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Subscribe Sign in Share this post VALUE ACCRUAL IN THE MODULAR STACK www.shoal.gg Copy link Facebook Email Note Other DISCOVER MORE FROM SHOAL RESEARCH Crypto Research and Insights Subscribe Continue reading Sign in VALUE ACCRUAL IN THE MODULAR STACK UNPACKING WHERE VALUE MIGHT ACCRUE IN A MODULAR BLOCKCHAIN FUTURE. imajinl Mar 4, 2024 1 Share this post VALUE ACCRUAL IN THE MODULAR STACK www.shoal.gg Copy link Facebook Email Note Other Share INTRODUCTION Modular blockchains have been all the rave, but one often overlooked aspect of them is that they fragment value. In a world where we have one monolithic blockchain, all value accrues to this blockchain’s ecosystem — but that’s not the case with modular blockchains. This is due to the inherent design of these modular blockchains. Modularity as it relates to core blockchain components (data availability and consensus; why there’s a grouping of these two will be touched upon later in this post; execution, and settlement) is different layers specialize (do what they’re best at), and the best layers for data availability and consensus, settlement, and execution are coupled into one blockchain, which when presented to the end user, allows them to get a better product at a lower price. Elaborating on this, the modular stack’s main benefit materializes with users being able to access cheaper blockspace and better blockspace (better in the sense that this specialization allows for total blockspace to expand exponentially; more on this below; as more blockchains proliferate, unlocking applications that we haven’t even thought of yet — much like how broadband unlocked social media for us), as well as better security guarantees. Developers of applications also need to worry less about the ideal stack for them; they can just plug and play, subsequently deploying their app. So when the functions of all these core components are carried out by different blockchains, where exactly does value accrue? Thanks for reading Shoal Research! Subscribe for free to receive new posts and support my work. Subscribe But before getting to that, let’s get a little deeper into modular blockchains. One reason the modular blockchain narrative is going to be instrumental for the paradigm shift into blockchain technology and Web 3.0, in general, is that it allows us to scale bandwidth without compromising on the whole reasons blockchains are so interesting — their properties of censorship resistance, liveness, and credible neutrality. SCALABILITY WITH MODULAR BLOCKCHAINS In essence, with modular blockchains, we can try to make the best trade-offs on the blockchain trilemma (as seen above) by scaling in layers. Take Ethereum as an example. With modular blockchains, Ethereum can be used as a settlement layer as it has the most amount of validators and the most geographically distributed set of validators (as well as a lot of solo stakers and overall less cloud concentration, see here), as well as being secured by, objectively, the best crypto money after bitcoin, Ether. But, effectively, Ethereum is well suited to be a settlement layer, which would make it a place to have the canonical bridge, as well as have dispute resolution (like for fraud/fault proofs). Now, with regard to scalability, we do this on layers built on top of Ethereum, much like we do in TradFi (for example, Stripe or something like PayPal is built on top of many financial layers, and usually banks, say every week or so, settle up on the base layer using Fedwire, i.e., the Federal Reserve settlement system) — Nic Carter, in this episode with Lex Fridman, breaks it down well (it is worth noting that TradFi is at an advantage since TradFi utilizes centralized databases to record transfers, etc., while blockchains are distributed ledgers that require cooperation of thousands of nodes to append and verify). This takes the form of rollups (and other scaling solutions, rollups being the predominant one), which solely specialize in execution (execution is basically just running code in an execution environment, which takes the form of the EVM for Ethereum and Ethereum rollups), and can hence make some trade-offs when it comes to decentralization and security (this is also another post in and of itself). Rollups also need data availability (primer here) and, by extension, consensus in order to function, and while those can be done by Ethereum, it can be outsourced (tradeoffs here, too) also to blockchains like Celestia, which specialize in it (this video gives you a high-level overview of Celestia) A nice example of a project embracing modularity is Eclipse, which uses Ethereum as a settlement layer and Celestia as a DA+consensus layer and does execution by itself using the SVM (Solana virtual machine) as its execution environment. The SVM is creating a lot of buzz right now for being one of the only multithreaded virtual