October 1, 2021
How do Humans Approach Understanding New Systems?
Humans have evolved to navigate physical territories, avoid physical predators, and collect physical resources. And so the way we conceptualize the world is very much rooted in the physical. As economic activity migrates into digital space, it becomes more and more difficult for us to conceptualize what is happening and why.
The internet represented a new paradigm for the diffusion and transfer of information. At the beginning, the technically-minded struggled to explain its value proposition in accessible terms. What does the internet do? Why does it matter? What is it akin to? This final question alludes to a basic primitive of human comprehension, that of analogy. We cannot process every bit of new information afresh—doing so would be a computational impossibility. Instead, we position new stimuli within a latticework of heuristics, or mental models informed by precedent. So, instead of a “network of networks”, the internet (and the Fed ;-) ) might be described as a printing press with a constellation of highways protruding from it.
We might describe crypto as the internet for value, but even this presumes an intuitive understanding of the internet’s essence. I do not claim to fully understand either the internet or blockchains, but have spent the time collecting metaphors and vetting them for explanatory power. For crypto, my favorite analogy is to cities, coined by or at least popularized by Bankless.
Blockchains: The Infrastructure for Virtual Cities
Cities provide basic infrastructure to the businesses and people that inhabit them: public transportation, roads, water supply, and sewage. Cities also have their own sets of laws and those who enforce them. These basic guarantees enable humans to safely live in close proximity and exchange goods and services with others to mutual benefit.
Blockchains are public databases that track who owns which tokens and to whom they have sent them. Ethereum, Bitcoin, and Solana are blockchains, or Layer 1 networks. Layer 1s form the backbone of crypto because they act as the ultimate settlement layer for economic activity, or transactions.
Like cities, blockchains provide basic infrastructure to those who choose to use them. Cities provide the roads and transportation that shuttle goods and people. Businesses and citizens use these arteries according to their needs. Blockchains provide digital channels that shuttle packets of value called tokens. Each blockchain is governed by a different set of rules, or laws. These rules determine how tokens travel from one wallet to another, how such transactions are secured, and how disputes are resolved.
A high-functioning blockchain, similar to a well-run city, punishes those who violate the rules while rewarding those who promote them. Blockchains are transparent and those transacting on them necessarily own a piece of the network. In such an arrangement, those securing the network, usually either miners or validators, are incentivized to flag and punish illegitimate transactions, like double-spends. These transactions undermine the security of the chain and the value of its native token.
By providing strong foundations for exchange, cities and blockchains create economic opportunity. Businesses and citizens will migrate at significant personal cost to cities with better opportunities and start building, often from scratch. The opportunity is simply too large to pass up. Blockchains, by the appeal of open financial infrastructure, will drive an even larger and faster migration of businesses and citizens. After all, switching costs are much lower.
Stacking on the Shoulders of Giant Blockchains
Blockchains are a foundation, or a base layer, upon which applications can be built. Developers choose to build applications on blockchains because they provide more robust infrastructure and better rules than in previous paradigms. Applications combine the basic components of the blockchains beneath them in arrangements that suit their users’ needs. As a tier of legacy applications mature and become more stable, a frontier of applications are built on top. This dynamic stacking, called “composability”, is an essential property of blockchains.
Let’s use a restaurateur's journey to better conceptualize composability and to tie out our city analogy. Like applications on blockchains, this restaurant leverages infrastructure “lower in the stack” to deliver a tailored service to its customers. It takes advantage of the city’s police, firemen, water infrastructure, and garbage collection. It benefits directly from the city’s transportation, the speed and reach of which expand the restaurant’s serviceable market. The restaurant rents real estate from a landlord who owns property in a good location. It buys fluffy bread from the bakery down the street, French wine from the local wine store, and produce from the green grocer. It uses a lorry service for pick-up and delivery of all these input materials. By leveraging the city and the other business running within it, the restaurant can more effectively focus on its core competency and deliver an effective experience to its customers. This is composability.
The owners choose Manhattan, as opposed to Asheville NC or Chappaqua NY, because it is home to a greater number of prospective customers and composable services. Developers and users employ the same rationale online when selecting which blockchains to do business with.
A Tale of Two Blockchains: Ethereum and Solana
Manhattan: Ethereum
In 2017, Ethereum was really the only game in town. Bitcoin was and continues to be difficult to build applications upon. Like in a developing city, favelas cropped up on Ethereum. It became a breeding ground for Initial Coin Offerings (ICOs), unregistered crowd sales of low-quality tokens and services. As the chain grew more secure and its infrastructure improved, a bevy of useful applications like Uniswap and Yearn Finance replaced the generation of squatters that preceded them.
Ethereum is sort of like Manhattan. It is now home to an overwhelmingly large number of applications and users. As high-octane cities and performant blockchains host more and more economic activity, these networks become more attractive for future users. Though demand for Manhattan continues to grow, its supply of real estate is fixed, making it one of the most expensive places to live on earth. To successfully transact on the Ethereum blockchain, a user must pay for computing power. Compute is paid for in gas, a fee paid to miners for inclusion in a block. Being included in a block guarantees settlement of the submitted transaction. But just as square footage in Manhattan is fixed, Ethereum blockspace is fixed. A 2021 user is paying roughly 4x in gas what they would in 2019 for the same transaction.
Source: YCharts
Gas, quoted in gwei, is priced independently of the value being settled in single Ethereum transactions. Whether a user is swapping $50 of tokens or $2MM (swaps usually require more than one tx), the computation required is the same and the user will pay a similar amount in gas. So if the aggregate demand for blockspace remains high, users might pay more in transaction costs than the notional value of the transaction that they are attempting to execute. During high congestion, a user buying a piece of $25 NFT art could be paying $50 in fees settle. For retail users dealing in small amounts, continuing to transact in Manhattan is impossible, so they’ll either cease to transact or move elsewhere. Users might move to a cheaper area within their city or switch cities altogether.
