L1/L2 Rotation Thesis: Why Optimistic rollups are positioned for immense value capture

L1/L2 Rotation Thesis: Why Optimistic rollups are positioned for immense value capture

History of scalability and Layer-2’s

For investment professionals in crypto, understanding the scalability trilemma, the history of layer-2 approaches and the investment opportunity presented as a solution to the scalability trilemma is important. Ethereum's global turing-complete state machine relies on consensus participants for validation and ledger state updates, but its scalability is limited by each node's need to store and validate every transaction. Thanks to Layer-2 approaches like Optimistic rollups and the zkEVM there is a solution to this problem. These approaches execute transactions on an external computational layer with the same security guarantees as the underlying layer-1. This information compression approach to scalability has been the focus of Ethereum's rollup-centric roadmap. By understanding the road ahead and by investing in layer-2 implementations, investors can potentially monetize from improved scalability and throughput that will occur within the ethereum ecosystem.


Optimistic, Zero-Knowledge rollups and the zkEVM

Rollup is a process where transactions are batched together, and their state transition is provided as a single verifiable proof. This reduces the transaction validation process on Ethereum's layer-1 decreasing the size of bytes for validation. Layer-2 architecture allows cryptographic proofs to be used instead of verifying individual transactions, making the verification for batches of transactions more efficient. There are two types of layer-2 architectures available.

Optimistic rollup refers to an economic model in which transactions are not immediately guaranteed validity but are instead treated optimistically. In this model, state transitions are assumed to be correct by default, and a cryptographic proof is not immediately provided for every state change that occurs with every proposed block and its set of transactions. This is in contrast to other models where a proof is required for every transaction.

Optimistic rollup architecture is designed to be more scalable and efficient by batching transactions together. Rather than verifying each and every transaction, it allows the root chain to assume that they are all valid, thereby bypassing the validation process. This is where the term optimistic comes from; it assumes that most transactions will be valid, which decreases the computational resources needed for transaction validation.

In the event of a dispute, there is a 7-day contestation period during which actors can contest a state update using fault proofs. These cryptographic proofs are used to demonstrate that the disputed state transition was either invalid or that it was legitimate. If the state transition is not contested within this period, it is then considered finalized and becomes a part of the optimistic rollup's state history. This provides a high level of security for all actors involved in the network's consensus mechanism and ensures the network's integrity is maintained. This process is an important development in the evolution of blockchain technology and has helped to improve the network's scalability while also catering to the needs of a growing user base. Overall, the optimistic rollup architecture offers an approach to scaling Ethereum's blockchain while preserving its security and decentralization.

In optimistic rollups, block production is managed by a sequencer that constructs layer-2 blocks and executes state transitions for the set of transactions within the block. The sequencer then submits the relevant data to Ethereum's-1 for the fraud proving system to reconstruct the state. However, in their current form, optimistic rollups are quite centralized, with the sequencer role being managed by a single entity such as Offchain Labs for Arbitrum and Optimism PBC for Optimism. While this centralization was necessary in their guarded launch phase, it poses a risk to the network’s security and decentralization.

However, as the network develops, the sequencer's role will be decentralized, allowing anyone to participate in layer-2 block production and setting the foundation for layer-2 tokeneconomic models. This step will create a more decentralized and permissionless network. It will increase the participation of consensus participants in the network by allowing them to validate transactions and maintain ledger state while distributing block production. This will promote the network's security and decentralization, which are essential features of any blockchain-based financial system.

Zero-knowledge rollups is a different approach to improving the scalability of Ethereum's blockchain. The key difference between the two is that zero-knowledge rollups provide verifiable proof of the state transition, while optimistic rollups assume that state transition is valid unless proven otherwise. This difference in assumption leads to different finality periods, with zero-knowledge rollups only needing 45 minutes for verification, while optimistic rollups require a 7-day contention period to achieve transaction finality.

While zero-knowledge rollups offer a great solution to scalability, they currently face two primary challenges. Firstly, EVM equivalence is a critical issue, with Layer-2s like Starkware not being entirely compatible with Ethereum's EVM. This means that Solidity code cannot be ported to Starkware without first being rewritten in Cairo programming language, which poses significant overhead for developers. Secondly, the cost and time needed for producing validity proofs is not fully optimized, which limits its effectiveness.

