstraction of private keys involves utilising facial recognition or other unique factors. Worldcoin, a company founded by Sam Altman, the creator of OpenAI and ChatGPT, advocates for this approach. His team employs a convolutional neural network to modify and validate the stored iris data. Currently, their system relies on a trusted computing environment housed within a secure enclave in the device’s hardware. Going forward, they aspire to replace this with a zero-knowledge proof (ZKP), a privacy-preserving cryptographic technique, to verify the accurate computation of the model. This advancement would enable users to retain control and ownership of their biometric data while ensuring cryptographic security guarantees as long as the processing occurs on their personal hardware, such as their mobile phone.
While this sounds like a promising way to overcome Web3 hurdles to adoption, in this scenario, it’s important to ask yourself a few main questions: 1) Will this centralised company post biometric data for everyone to see on a blockchain without permission? 2) Will this centralised company encode a backdoor in the hardware device as others, such as Ledger, have done with private keys? 3) Is this the be-all and end-all solution to overcoming UX issues?
That said, what’s the difference between Apple and other software companies that store billions of people’s biometric data — face, iris, thumb — in secure, closed-wall environments? The problem here is Worldcoin is playing with new, untested techniques and strategies on a public blockchain for everyone to see. Blockchains should not be used for everything — especially regarding medical and health information.
Perhaps answering those questions above, especially number three, may demonstrate how blockchain is useful for AI. Deepfakes continue to become more sophisticated with the help of AI. We recently wrote a piece on Verifiable Credentials (VCs) and Decentralized Identifiers (DIDs), reasoning why these off-chain approaches are better than our current on-chain, inefficient, non-private, and expensive approaches. DIDs and VCs are off-chain customised data ‘backpacks’ that leverage public key cryptography to sign and verify truthful identities, images, videos, texts, and files. This type of cryptographic watermarking technology is used for tamper-proof timestamping to help verify the authenticity of ‘who knew what when.’ Adoption will likely take longer with this approach. However, one’s data ‘backpack’ is tamper-evasive, decentralised, cheap, private, and, most importantly, self-generated away from the third party to maintain authenticity, truth, and trust in a digital, on-chain world.
In summary, while the realms of blockchain and AI may have some overlapping areas of interest, regardless of credibility and validity, it is crucial to recognise their distinct computational requirements and limitations and unrealistic examples of blockchain and AI intersections. We raised some issues regarding putting AI models on-chain, self-editing blockchains, and replacing private keys with biometric authentication on-chain. Off-chain approaches, such as Verifiable Credentials (VCs) and Decentralized Identifiers (DIDs), offer promising solutions to enhance trust and authenticity in digital interactions, albeit may take longer for worldwide adoption. But as the synergies between decentralised systems and AI become more apparent, integrating cryptographic guardrails can underpin AI’s truthful development.
Ethereum, as a Layer 1, originally had the vision to ‘shard’ the execution layer. Sharding was a way to internally scale the blockchain by splitting the part of the blockchain where users execute transactions for specific functions (execution layer) into smaller, faster blockchains. But a higher risk of centralisation from stricter validator requirements forced the Ethereum Foundation and community developers to pivot to a “Rollup-centric roadmap” encompassing Layer 2 organisations where scaling is achieved.
Layer 2s are just another user of Ethereum. Whilst Layer 2 transactions have surpassed Ethereum’s count:
Ethereum’s blocks are still full;
More chains continue to use the Ethereum Virtual Machine (otherwise known as the EVM, which executes Ethereum’s smart contracts);
Teams are developing zkRollups to be compatible or equivalent to the EVM;
Academic institutions and enterprise blockchains utilise the EVM, and prominent financial institutions use it; and
EVM network effects continue to grow each year, and many teams are working on EVM improvements.
Ethereum and its Layer 2s and 3s create a tree-like structure. The strong, decentralised ‘trunk’ is Ethereum, which settles Layer 2 transactions and executes its own transactions. These Layer 2s are scalable, cheaper, use-case-specific ‘branches’ and can create an ecosystem for the Layer 3s’ leaves’ on top via their own specific tech stacks. These ‘leaves’ are their own use-case, specific and customisable, super fast and cheap protocols or applications. Layer 2s and 3s are currently less decentralised than Ethereum and broadly similar to other ecosystem scaling solutions.
Custom Layer 2 modularity is the next step
A modular approach involves dividing a blockchain into different parts optimised for execution, consensus, settlement, or data availability. This approach paves the way for a future where each layer caters to specific use cases, with some level of variability and convergence between layers. DeFi applications seeking higher speed and lower costs have chosen to deploy smart contracts on Layer 2s. However, it’s worth noting that the three largest Layer 2s account for only 10% of Ethereum’s total value locked. This suggests that users are cautious about migrating without the assurance of longevity (Lindy effect) or battle-tested code. Layer 2s have not yet achieved the same level of Lindy effect and battle-tested code as Ethereum. These two factors have proven their value over time, attracting liquidity and providing guarantees of censorship resistance and security, although primarily the former.
Layer 2s fit well within the modular approach as they handle execution while outsourcing consensus, settlement and data availability to Ethereum. This innovation began with general-purpose Rollup Layer 2 solutions like Optimism and Arbitrum and has now expanded to privacy-preserving ‘zkRollups’ and Custom Rollups. Custom Rollups, such as Optimism Bedrock (the foundation of Coinbase’s Layer 2) and Arbitrum Nitro (the technical stack powering all Arbitrum products), enhance execution similar to general-purpose Rollups. However, they differ by using custom Virtual Machines (execution functions for user applications), which increases flexibility. These custom Rollups act as Rollup-as-a-Service, allowing developers to create their own Rollup for Layer 3 apps/protocols.