Brooklyn: Layer 2
Brooklyn provides an appealing alternative to Manhattan—it is more reasonably priced, offers only a slight downgrade in goods and services, and is only a bridge away from Manhattan. Layer 2 scaling solutions, or Ethereum’s Brooklyn, offer an alternative to the prohibitive congestion of Layer 1. Layer 2 scaling solutions bring an extra supply of computing capacity to users. By moving the computation for transactions to Layer 2, as opposed to directly on Ethereum’s main chain, users pay much less in gas to transact.
Layer 2 scaling solutions take a variety of approaches, but the most entrenched are Polygon (Matic), Arbitrum, and Optimism. Applications, like restaurants, recognize that having locations only in Manhattan would hamstring the scale of business they could do. To accommodate users who are priced out of Ethereum, these applications deploy on Layer 2. Users can bridge their assets to Layer 2 solutions and use their favorite Ethereum applications for almost nothing. Upon completion of their desired activity, these users may choose to bridge their assets back to Ethereum, where both economic activity and security are higher.
Ethereum and Layer 2s, like Manhattan and Brooklyn, generate more scale together than they would independently. If Ethereum is going to scale to billions of users, Layer 2 scaling solutions are essential. But the evolution of Layer 2s, from side chains to optimistic rollups to zK-rollups, complicates things. As Ethereum pivots to a Proof-of-Stake security model and integrates sharding, or the fracturing of the chain, the road ahead is already windy. With many different Layer 2s communicating with many different applications communicating with Ethereum, might a wholesale re-imagination of the blockchain structure be compelling?
Austin: Solana
People who’ve lived in New York often get burnt out. It’s expensive, chaotic, and crowded. Brooklyn (Layer 2) offers an improvement, but it’s less safe and the constant shuttling to Manhattan (Ethereum) gets tiring. Austin offers asylum: it has less economic activity but is a smoother, lower-stress experience. As more businesses and people make the move, assuming it continues to function crisply, it only grows in appeal.
Just as Austin is not necessarily trying to “be” or to “beat” New York, Solana is building a blockchain on its own terms and with its own priorities. Whereas Ethereum started with decentralization and is building towards scale, Solana started with scale and is building towards decentralization.
Solana currently accommodates roughly 50,000 transactions per second, compared with Ethereum’s 30. Rather than embark on a complicated journey to split up the blockchain (sharding) and to process transactions off-chain (Layer 2), Solana starts with larger blocks and processes transactions in parallel. These features, while enabling higher throughput, increase the technical and financial requirements for validators, or those who verify transactions and secure the chain.
Many of those with the resources to validate Ethereum blocks are not able to validate Solana blocks. As such, the Ethereum 2.0 blockchain is currently secured by 200,000 validators, compared with Solana’s 1,000. As the hardware necessary to validate on Solana becomes cheaper, more and more nodes can help secure the chain. Until then, Ethereum, by proxy of the decentralization in its validator set, is the most secure place to do business. If a user is willing to endure a downgrade in security for a better direct user experience, Solana is a sensible option.
Unlike physically migrating from New York to Austin, or even migrating from traditional banking to DeFi, virtually migrating from Ethereum to Solana is relatively simple. Switching costs are low. And they are getting lower. Wormhole Token Bridge allows users to easily bridge assets between Ethereum and Solana. Phantom Wallet is an intuitive browser extension akin to MetaMask. Raydium is a decentralized exchange, accessible via Phantom, that sources and executes trades more quickly than Uniswap and Sushiswap. But Solana is still new to users. Rather than plunge into the unknown, users will endure what is familiar far longer than is “rational”. But all users have a breaking point, where the costs of doing business, financially and otherwise, are simply too high to not explore other solutions.
A Multi-Chain World: Follow the Devs
People select their home cities based on different criteria. For some, the culture appeals. For others, quality of life is important. But these perks do not materialize out of thin air—they arise from the collective progress of generations of residents and businesses that came before. The engine of urbanization is economic opportunity. It is the temerity of risk-seeking entrepreneurs that drives the second order attributes (e.g. culture, quality of life) that now dictate our residential choices.
Back when a “city” was just “infrastructure” and infrastructure was just topography, farmers, merchants, and builders had to make a very important decision: which of these places contain the set of qualities that, by adopting them, make it most likely that my endeavor succeeds?
I reckon that a similar dynamic plays out in crypto. Developers will settle blockchains first. They’ll be selective in where they deploy, electing for the option that is most additive to their missions. Some will be drawn to the vast network effect that Ethereum commands, building applications for the space as it currently lies. Others will be more forward-looking, anticipating and shaping a future for other chains. Some will build on chains with scale and others will build on chains with geographical significance to their user base. And still others will look for properties that I am not prescient enough to know even matter.
In five years time, I believe we will see a specialization of labor in blockchains. Certain ecosystems of applications will live on certain blockchains, relying on them for security and settlement. High-value transactions like blue chip NFTs, sovereign and corporate bond issuance, and real asset transfers might live on Ethereum. Gaming, micropayments, and high frequency trading might live on Solana. And who knows, maybe CBDCs live on Algorand or Cosmos. As users shift from speculators to practitioners, they’ll become loyal to the chains that host applications that most directly make their lives easier. To understand where the market is going, always follow the devs.
* Disclosures: Not financial advice. I own Algorand, Ethereum, YFI, and Solana
A thoughtful analogy and spot-on heuristic. I think Geoffrey West's "Scale: The Universal Laws of Growth, Innovation, Sustainability, and the Pace of Life in Organisms, Cities, Economies, and Companies" will provide some useful support for this approach to understanding blockchains.