machines, allowing for parallelization (basically transactions to be processed in parallel to each other), unlike the Ethereum virtual machine, which is single-threaded; hence, sequential transactions are the norm and parallelization is not possible. MODULAR OR MONOLITHIC? Let me caveat all this by saying that Ethereum in and of itself is not a modular blockchain, in the sense that it can do everything (data availability, consensus, execution, and settlement) by itself, but it can be used by other blockchains and layers of the modular stack (for example, execution layers like rollups) for functions like settlement, which then makes Ethereum a component of another project’s modular stack. This is where this meme from Jon Charb, who has done some amazing writing on Ethereum’s roadmap and Ethereum rollups, comes from. The way this meme can be understood is that everything is a modular blockchain, and everything is a monolithic blockchain (doing all the functions on the base layer, like Solana), depending on how you look at it. For example, if I built a rollup on Solana, is Solana itself a monolithic blockchain or a modular one? Likewise, for Ethereum. Even Celestia can do execution and settlement too, but if it’s only utilized for data availability and consensus, then it's a modular blockchain — you get the point. By embracing modular blockchains, you can have different blockchains that specialize in what they do to fulfill the requirements to have an “optimized” blockchain, as I’ve elucidated above. But that begs the question, which one of these layers (data availability/DA for short, consensus, settlement, execution) will capture the most amount of value (have the most value accrual)? This post was provoked after discovering this Tweet and these are the conclusions and frameworks that I have drawn from it (spoiler alert - I disagree with the Tweet). To formalize my thinking more concisely: 1) For a DA layer to work, you need some kind of ordering on that layer (hence, DA layers come with their own consensus, i.e., ordering protocols), so in this modular stack, consensus and DA are not two separate things — just imagine using data available on one chain in order to create proofs but this data (because it's on a blockchain) is ordered in some other way by another chain — it’s just a mess. 2) Execution layers like Arbitrum have pricing (discrimination) power, whilst DA layers like Celestia do not. This is because Celestia provides a homogeneous service (data availability), while Arbitrum (and other rollups like Optimism; I’m just taking Arbitrum as a main example) provides an execution environment for some of the best crypto apps not found elsewhere — this in itself is the reason why Arbitrum makes a significant amount of revenue (somethings hundreds of thousands of dollars a day) while Celestia makes negligible fees, less than $100 per day at the time of writing, as seen below (but this is also a function of Celestia’s nascency). Arbitrum is also closer to the end user due to the monopoly on sequencing they have (the foundation runs the only sequencer), and while this will change in the future (like for example with the adoption of shared sequencing), the Arbitrum protocol (sequencer, builder, searcher) will still be the only ones to receive user fees, and most importantly, MEV and some part of the fees will trickle down to DA layer as the rollup/execution environment will still write the data to Celestia, etc.! And remember, if DA layers captured most of the value, then rollups today would be charging lower fees to users than cost to post/write data to the DA layer (i.e., operating at a loss, which is not the case today). Anatoly Yakovenko (the founder of Solana) explains this phenomena in-depth on the Lightspeed podcast. 3) Settlement layers are more valuable than DA+consensus layers (and I’d argue execution layers) simply because of the fact that the settlement layer will be secured by the most money/money-like crypto asset, as in the case of the most credibly neutral settlement layer today, Ethereum, being secured by $ETH. DA+consensus layers will inevitably have more activity/volume flowing through it relative to the settlement layer (which will only be used for bridging and dispute resolution, so occasionally, block headers will be posted to it from the DA+consensus layer), but the settlement layer’s asset will still be more valuable albeit the settlement layer “doing less.” Just look at $TRX vs. $ETH; the former’s blockchain does more volume and burns more of its native token than Ethereum has volume and burns its native token, yet its valued magnitudes less than $ETH — what gives? Exactly. Monetary premiums. Simply put, the monetary premium is a multiple an asset trades at relative to its fundamentals/fundamental utility due to its “moneyness.” Gold is a good example, wherein it's really not so used in the economy for production processes, and yes, it also