Layer 3s make purposeful optimisations and trade-offs for a tailored experience
Most applications in the industry are finance-related, with limited alternatives for non-financial applications. Gaming and social media apps can fully migrate to Layer 3 or utilise certain aspects. Otherwise, applications that don’t choose to do so may face competition from new players already embracing Layer 3. Proposed by Starkware, an Ethereum Layer 2, these Layer 3 Rollups serve different purposes. They are not built on top of other Rollups but offer higher speed, lower costs, or customisation for specific use cases like interoperability, privacy, or engineering ease of use. However, these specialisations come with trade-offs in terms of security and decentralisation.
The three-layer model allows for an entire sub-ecosystem where many leaves stem from a single branch. This model enables cross-domain operations within the ecosystem to occur much more cheaply and settle on Layer 1 if necessary. The identity and privacy ecosystem aligns well with this model, as chains or applications built on top can leverage zero-knowledge proofs without committing fully to the base layer.
Web3 Middleware will unlock Pandora’s box just as Web2 hosted backends did
Blockchain middleware serves a similar purpose as the lifeblood of hosted Web2 backends — the software that connects applications, data, and users. It resembles the concept of SaaS that played a crucial role in the success of internet companies’ user interfaces in the 2000s, surpassing the giants of the 90s. It empowers developers to build what consumers and enterprises desire by leveraging the blockchain’s strengths.
Web2 middleware includes data management, application services, messaging, authentication, and API management. Web3 encompasses sufficiently decentralised protocols and networks, capability-specific software (optimised for specific use cases), oracles, bridging, developer tools, and infrastructure for different types of applications and protocols. Chainlink, an Oracle and a key player in tokenising real-world assets, is a central piece of Web3 Middleware. It connects real-world data to the blockchain. Their partnership with SWIFT, although still in the Proof of Concept stage, will enable over 11,000 banks to send and receive tokens and messages across any blockchain without prior knowledge.
Restaking, pioneered by Eigenlayer, involves staking ETH multiple times for purposes other than validating the Ethereum blockchain. The most useful cases with immediate and beneficial product market fit are using Eigenlayer to decentralise bridges and Layer 2s — core crypto infrastructure. Billions of dollars have been hacked from bridges, and Layer 2s have centralised sequencers, often run by the respective Foundation. By trusting bridges and Layer 2s that have re-staked ETH, a user knows that something is less likely to go wrong (theoretically) because a bad actor would get slashed and lose their ETH. Other use cases for restaking include MEV management, securing other blockchains, and potentially more that are yet to be discovered.
The Infrastructure Build-Out is Almost There, But We Need To Focus on Apps
While the infrastructure build-out is nearly complete, the focus must now shift towards developing applications. Currently, there is excess block space and insufficient demand, mostly because Layer 1s and Layer 2s have yet to abstract the problems that contribute to poor user experience and inadequate use cases. But Layer 3s and Middleware aim to address these issues by offering trade-offs that enable developers to cater to specific problems.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to.This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
Beyond Layers 1 and 2 was originally published in CoinShares Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.
A dominant industry leader for the number of transactions, total value secured, network effects and real-world partnerships
A diversified and forecasted 38% increase in revenues year-over-year amongst a wider industry bear market
Decreased gas costs from architectural upgrades have increased profitability, which may lay the foundations for operational expansions and network scale
The Chainlink-SWIFT partnership, although in proof of concept, and external, unsubsidised revenues, albeit both early, could provide a stronger tailwind for the network than current and inorganic scaling programs
A native drawback of blockchain networks is that they are unaware of what happens outside their network of nodes. Therefore whenever a blockchain application needs to interact with external data, it needs a reliable data source. These data sources are known in the industry as “oracles.” Relying on one oracle creates a single point of failure. Chainlink aims to solve this issue by providing a decentralised network of multiple oracles to evaluate the same data. The accuracy of this data can be important if this data is used to trigger activity on a smart contract or other blockchain application.
Chainlink is more than a Proof of Stake blockchain, and each node is more than a piece of hardware running code in the background. Chainlink nodes are real-life businesses with a few main roles. They keep the network running by verifying data submitted by real-life data providers; they pay their bills to such data providers and also manage their treasury to be sufficiently capitalised for gas (in USD) and data expenses mostly through hedging LINK price action. Chainlink does the bulk of the business development work of handling and building relationships with real-life data providers, promoting node services to clients, and finding application developers who may want off-chain data. All of this requires operating and capital expenditure, including gas costs which get subsidised to guarantee a higher level of profitability as part of the plan to help scale. Going forward, the network’s aim is to have less ‘hand-holding’.
Chainlink’s network effects have accelerated, consolidating it as the leading and dominant player in this Oracle sector. Securing and delivering the total value and data on-chain and between chains is significantly higher than all its competitors. Diversification and increased revenues, transactions, and products show this in action. One of the most underrated and positive signs is the emergence of external sources of unsubsidised revenue. There is also early evidence to show the network’s largest costs (gas) are also decreasing, putting a floor on declining gross profitability in a bear market and providing a leg up for token holders in a bull market.
Ambitious product development highlights developers have a keen eye for enabling non-financial applications such as gaming and privacy. Although most Chainlink innovations will not move the needle in the short-to-medium term, a roster of differentiated products opens up the network to multiple addressable markets. Further cautions involve Chainlink’s Cross-Chain Interoperability Protocol (CCIP) being less fruitful than some believe, affecting utility and narrative.
Click here to read more about Chainlinks architecture, team and further on-chain and product analysis.
Market Comparison
One of the most bullish factors for Chainlink is that it is a substantial market leader in a sector much needed to transform the crypto industry and make it a productive value-add piece of software to the real world. Chainlink secures almost three times the total value of its nearest competitor, Chronicle, and over three times the number of protocols compared to TWAP, a competitor. Total Value Secured measures the total dollar value of data brought on-chain and used in applications. An example would be the total dollar value of an insurance contract underwritten by Nexus Mutual (a decentralised on-chain insurance protocol) using Accuweather (real-life weather data provider) data for a farmer’s crop in a specific region.