Despite these challenges, work is underway to address them. The ultimate vision for zero-knowledge rollups is to achieve full EVM equivalence and improve the time and cost needed to produce validity proofs for state transitions. New zero-knowledge setups made specifically for optimal zero-knowledge proof times/costs are being developed, and hardware that is optimized for these proofs is also being explored. Both optimistic and zero-knowledge rollups offer benefits and have their unique set of challenges. The developments in both areas of layer-2 architecture will contribute to the continued innovation of blockchain technology.

Lastly, the zkEVM or Zero-Knowledge Ethereum Virtual Machine is an ambitious solution that aims to fully integrate the Ethereum Virtual Machine (EVM) into an arithmetic circuit that is used to compute zero-knowledge proofs. Instead of constructing a custom arithmetic circuit for every program, the zkEVM intends to implement every opcode within the EVM, so that any smart contract operating inside the EVM can have a proof-of-computation without the need for a custom arithmetic circuit. This approach will significantly reduce developer overheads, but it requires several novel cryptographic techniques and optimized hardware to decrease proof times. Teams such as Scroll, zkSync, and Polygon are working on the implementation of the zkEVM to make the Ethereum network more scalable.

The zkEVM requires the use of a zero-knowledge optimized cryptographic hash function, polynomial commitments, lookup tables, recursive zero-knowledge proofs, and zero-knowledge optimized hardware. The codebase for this solution is extensive, and hence it has a large attack surface, resulting in a long guarded launch phase to battle test the solution. In the immediate term, optimistic rollups such as Arbitrum and Optimism may outperform the likes of Scroll and zkSync.


Modularity in Layer-2 architecture

Modularity in Layer-2 Architecture is a crucial factor in efficiently implementing the solution. The debate between the monolithic and modular architecture has become prominent as engineers understand that blockchains are composed of several interlinked systems, each with its own purpose in the lifecycle of state updates to the ledger. Modular components adhere to the UNIX philosophy of software development, wherein software is batched into single-purpose modules that function efficiently. These modules can be imported and reused, abstracting the workload associated with programming and preventing repeating operations that have already been tested.

Optimism Bedrock Architecture is an example of the application of modular components and the best way to illustrate the benefits of this approach. The architecture offers several core components that developers can import and reuse, such as Optimistic Rollup (OR), Optimistic Virtual Machine (OVM), State Repository, and Data Availability Chain (DA-chain). The separation of concerns offered by this architecture provides several benefits, including improved security, better scalability, easier code management, and faster development cycles. The development of zkEVM and modularity in layer-2 architecture demonstrates the continued innovation of blockchain technology and provides solutions that address the challenges faced by Ethereum in terms of scalability, security, and decentralization. These approaches offer great potential to improve the efficiency of blockchain technology while fostering its adoption in various industries.


What is EIP-4844?

To pursue scalability while maintaining decentralization, Ethereum has been following a rollup-centric roadmap. Optimistic rollups are the most production-ready scalability solutions, have been functioning on the mainnet since December 2021, while zero-knowledge rollups have only been deployed to the mainnet. In the short term, it will be critical that optimistic rollups decrease the gas cost associated with posting data to Layer-1 to improve throughput and lower gas costs for users which are major pain points today. The posting of data to Layer-1 remains costly for users, despite optimistic rollups offering cheap costs for Layer-2 execution and storage. The calldata opcode is used to publish data to Ethereum's Layer-1, and Arbitrum and Optimism have been using compression algorithms like Zlib and the brotli compression algorithm to reduce gas costs. Sush optimization reaches its theoretical limits under Optimism Bedrock architecture, minimizing Layer-1 transaction costs before the implementation of EIP-4844.