looks good, but most of its value comes from its hard money trait — case in point. H/T to Polynya for this point, who puts it better than I do, as seen below. So where does that leave us? This is what I think: the most valuable part of the stack is settlement, then execution, and then DA+consensus, for all the reasons mentioned above (and why I’m not delineating between DA and consensus). My argument can be summed up as follows: settlement layer is the most valuable because of monetary premiums, and execution is much more valuable than DA+consensus because the latter provides a homogenous service where competition is fierce, and costs (and hence revenue for the DA+consensus layer) will trend to 0 (slightly unrelated, but this talk by Peter Thiel is great and talks about why these sorts of businesses don’t make sense to pursue), whilst the former (execution) can build network effects at a much greater rate and solidify them with mass liquidity! They’re also much closer to the users and do not compete on fees! Let me explain this point a little more. Right now, rollups like Optimism and Arbitrum pay more than 90% of their costs (which are actually paid by users) for DA costs (this Bell Curve episode expands on what I’m saying), and want to minimize this. So they might switch to Celestia for DA (and hence consensus), and hence lower the cost (and therefore their revenue) drastically (right now, data on Celestia costs pennies for rollups; if Arbitrum wrote as much data as it did today to Ethereum to Celestia, it would only pay a few thousand dollars — Dan Smith has done good research on this). But users don’t care about small fee increments between rollups! I don’t care if I’m paying $0.01 for a swap on rollup A when I could be paying $0.007 for a swap on rollup B, simply because I don’t swap that much, and bridging my assets is a hurdle and entails security risks! But for a rollup, which is, after all, a business posting thousands of megabytes of data to the DA layer, these “increments” in cost matter a lot because they add up. Basically, rollups are price elastic, like very price elastic. But rollup users aren’t, to a large degree. CONCLUSION From fat protocols to fat applications, modeling value accrual in the blockchain landscape is not a new endeavor. The advent of modularity introduces new components to the public blockchain landscape, and thus new economic and value dynamics as well. Modular blockchains represent a paradigm shift in the blockchain stack - from building a powerful fully-integrated network that can serve all 4 blockchain functions on the base layer, to building networks which use specialized layers for fulfilling these functions as optimally as possible. To reiterate, I believe that the settlement layer is the most valuable component of the stack, underpinned by the monetary premiums associated with the underlying asset. execution layers follow closely behind. In contrast though, DA+consensus layers, despite providing essential functions, face growing competition and diminishing revenue potential due to their semblance to commodities. In short, the order of value accrual in the modular stack: Settlement > Execution > DA + Consensus Not financial or tax advice. The purpose of this newsletter is purely educational and should not be considered as investment advice, legal advice, a request to buy or sell any assets, or a suggestion to make any financial decisions. It is not a substitute for tax advice. Please consult with your accountant and conduct your own research. -------------------------------------------------------------------------------- Disclosure. All reports are the authors own, not the views of their employer. Thanks for reading Shoal Research! Subscribe for free to receive new posts and support my work. Subscribe 1 Like · 1 Restack 1 Share this post VALUE ACCRUAL IN THE MODULAR STACK www.shoal.gg Copy link Facebook Email Note Other Share A guest post by imajinl find my work: https://fueler.io/imajinl ✦ doing stuff @tokenomicsDAO ✦ shitposter Subscribe to imajinl Comments Top New Community Liquid Restaking Tokens: A new Frontier for Yield An Overview of liquid restaking tokens on Eigenlayer Dec 18, 2023 • 0xJermo , Duck , and Gabe Tramble 10 Share this post LIQUID RESTAKING TOKENS: A NEW FRONTIER FOR YIELD www.shoal.gg Copy link Facebook Email Note Other 2 Banana Gun: Telegram Sniper Bot Bringing MEV, Block 0, and token trading all in a single telegram user interface Sep 19, 2023 • Gabe Tramble Share this post BANANA GUN: TELEGRAM SNIPER BOT www.shoal.gg Copy link Facebook Email Note Other GMX: A Real Yield & Defi Primitives Launchpad Defi composability, real yield, and 35+ protocols leveraging GMX perps protocol Feb 21, 2023 • Gabe Tramble 7 Share this post GMX: A REAL YIELD & DEFI PRIMITIVES LAUNCHPAD www.shoal.gg Copy link Facebook Email Note Other See all Ready for more? 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