These network effects have solidified Chainlink as the number one Oracle with real-world Chainlink node-operating businesses that gather and distribute data from a variety of real-world systems such as Associated Press (sports) and data providers such as T-Systems (cloud services), Accuweather (weather), and Kraken (crypto exchange data). The SWIFT partnership allows 11,000 banks to connect to hundreds of blockchains with one piece of key infrastructure but is currently in Proof of Concept.
Network Financials
Profitability has steadily declined since Q1 2021 but has remained relatively flat throughout 2023 when denominated in dollars, as this is most likely a function of price. The large drawdown in gross profitability in May 2022 came from the Ethereum chain, where the average gas price spiked to over 10 times its historical average in one day from Yuga Labs’ Otherside NFT drop. Looking more closely, revenues (denominated in LINK) and transactions are flat year-over-year, whilst most of the pain in dollar-denominated revenues and gross profits has stemmed from the decline in the price of LINK.
Gas costs are the highest costs for node-operating businesses, but there is evidence to show during an increase in the number of transactions and flat revenues that costs are decreasing. Annualising this year’s figures could lead to an average reduction of 40% across eight chains. This reduction can be attributed to Chainlink’s Off-Chain Reporting (OCR), which acts similarly to a Rollup, where nodes aggregate their observations off-chain into a single report and then submit the transaction on-chain. This reduces network congestion and cost and increases the speed at which these chunks of data can be delivered on-chain.
Network Projections
We predict no growth in Ethereum’s revenues. A combination of two overarching reasons — little block space left and lower gross profit margins compared to other chains — could put a theoretical cap on Ethereum revenues as the adoption of transactions and network effects occur elsewhere. Including Ethereum within total year-over-year growth rates dampens the picture. In reality, excluding Ethereum in total revenue projections, we predict a 117%, 97%, and 48% increase in revenues for this year, 2024, and 2025, respectively. Most of this is driven by Polygon and Binance Smart Chain.
Whilst Polygon’s network utilisation is also maxed out like Ethereum’s, the difference is that Polygon continues to make efficiency improvements internally, allowing the number of node jobs, transactions, and revenues to increase. Also, Polygon’s lower-than-average gas cost per transaction is 99.7% cheaper than Ethereum, making it very attractive to set up shop. Binance Smart Chain will continue to drive adoption and profitability for the network due to its DeFi liquidity, on-ramp advantages, speed, and cost advantages.
Opportunities, Threats and Mitigations
Chainlink products could become commoditised as node-operating businesses compete for jobs, driving down price and profitability and creating a ceiling for the scale and adoption of the network. However, competition between nodes could incentivise businesses to improve their cost structures, security measures, and overall services to remain relevant. The addition of unsubsidised revenue from external applications, albeit early, could also be a powerful force to sustain the Chainlink network. A proposal from GMX, one of the highest growth and profitable DeFi exchanges, stated an allocation of 1.2% of total protocol fees generated towards the node operators providing decentralised, aggregated, reliable, and secure information from a low-latency Oracle solution, as well as future development and technical support utilised and needed by GMX. The Chainlink Network could generate an incremental ~$621k in unsubsidised revenue based on GMX’s $51.80mm protocol fees over the past 3 months, approximately 6% of total revenue year-to-date for Chainlink. If other financial applications pursue a similar route, this would be a boon for the Chainlink network.
The Cross-Chain Interoperability Protocol (CCIP) has the vision to move towards a cross-chain world where a single application can be deployed across many chains for better efficiency, liquidity, and interoperability. The yearly average growth rate of transactions and revenue (LINK) is considerably higher across non-Ethereum and non-Layer 2 chains. This results from starting from a much lower base and filling holes in the rest of the ecosystem. However, the dominance of Ethereum and its Layer 2s in financial use cases and the security vulnerabilities of cross-chain bridges may hinder CCIP’s adoption. While the multi-chain route may be slightly less ambitious and risky, it’s the safer, more trodden path.
Luckily for Chainlink, cross-chain or not, the collaboration with SWIFT is not affected and still allows over 11,000 banks to send and receive tokens and messages across any blockchain. Potentially producing the largest revenue-generating opportunity for the Chainlink network, CCIP-enabled smart contracts could become adopted much faster than isolated bridges in a multi-chain world.
The biggest fundamental shift to Chainlink is its Staking upgrade. Currently, most of Chainlink’s node-operating businesses work under a trusted model where well-known companies don’t want to lose their reputation when defrauding the network by submitting false or poor data. Under Economics 2.0 and the new Staking regime launched on Ethereum on December 6th, 2022, the trusted model is turned upside down by allowing the community to put their LINK to work by helping to secure specific node networks such as an ETH/USD price feed on Ethereum. Ultimately staking is not just an additional crypto-economic layer through monetary incentives of rewards and slashing but also a means to further decentralise and create a more trust-minimized environment to create a completely trustless ecosystem. Not only is the network decentralising at the node level but also at the data provider level by spreading out the number of companies that submit this data to the node networks.
Investment Case
Improved efficiencies of Chainlink architecture and operations of these node-running businesses could put a floor on declining profitability in the bear market. Going forward, Chainlink and chain updates and operational improvements for node-operating businesses will likely provide a leg up for profitability. Innovations such as Off-Chain Reporting could make it much more attractive to join the network and financially easier to expand operations across chains and with real-life data sources.
It’s important to note that these network financials only rely on Price Feed data because of the importance of simplicity when projecting a nascent industry. Other factors such as BUIDL, SCALE, staking, and external and unsubsidised revenues are speculative and too opportunistic to forecast with conviction. Additional adoption will only be an added bonus.