The fees L2s pay to post their transaction data to Ethereum reduces by 90% with the help of 4844. L2 contributions to Ethereum gas fees are becoming increasingly significant, with 8% of total gas fees already being paid by them. This percentage has been growing rapidly, comprising 3% of total Ethereum gas six months ago. L2 transactions have been growing, and this has been the cause of 70% of the year on year growth in gas from February to April this year. Below is a chart showing Ethereum gas paid by usage type.

Source: artemis.xyz

The Ethereum Improvement Proposal (EIP) 4844 proposes a new transaction type known as a blob-carrying transaction as a way to change how data is posted to Ethereum's Layer-1. The current approach of using calldata is costly, but the blob transaction is estimated to reduce Layer-2 transaction gas fees by a minimum of 20x. With this new transaction type, data is not posted to Layer-1 but is stored in the Beacon chain nodes' consensus layer for around 14-30 days. For contestation periods, such as with Optimistic rollups, the data needs to be available for seven days, but once the transactions are finalized, the blob data used for data availability doesn't need to be persisted and can be wiped from the consensus node.

Originally, this was to reduce the gas cost of the calldata opcode by 10x to make posting data to Ethereum's Layer-1 cheaper. However, this would increase the average block size, requiring additional node hardware and storage capacity since the data is stored in the execution layer with no form of pruning. Instead, the Proto-danksharding method stores the blob data in the consensus layer on the Beacon chain and is downloaded by the consensus clients known as "blob space." Consensus clients can prune the data after the time period for blob data storage has expired for Layer-2 data availability, proving much more feasible than storing the data in the execution layer indefinitely. EIP-4844 proposal for a new transaction type and the implementation of "blob space" is a promising solution for reducing gas costs and improving data availability for Layer-2 transactions. The successful implementation of EIP-4844 would significantly benefit the blockchain industry, offering solutions to some of the most challenging issues faced by blockchain technology.


What’s next for Layer-2’s? Layer-3’s?

After outlining the history of layer-2’s, different approaches in architectures and the upcoming EIP-4844 catalyst what thesis can we operate on? Users prefer lower transaction fees due to Ethereum's core scalability limitations and its emphasis on maintaining a decentralized network. Ethereum's layer-1 will likely become a data availability/proof layer for layer-2's, leading to a decrease in on-chain activity over time. With Ethereum's TVL at $25.25B and Optimism/Arbitrum TVL at $802.32m and $2.08b, respectively, capital is expected to migrate from Ethereum to layer-2 networks due to low transaction fees. EIP-4844 is a central catalyst in this migration, predicted to reduce transaction fees on Optimistic rollups by a minimum of 20x. In the long term, it is estimated that 70% of Ethereum's layer-1 TVL will migrate to layer-2's within the next five years. These layer-2's are expected to become the standard network for onboarding new users, and new users will primarily interact with layer-2's rather than Ethereum's layer-1. Therefore, layer-2s should be considered the stronger beta relative to ETH and have a higher probability of outperforming ETH on an annual basis. In addition, with layer-2 modularity, projects will be able to deploy their own 'opchains' that inherit the sequencer of the original Optimism Layer-2 and allow for cross-chain atomic transactions. Appchains or sovereign chains will be able to maintain their performance without interference from other DApps. Another example is zkSync's 'HyperChains' which enable developers to customize their chains while ensuring cross-chain atomic transactions. In summary, these developments showcase the potential of layer-2 and layer-3 solutions to enhance Ethereum's scalability and the growth of the blockchain industry.


Conclusion

Layer-2 solutions are integral to Ethereum's scaling roadmap, and the limited scalability of Ethereum has resulted in a layer-1 rotation trade. Optimistic rollups are reducing transaction fees with the help of calldata compression algorithms and are now in their guarded launch phase. EIP-4844 will further enhance the scalability of Optimistic rollups. With a significant reduction in layer-2 transaction fees, an expected migration of liquidity to Optimism and Arbitrum is highly probable. As Ethereum has the largest developer community and the best developer tooling, developers are likely to transition their decentralized applications to Optimistic rollups to reduce gas costs for users. It is estimated that the majority of on-chain activity will occur on Optimistic rollups within the next three years, allowing for immense value capture as liquidity and on-chain activity move towards a more affordable transaction environment.

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