Examining Base Layer Security and Token Value
In an earlier dispatch, we referenced Chris Burniske and Placeholder’s work on quantifying smart contract demand via the aggregate amount of fees paid to validators or miners. While illuminating in its own right, it led our research team to consider the long-term resilience of such a fee market on Ethereum and how this relates to a network’s native asset. Nic Carter of Placeholder Ventures has produced thought-provoking material on the subject and in part influenced our thinking.
It is generally accepted that cryptonetworks need to have a high level of security expenditure at the base layer relative to the total value of economic activity occurring atop both in the form of tokens and second layer networks. While there has been significant debate as to the exact ratios that constitute a healthy versus a dangerous scenario, the fast-growing use of stablecoins and the development of second layer networks or sidechains on Ethereum raise possible security concerns. This is especially relevant in light of the network’s transition to Proof of Stake whereby Ether will assume a new and arguably more important role as a consensus and network security token in addition to its existing function as a monetary asset, computational resource, and financial asset by way of collateral in the DeFi ecosystem. It is essential that ETH, as a staking token, providing the security to the base layer instead of hash power, retains, and grows in value.
At the same time, the fast-growing use of stablecoins raises the possibility that these assets become the de facto mediums of exchange on the Ethereum network instead of Ether. There is already $7.3 billion worth of stablecoins atop the Ethereum network with close to 50% of this having emerged since January this year. While Ether currently benefits from a gas payment discount relative to Ethereum-based tokens, and there is arguably a social consensus within the community of resistance to diminishing this benefit, it is quite possible that stablecoin transfers increasingly pay network fees in their respective tokens, despite the higher costs, on account of simpler user experience, thus undermining the demand for Ether, and harming network security over the long term.
Linear 1 Year Chart of Major Ethereum Stablecoins Market Capitalization
Source: Coin Metrics
Furthermore, despite Ethereum’s capacity to enable fully expressive smart contracts, there is strong evidence that the network is still used predominantly for simple token transfers, suggesting that it has still yet to transition from an infrastructure for fundraising or as payment rails for ERC20 tokens and stablecoins. To this end, George Pîrlea, a computer scientist and blockchain researcher for Zilliqa, recently published findings showing that 73% of Ethereum transactions from July 2015 – January 2020 involved no complex smart contract logic whatsoever.
Percentage of Transaction per Type (100k bucket)
Equally, the emergence of second layer network implementations, such as Optimistic Rollups, Zk-Rollups and STARK-based constructions, which unlike state channel designs do not require ETH to be locked as collateral, threatens to divert economic activity away from the base layer on account of their superior throughput, finality speeds and in some cases, privacy guarantees. Critically while constructions such as Optimistic Rollups do require block producers to post ETH-denominated bonds as a security measure, they allow for rollup block producers to collect fees in whatever token they wish and ultimately pass on a fraction of economic activity as gas payments to layer one block producers. Given the continued volatility of Ether and other cryptoassets, it is hard to imagine why layer two block producers would collect fees in ETH whereby they would have to hedge the volatility risk when they could simply collect fees in stablecoins.
The fast-growing use of stablecoins and the deployment of layer two networks on Ethereum highlights the complex interplay between network demand and cryptoeconomics. Although the network, for now, is in a healthy equilibrium between security expenditure on the base layer and non-ETH related economic activity atop, these emergent trends could pose long-term risks to the robustness of the network as well as other networks with similar architectures.