Summary
Chainlink is a dominant market participant in an industry with very large addressable markets of tokenisation, bringing real-world assets on-chain, gaming and privacy. While most products and scaling programs will not move the needle regarding profitability in the short-medium term as most are highly speculative, Price Data Feeds have managed to kick-start adoption and generate industry-leading network effects. We believe external, unsubsidised revenues and the CCIP-SWIFT partnership could provide the two largest opportunities for scale and profitability going forward.
Overall, Chainlink has performed well under the hood of a bear market, with a nominal increase in transactions and only a slight decrease in revenues (LINK) year-over-year, although on an annualised basis, the network could end the year almost 40% higher. There is also significant diversification of activity on different chains, making the network more sustainable and bullet-proof to changes and flows of ecosystem value. Arguably the most promising insight, spear-headed by architectural improvements, is the decrease in gas costs, nodes’ largest expense, and increasing profitability. This has provided stability in a down-market and will lay the foundations for expansion in an up-market.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
Arbitrum, the Layer 2 solution that helps scale Ethereum, recently took a significant step towards decentralisation by launching its token, ARB, and transforming into a DAO, Arbitrum DAO. However, the Foundation’s actions without the approval of the DAO led to an immediate issue, which raised some significant questions in the crypto space. Are DAOs still decentralised, autonomous and organised? Is a token-voting model the right approach? Do governance tokens have any value? And what does the path forward look like?
The concept of DAOs being decentralised, autonomous and organised is much further away from the truth than it is close. In the case of Arbitrum DAO specifically, amongst many issues, decentralisation is a facade. The council of 12 members signs a special key called a multi-sig, which exposes governance processes and operations to corruption. The 12 members also have the unilateral power to enact any emergency or non-emergency action, making it more of a decentralisation theatre. The Security Council’s membership requires holding at least 0.2% of all votable tokens and being within the top six most-voted candidates, which creates political dynamics, a core reason for decentralisation in the first place. Furthermore, only some rules are enforced by smart contracts, leaving some elements prone to disaster when reliant on humans to act properly.
Autonomy seems non-existent within the Arbitrum DAO. They made a unilateral decision before putting it up for community voting, and this decision involved one of the most crucial issues — tokens, which are essential to crypto. Despite the DAO’s flaws or merits, defined organisational governance processes are established in its constitution.
While tokens and DAOs are theoretically needed, they are not always necessary. Tokens provide incentives to align computers’ consensus and prevent bad actors from engaging in bad actions in decentralisation. Token-voting has been advocated by DeFi projects since 2020’s DeFi Summer. Compound, Synthetix, and Uniswap all launched with some kind of DAO. In Arbitrum’s case, a DAO was created, a token was pre-mined and airdropped, and it was used to start their decentralising Arbitrum, the Layer 2.
However, Tezos aims to do something similar to Arbitrum — scale transactions and throughput — but does not have a token or a DAO, nor does it claim that a token is needed for ‘progressive decentralisation.’ Tezos’ Smart Contract Optimistic Rollups are enshrined into the protocol rather than as an external smart contract to Ethereum, similar to Ethereum’s Layer 2s.
Governance tokens, such as ARB, are only valuable for whales. ARB is not used for transaction fees or to help secure the network by staking, two of the most common reasons for a token. ARB is used to vote on issues, but since the influence on votes is weighted based on the number of tokens someone has, most holders will have very little impact. Furthermore, governance becomes less valuable when a Foundation acts regardless of a vote, and even though the Foundation backtracked and spun the narrative, the value of governance is still lost.
Whilst token-voting governance is still the primary process, structures are evolving towards a more traditional hierarchy. Sub-domain structures try to align incentives through autonomous and specific decision-making power within one broader organisation, as evidenced by Yearn Finance and Metropolis. Other approaches are also being developed to decrease voter apathy via gamified governance, which ‘increases the fun in voting’ although not used widely, and steps have been taken away altogether from other approaches such as Soul-Bound Tokens (however, we have highlighted the dangers here).
In conclusion, the reality of DAOs and ‘progressive decentralisation’ has been stress-tested by the Arbitrum DAO’s recent hiccup, which could lead to legal troubles. Nevertheless, this experience has provided teams with clearer guidelines on what to do and what not to do going forward, particularly regarding communication.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
Highest native TVL year-over-year increase and lowest all-time-high decline
Highest number of monthly transactions per user
3rd largest number of developers
4th largest number of smart contract deployments
Tezos is an open-source blockchain that provides a low-energy, self-amending platform to capture the full network effects of an aligned community. A vibrant and committed developer community has laid the foundations for a flourishing ecosystem that ignores volatility and grows through market cycles. The number of users and transactions has increased by 81% and 193%, respectively, per year since 2019, and the number of developers has increased by 15% per year since 2017.
Tezos initially stood out for its energy-efficient, liquid proof-of-stake blockchain that established itself as a technology leader in its field. Low gas fees also made it highly appealing to artists and organisations interested in creating digital assets like NFTs. Ubisoft and LVMH are notable participants in the network. More recently, Tezos has found its footing in the broader DeFi ecosystem. As one of the best performers in terms of YoY growth in TVL relative to its competitors, Tezos has a potentially bright future.
The way Tezos was designed fosters a collaborative, open, and global community, where preventing forks is a competitive advantage and a key architectural component essential in building its network. Testament to this are its 12 secure and forkless upgrades which continually improve network functionality and optimise existing infrastructure and processes. We believe the developer’s focus on scaling the network, especially since 2022, will pay dividends in the long run.
Despite a reputation for delivering technology and onboarding clients and users, Tezos faces a challenging market. One that is dominated by Ethereum’s network effect and hype surrounding alternative competitors in a saturated sector.
Yet, Tezos is primed to garner greater market share with its sizable and proven developer cohort and recent unfair advantage from the newly deployed Optimistic Rollups in the recent Mumbai upgrade. This tech can run EVM, WASM and any other standards as a gas-less L2 that leverages the network’s L1 security and reliability. Whilst improved composability is a key benefit, this upgrade also puts them one step closer to the 1m transaction per second goal. Alongside an institutional NFT track record and high-growth DeFi ecosystem, this capability helps expand product market fit into gaming and other transaction volume-hungry use cases. Further, L2s on Tezos will not require new tokens to operate, making them an even more attractive platform for an increasingly legislated and cautious industry. The technology Tezos offers is ready to capitalise on the next wave of Web3 users and applications thanks to its visionary architecture decisions, low energy and low-cost network.
Strength and opportunities
One of the problems Tezos tried to solve when looking at competitors such as Bitcoin and Ethereum was the potential for communities to split off in different directions. Governing and implementing changes in a decentralised fashion is hard to do, as seen from forks such as Bitcoin Cash and Ethereum Classic. But Tezos has turned this problem into a strength, resulting in different protocol architecture, greatly assisting developers that know how to, and have the ability to, ship upgrades regularly. This is different in the case of Ethereum, for example, which has forked every upgrade and requires much slower growth of technical development.
Consequently, Tezos has become the third-largest active developer community, with approximately 334 active devs (30 days avg). During 2022 — a year of exodus for developers from most protocols — Tezos experienced the second lowest decline amongst its competitors of 57%, compared to the broader market seeing an 87% decline.
A smart contract increase of 18x since January 2021 shows developers are building to accommodate keen end users. Most of this adoption has come from the NFT industry, where Tezos has built a niche narrative. As an alternative to Ethereum for NFT market participants due to Ethereum’s network congestion and excessive gas prices. Community-led and art-focused marketplaces gained popularity within the Tezos ecosystem, attracting new and emerging artists who found it more profitable on Tezos due to faster and more affordable transactions. Six of the top ten Tezos applications with the highest number of users are NFT-focused.
Diversification of users is evident through a high-growth DeFi ecosystem, albeit still small compared to its competitors. Tezos’ TVL, denominated in its respective token, grew whilst most others declined and fell the least from its highest point. Although this growth started from a lower base and still does not yet match the likes of its competitors, users have sent a signal committing themselves to Tezos, an important part of building sticky network effects.
Last, a strong Foundation audited by PwC has maintained a balance sheet of over $470m, as of the end of 2022, with a runway of around 18 months since the start of the year. Demonstrating strict adherence to regulatory and compliance standards whilst having large reserves to navigate volatile markets sensibly. Further, Tezos Foundation also has respectable token floats in reserves compared to other Foundations. 15% is lower than the Tron Foundation’s (34%) and higher than Ava Labs’ (10%) but is in line with others such as Optimism Foundation (15%) (all based on token allocation). Treasury risk management follows mainly a liquidity and diversification logic and predominantly uses traditional funds or Bitcoin when fiat is required.
Risks and Mitigation Factors
Focusing on building a blockchain that minimises the likelihood of forks is an excellent way to align development and implement the best tech. However, a large trade-off is that the protocol never ossifies and lacks token value accrual. It could be argued that is the exact reason for token value accrual, but an additional approach could be to implement more ways to burn Tez. The burn-issuance ratio is only 2%, significantly lower than its competitors, and given Tezos’ uncapped supply, validators and token holders would be less diluted.
Tezos taking a different approach in design early on was a bold move and likely a factor as to why Tezos lagged in adopting the major DeFi applications. Largely divorcing themselves from the Ethereum Virtual Machine still has a hangover effect. But innovations such as Smart Optimistic Rollups, part of the Mumbai upgrade activated in March, are further evidence of championing different architecture, which should continue to pay off. Unlike other blockchains, Tezos rollups have no token, no multi-signature and no ‘progressive decentralisation’. The plethora of benefits notably includes enhancing the network’s capabilities by increasing throughput and supporting new execution environments. Thereby boosting blockchain development and encouraging the migration of applications from other networks, especially Ethereum and similar blockchains, to Tezos.
Tezos’ large, active and robust developer community lays the foundation for a flexible protocol optimising for the best tech. Whilst it seems they may not be the most productive, Tezos activity is highest on a per-user basis, indicative of the high-growth DeFi ecosystem and NFT niche.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
The battle for dominance in DeFi is intense, and Avalanche feels the heat. With strong competition from Arbitrum and Ethereum, the blockchain network looks to be struggling to maintain its market share and generate profits. Barriers to growth are significant, and token incentives are not delivering the desired results. A divergence from the main Avalanche network to smaller, more sovereign, customisable chains called Subnets seems to work as desired. Still, the type of adoption may not be the right approach to reverse declining profitability. Community relevance is likely, and good tech is a bonus, but a competitive and sustainable growth outlook remains uncertain.
DeFi Competition is Strong With Large Barriers For Growth and Sustainable Earnings
The top three of the five largest DeFi apps on Avalanche also sit on Arbitrum, two of which only sit on both chains (Trader Joe and GMX), so looking deeper into those is a good proxy as to how both apps are performing on those chains.
Trader Joe (decentralised exchange), one of Avalanche’s most loyal applications, recently joined Arbitrum to grow and diversify its user base. Three months later, Arbitrum now commands, on average, over a quarter of volumes over the last 30 days, and over half, over the last week. When GMX moved to Avalanche, market share only increased by 18% over the same time period. However, this growth trend has reversed, declining 8% on average month over month since January 2021.
Ethereum’s Layer-2’s are booming; previous onboarding from Uniswap, Curve, Aave, Sushi and the recent success of other platforms like Gains Network and Radiant since the beginning of 2023 would have likely led to spillover into GMX on Arbitrum and only add to Avalanche’s woes. A higher trading volume growth rate, albeit from a lower base, has clawed back some market share since the depths of the bear market in December, but it remains far off where its share was just nine months ago. This growth can largely be attributed to Avalanche adding their first real concentrated liquidity DEX on Trader Joe which helps improve capital efficiency and flexibility within any market for liquidity providers (LPs). Balancer and Uniswap have also recently passed votes to launch on Avalanche, which should also assist volume growth.
Further, a source from the Ava Labs foundation says only a ‘very small portion’ of the $180M liquidity mining incentive program was used, perhaps why they have struggled to attract sticky users and volume from Aave and Curve. With less than 1% and 8% of Curve and Aave TVL on Avalanche, respectively. Ethereum commands the rest and will likely continue to provide considerable barriers to market share growth.
Gaming Adoption Does Not Lend a Helping Hand For Profitability
Subnets are key to Avalanche’s scaling thesis. These smaller chains allow applications to be more customisable and sovereign compared to abiding strictly by the rules of the main chain, known as the C-Chain. Demand filtered to other parts of the ecosystem due to the availability of Subnets reduces congestion and fees and improves the user experience.
Subnets may not be the silver bullet solution for low top-line fee revenue and negative earnings. Swimmer’s move to its own chain in May 2022 led to a massive drop in transactions and fees on the C-Chain (coincidentally, this is also the month of the Luna collapse); now, DeFi Kingdom (another gaming chain) comprises over 90% of all total Avalanche transactions (main network and Subnets) and has failed to restore profitability and accrue adequate value to its token.
Perhaps focusing on more organic growth incentives such as Optimism’s Quest, where users were rewarded with an NFT for doing tasks on different apps. Similar to Optimism’s case, fickle users will likely leave after the program ends. But it may reduce reliance on token incentives and give participants reasons to explore, transact and interact. Thereby cutting costs, driving top-line fee revenue, and building loyalty and buzz through a well-earned accolade.
Credit Where Credit is Due: Avalanche Has Good Tech
Subnets are Virtual Machine (VMs) agnostic. VMs are what define blockchain rules, and being VM agnostic means developers can use languages, libraries and tech stacks they’re familiar with. Developers have fine control over the behaviour of their blockchain to fit any use case they have. This dramatically expands the potential universe of applications built on top of Avalanche.
Subnets may also use the Avalanche token (AVAX) as a gas token. This is most recently evident with TSM and their Blitz subnet potentially onboarding 30 million gamers burning a portion of AVAX fees with every transaction made. Depending on the level of adoption amongst other chains using AVAX, this could move the needle regarding profitability.
Time to finality shows how fast transactions are put on the blockchain after a user executes an action, for example, a swap on a DEX or a peer-to-peer transfer. It takes less than 1 second on Avalanche, a market-leading stat, to guarantee irreversibility (immutability) — one of the core value propositions of blockchains and is an essential metric for applications.
Other technology includes Avalanche Warp Messaging (AWM) which is a messaging tech that allows any subnet to send and verify messages from other subnets. Whilst this isn’t finished yet, this could be additive to its interoperability advantages.
Avalanche has thought deeply about its end game: a chain that can scale efficiently, minimise finality concerns for applications and users, as well as developer constraints, and expand its total addressable market. Based on these critical advantages, Avalanche is product-ready. All that is needed is adoption, which should hopefully come as the ecosystem grows. Yet, it’s just not there, and competition is fierce.
Blockchain Economics
Fewer users and reduced activity has led to a 98% decline in fee revenue year over year, whilst some of this is attributed to the decline in the price of the AVAX token; when denominated in AVAX, fees declined 90% year over year whilst many of its competitors such as Solana, Optimism, Arbitrum and Polygon had positive native fees. This outcome can be argued as an intended side effect of their scaling thesis but may not be positive going forward. Consequential volume fragmentation across chains and migration from Avalanche to Arbitrum and others also reduces nominal fees on Avalanche and makes sustainable protocol earnings and growth less certain.
Avalanche was most unprofitable at the end of March 2022 because of over $700m in token incentives in one quarter. Since then, token incentives have declined faster than revenues, pushing it towards breakeven over the past year. Two broad and simplified profitability scenarios arise. Assuming wide-ranging adoption occurs on subnets because of their impressive and differentiated tech which, importantly, use AVAX as their token for gas fees, higher fee revenues would burn AVAX, reducing supply and increasing dollar-denominated net earnings. On the other hand, assume the current trend that few subnets use AVAX as gas fees and Avalanche continues to hit roadblocks from competitors such as Ethereum as its Layer 2s, revenue will continue to stay low, and if they want growth they will be forced to print money (token incentives), therefore, always staying below breakeven.
Poor DeFi Outlook, Wrong Scaling Adoption and Negative Protocol Earnings
Intense competition from Arbitrum and behemoths like Ethereum, shallow and declining liquidity, gaming adoption concentration and unfruitful token incentives make Avalanche’s DeFi growth outlook challenging. Contrary to the broader narrative and the Foundation’s goals of ‘tokenising the world’s assets’, scaling metrics show concentrated adoption in gaming, which puts further downward pressure on long-term sustainable growth and transaction fees.
Avalanche will likely remain a relevant alternative Layer-1, with its attractive tech stack ready for various use cases and a flood of mass adoption. But looking at its financials and the adoption pathway going forward, Avalanche may struggle to compete over time with other mature Layer-1s and faster-growing Layer-2s.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
Fee switch should drive profitability in 2024 in all bull, base and bear case scenarios
End of the vesting schedule compounds protocol profitability for token holders
Better relative fundamental value compared to competitors
Market leader in volumes and fee revenues
Two major risks include securities laws and order books
Overview
Uniswap is a platform that enables users to swap and trade tokens without using Centralised Exchanges (CEXs). Unlike CEXs, which match up order makers and takers based on order-book models, Uniswap’s trading market is created by liquidity providers. Liquidity Providers (LPs) lend their tokens to Uniswap pools and earn a portion of the fees generated in their respective pools. Uniswap typically has several fee-tiered pools for its various trading pairs, with volatile pairs having three fee-tiered pools and stable pairs having two fee-tiered pools. All fees generated on the Uniswap protocol are paid out to LPs based on their percentage of funds loaned/deposited in a given pool, with none of the fees generated fed back to Uniswap. Uniswap v3 has a built-in “fee switch” to redirect between 10% (1000 bps) and 25% (2500 bps) of the total fees in each pool from LPs back to Uniswap. For an additional report on Uniswap’s team, protocol architecture and on-chain activity, see here.
Investment Catalyst
Uniswap has made an impressive $2.5 billion in cumulative fees since inception, but not a single dollar has returned to the protocol. The fee switch is essential because it mends Uniswap’s broken value accrual mechanism and ultimately results in a sustainable earnings model. Reducing issuance, which is a cost to the protocol, compounds profitability.
Accounting Value Accrual
Uniswap has two sides to its value accrual: accounting and cash flow. On the former, Uniswap’s daily issuance — which supports its treasury, team, advisors, and investors — has mostly decreased over time which has led to an average annual increase in earnings of 41% since 2020, even though the earnings are still negative and Uniswap has made no top-line revenue. Based on value accrual through accounting standards and without the fee switch, Uniswap is predicted to break even in 2025, where gross profit is zero and issuance is zero.
Free Cash Flow Value Accrual
After implementing the fee switch and when issuance goes to zero, fee revenue would flow straight to Uniswap’s bottom line. In our base case scenario, without the fee switch, we’ve predicted a $118m loss in 2023 compared to a ~$113m gain in 2024 with the fee switch; net margins could equate to 64%, and earnings per token could increase to $0.12. Theoretically, this should only increase as costs to the protocol (issuance) stay flat at zero and value continues to accrue in the future. Currently, Uniswap doesn’t have earnings per token or profitability figures because that assumes it makes fee revenue; it doesn’t.
Without implementing the fee switch, Uniswap will not be profitable going forward. 2023’s scheduled issuances of around $118m present a significant cost that the bear and base cases fail to overcome, resulting in a $19m profit in the most bullish scenario of a 2500 bps fee switch. This situation is similar on an earnings-per-token basis, a mere $0.02 per token using the bull case, whilst bear and case cases are negative.
2024 represents the inflexion point, where all scenarios across gross profit, net profit, and per token, respectively, are positive, representing multi-hundred per cent increases from 2023 scenarios, both with and without a fee switch.
More robust relative fundamentals
Uniswap’s power is in its capital efficiency. The protocol turns over more dollars per one dollar of total value locked (TVL) and commands the highest fees per user than any other competitor. This is due to concentrated liquidity and customisable fee tiers from the v3 upgrade on 5th May 2021, which forces LPs to take a view of the market by risking their capital (more specifically, a portion of their collateral marked as an impermanent loss) at specific price points on the asset, thereby affecting their preferred risk-adjusted returns. This favours more sophisticated users with larger sums of money who tend to play with stable assets in pools with lower fee tiers, volatility and higher liquidity. This is evident in the average fee tier declining from 3000 bps to 1400 bps since 2020 as volumes have risen.
Strategic Vertical Integration
NFTs and ERC-20 tokens have largely existed as separate ecosystems within crypto, but both are essential to growing the digital economy. Launching its NFT capability in November 2022 and the recent February 2023 upgrade, allowing buyers to purchase any NFT with any ERC20 token whilst the seller still receives their desired token, comprise Uniswap’s first significant steps in building more interoperable experiences between the two ecosystems. Expanding into the NFT market will help drive market share, revenue, profitability and value for token holders.
Uniswap has also recently released a self-custodial mobile wallet, a core tenet of DeFi that ensures one’s crypto can’t be misused by a centralised party. Although currently in test flight as uncertainty builds due to Apple refusing to give the green light on the App Store, this could likely be a core strategy to keep users within Uniswap rails.
Risks
Token holders subject themselves to two main risks: regulation and order books. The fee switch subjects Uniswap to securities laws if it were to take some of the protocol revenue generated. To reduce any possible legal issues, a suggestion is only to enable the fee switch for liquidity pools of tokens that have not been in the cross-hairs of regulatory firepower, such as select stablecoins, BTC or ETH. A problem with this is that volatile pairings with higher fee tiers (stablecoin:ETH/BTC or ETH/BTC) tend to have less liquidity, capital efficiency, and fee market share and hosts more elastic users and LPs who will likely receive less revenue, therefore, directing them away from the protocol or towards pools without the fee-switch, resulting in less overall protocol revenue and decreased market share.
Order books have advantages that may detract from Uniswap’s DEX market dominance over the long term. Lower slippage is primarily a result of smaller spreads from the role of market-makers and granular limit orders. These privileges are not available on Uniswap’s AMM because its pricing function (x*y=k) determines prices instead of traders — one takes the price they are given, not the price they set. Order books remain optimal for surfacing market prices and placing large orders. Widely accepted and used by institutions and retail traders, order books often provide a better experience to trade, as is reflected in volume/TVL. GMX is a popular order book which has proven its capital efficiency. Albeit, Uniswap is significantly larger in terms of nominal fees, volumes, TVL and users — around 3x, 6x, 6x, and 19x, respectively.
Investment Summary
Uniswap’s better fundamental relative value against other AMMs concerning capital efficiency and dominant market share of volume and fee revenue demonstrate its market-leading nature. But the main value driver over the coming years is the fee switch, planting its flag in 2024 as the protocol turns profitable in all scenarios and accrues value directly to token holders. As costs trend to zero around September 2024, Uniswap’s profitability theoretically only increases as all top-line revenue will flow straight to its bottom line and compound for all token holders.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
Picture this: it’s 2024, and a malicious actor has messed with social security and national insurance numbers. In this scenario, an individual could not file taxes or prove to their government they have their right to work. Panic would likely set in as no one could tell truth from fiction.
Public blockchains may have a solution. By storing verified information permanently without the need for a middleman, these blockchains could create an environment where any attempts at hacking come with a hefty price tag or significant operational and infrastructural barriers. However, it is worth noting, using these publicly readable and accessible networks can be tricky regarding privacy, and current identity approaches do not scale well. Ultimately, we believe that on-chain infrastructure should be minimised — a controversial view of today’s decentralised identity landscape.
Current Approaches Don’t Fit The Bill
One such blockchain solution is non-transferable NFTs (nNFTs), also known as ‘soulbound tokens’. These tokens are bound to individuals, making it difficult for owners to respond or remedy false information tagged onto them by others. This can result in an untrue and unwanted on-chain profile being curated. These tokens also become increasingly difficult to police as they scale, creating negative implications for engagement and regulatory scrutiny.
Another potential solution is Proof of Attendance Protocols (POAPs), which represent real-world events, college degrees, and mortgage loans on the blockchain. While POAPs are Sybil-proof which means it is hard to create fake spam addresses, they sacrifice privacy to a worrying degree due to the transparency of the blockchain. Using zero-knowledge proofs could solve privacy complaints, but it requires more complexity to use across on-chain ecosystems. These technological advancements are still far away.
Lens is a social media application built on Polygon that uses NFTs as users’ profiles. Similar to the problems Soulbound Tokens have, Lens profiles may not accurately reflect the person. Take a Lens-based Tinder, for example, one wouldn’t want right swipes time stamped on-chain, nor would left swipes attached to one’s profile suffice!
Nostr is a social network protocol that has become popular among Bitcoin enthusiasts because it supports Bitcoin payments via the Lightning Network. However, because everyone’s identity is a public key on the blockchain (which is like a bank account number), there’s no standardisation or interoperability, which limits the platform’s ability to support different types of apps and use cases. While micropayments are an effective way to reduce spam, they also take up valuable block space that could be used for monetary transactions — which is what Bitcoin and the Lightning Network were designed for. Some might think it doesn’t matter what you put on-chain, as scaling will solve such concerns. However, using block space and gas has a real cost, which means users need to have cryptocurrency, which limits the potential for scaling and off-chain utility.
Putting large amounts of information on-chain is “fine until it’s not” and eventually will become unpalatable, if not outright risky, to more and more people. CoinShares believes that decentralised identity should rarely involve the blockchain due to: 1) privacy concerns not solved by zero-knowledge proofs, 2) easier to scale, and 3) the importance of minimising block space and gas. Combining off-chain and on-chain architecture is the best approach.
Decentralised Identifiers (DIDs) are off-chain, user-generated, self-sovereign identifiers for our existing addresses (bitcoin address, email address, website etc.) that you own. These DIDs point to public keys and prove ownership over one’s Verifiable Credential (VCs) that store long-lasting, personal and unique data of any and all sorts one chooses.
(Source: W3C, Gataca)
If you use VCs with your DID, it’s only linked publicly by others if you agree to it and choose to make it public. This prevents unwanted tagging and reduces privacy concerns. Because DIDs are system-agnostic and standardised, they can be connected to any protocol or application, which helps overcome scaling challenges. Plus, they require minimal gas and block space, making them more inclusive for off-chain people, identities, and utility.
So What Do DIDs and VCs Offer That Alternatives Don’t?
In a worst-case scenario where people must prove ownership quickly, controlling your identity is crucial. This is especially true in the digital world, where copycat identities can be problematic. Decentralised Identifiers and Verifiable Credentials are better for privacy and decentralisation, and they are also cheaper and more efficient than current approaches like NFTs and social media. They don’t clog up the chain and provide a censorship-resistant and tamper-evasive solution away from a centralised entity.
Disclosure
The information contained in this document is for general information only. Nothing in this document should be interpreted as constituting an offer of (or any solicitation in connection with) any investment products or services by any member of the CoinShares Group where it may be illegal to do so. Access to any investment products or services of the CoinShares Group is in all cases subject to the applicable laws and regulations relating thereto.
This document is directed at professional and institutional investors. Investments may go up or down in value and you may lose some or all of the amount invested. Past performance is not necessarily a guide to future performance. This document contains historical data. Historical performance is not an indication of future performance and investments may go up and down in value. You cannot invest directly in an index. Fees and expenses have not been included.
Although produced with reasonable care and skill, no representation should be taken as having been given that this document is an exhaustive analysis of all of the considerations which its subject-matter may give rise to. This document fairly represents the opinions and sentiments of CoinShares, as at the date of its issuance but it should be noted that such opinions and sentiments may be revised from time to time, for example in light of experience and further developments, and this document may not necessarily be updated to reflect the same.
The information presented in this document has been developed internally and / or obtained from sources believed to be reliable; however, CoinShares does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this document are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Third party data providers make no warranties or representation of any kind in relation to the use of any of their data in this document. CoinShares does not accept any liability whatsoever for any direct, indirect or consequential loss arising from any use of this document or its contents.
Any forward-looking statements speak only as of the date they are made, and CoinShares assumes no duty to, and does not undertake, to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Nothing within this document constitutes (or should be construed as being) investment, legal, tax or other advice. This document should not be used as the basis for any investment decision(s) which a reader thereof may be considering. Any potential investor in digital assets, even if experienced and affluent, is strongly recommended to seek independent financial advice upon the merits of the same in the context of their own unique circumstances.
This document is directed at, and only made available to, professional clients and eligible counterparties. For UK investors: CoinShares Capital Markets (UK) Limited is an appointed representative of Strata Global Limited which is authorised and regulated by the Financial Conduct Authority (FRN 563834). The address of CoinShares Capital Markets (UK) Limited is 82 Baker Street, London, W1U 6TE. For EU investors: CoinShares AM (napoleon-am.com) is a French asset management company regulated by the Autorité des Marchés Financiers (AMF), registered under number GP-19000015 since 27/03/2019. Its office is located at 25 rue du 4 Septembre, 75002 Paris, France.
