Vampire attack! LooksRare vs. OpenSea

Analyzing a new contender for NFT marketplace dominance

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Connor Dempsey, Justin Mart, & Mike Cohen (WE’RE HIRING)

Only in crypto can a platform built by anonymous founders come out of nowhere to challenge an industry leader, all in a matter of weeks.

That’s precisely what happened with the launch of NFT marketplace LooksRare, whose $9B+ in January volume nearly tripled that of OpenSea. On top of that, within 30 days of launch LooksRare produced $307M in protocol revenue, vs OpenSea’s $110M over the same period.

The raw numbers don’t tell the full story, however…

In this edition of Around The Block, we’ll explore the LooksRare vampire attack of industry leading NFT marketplace OpenSea.

The OG vampire attack

Vampire attacks are purely a crypto/Web3 phenomena. At their highest level, a vampire attack refers to a method for sucking users out of an existing platform into a competing one by offering some kind of incentive (typically tokens).

The most notorious vampire attack occurred in 2020, when SushiSwap launched a near identical decentralized exchange to industry leading Uniswap with one key difference: users who migrated their liquidity from Uniswap to Sushiswap were given $SUSHI tokens. $SUSHI offered holders governance rights over the platform in addition to a cut of trading fees collected on SushiSwap.

The result? Uniswap’s liquidity temporarily took a nosedive, as users moved $1.2B in funds over to Sushiswap to cash in on the superior incentives being offered. Uniswap eventually recovered and responded with a token launch of their own, but a new DEX was bootstrapped over a relatively short period of time.

LooksRare’s vampire attack

LooksRare followed the typical vampire attack playbook which is as follows:

  1. Identify industry leader
  2. Build competing, yet strategically differentiated platform
  3. Offer superior incentive for users who migrate over

The main difference between SushiSwap’s attack and LooksRare’s is that SushiSwap was a near identical copy of Uniswap’s code (known as a fork) with token incentives built on top. LooksRare appears to have built their own smart contracts (according to their documents); everything else in the playbook is the same:

  1. Identify industry leader: in this case, it’s OpenSea by a country mile.
  2. Build a competing, yet differentiated platform: looksrare.org.
  3. Offer superior incentives for users to migrate: meet the $LOOKS token.

A $LOOK at the initial incentives

Due to the open-sourced nature of blockchains, the LooksRare team was able to identify OpenSea users who had traded at least 3 ETH worth of NFTs over the prior six months and airdrop them LOOKS tokens. However to claim these free tokens, users first had to list an NFT on the LooksRare exchange.

Airdropping tokens to an existing community of active NFT traders proved effective, as NFTs flooded onto the new marketplace. The LOOKS token would climb to nearly $7 just 10 days after launch, fetching a $1B marketcap in the process.

And the incentives didn’t stop there…

MOAR Incentives

Beyond the initial airdrop, users of the LooksRare platform could earn more tokens by staking their LOOKS and by trading NFTs on the platform. LooksRare charges a 2% fee for every sale (vs. 2.5% on OpenSea), and staking (locking LOOKS into a smart contract) entitles stakers to 100% of those fees. Stakers also earn additional LOOKS on top of trading fees.

At the time of writing, staking LOOKS earns an eye-popping 500%+ APR.

The trading incentives is where things start to get interesting. It’s pretty simple: buy or sell an NFT on LooksRare and earn LOOKS. Rewards are paid out daily, based on the % of that day’s volume. Currently 2.8M LOOKS, or just under $10M USD at current prices, are being awarded daily.

So far, a free airdrop was enough to get people to the platform, and a $10M daily reward has been enough to keep daily trading volumes outpacing OpenSea. However, when you look the total daily # of users, it’s clear that these volumes aren’t as impressive as they initially appear.

Wash trading

While LooksRare is doubling OpenSea’s volume on any given day, OpenSea has 20–40 times more active users than LooksRare. This suggests that LooksRare’s volume is fueled by a small number of traders gaming the incentive system to earn LOOKS.

There’s nothing stopping a user from swapping the same NFT back and forth between their own wallets at a high dollar amount. Since daily rewards are paid out as a % of the day’s volume, if, for example, someone can wash trade their way to 10% of that day’s volume, they can net $1 million in LOOKS.

The wrinkle here is that for every trade, users must pay a 2% fee priced in ETH. The math works out such that the fees traders are paying in ETH are roughly equal to the rewards being paid in LOOKS. As such, traders are basically swapping ETH for LOOKS, which will pay off should the price of LOOKS appreciate relative to the price of ETH.

Essentially, there’s an interesting bit of game theory in motion, as early adopters will be rewarded should the LooksRare platform succeed.

Beyond wash trading

At this point, no one would dispute that LooksRare’s staggering volumes are a result of their lucrative incentive scheme. However, that doesn’t necessarily mean that LooksRare is all hat and no cattle.

At the end of January, Crypto Slam estimated that about $8B of the $9B in January volume was washtrading. However, the remaining legitimate NFT volume is still more than what NFT marketplaces Rarible, SuperRare, Foundation, Makersplace, and Aysnc did in all of 2021 combined.

Even with washtrading eliminated, LooksRare’s launch can still be considered a success. Plus they offer other interesting and novel features such as no transaction fees for private sales and the ability to make a single offer across an entire collection of NFTs. Lastly, their “real volume” is continuing to grow.

Is it sustainable?

LooksRare’s trading rewards will wind down over the course of the next two years, at which point the marketplace will have to compete on its product and community alone. Whether it can continue to grow its market share without powerful incentives is up to the anonymous team behind it.

We can look to its vampire attacking predecessor, SushiSwap, for a glimpse into what the future may hold. SushiSwap by many measures has remained relevant after its initial rewards dried up. They continued to innovate and deploy across multiple chains, with nearly $5B in TVL today.

However, usurp Uniswap they did not. Uniswap eventually launched a token of its own (there’s speculation that OpenSea may one day do the same) and has maintained its standing as crypto’s dominant DEX with over $7.5B in TVL today. It’s also worth noting that no contentious hard fork (Bitcoin Cash, Ethereum Classic, etc) or vampire attacker (SushiSwap, Swerve, etc) has ever supplanted an incumbent.

While Sushiswap has enjoyed success, it has had its fair share of struggles as well. Community infighting between the core team and Sushi token holders led to the exit of several high profile team members, including the project’s CTO. Once LooksRare hands governance over to LOOKS holders, it will likely be reminded of how nascent and messy DAO governance truly is.

Lastly, for LooksRare users, it bears mentioning that anon teams always come with rugpull risk. On top of that, LooksRare’s smart contracts launched unaudited and without a public GitHub repo — so trader beware.

Top analysis on LooksRare and past vampire attacks

Top tweets on LooksRare

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.


Vampire attack! LooksRare vs. OpenSea was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.

Crypto’s 69 most interesting charts from 2021

As most of us were enjoying some R&R over Christmas break, Coinbase Cloud protocol specialist Elias Simos was scouring the web for the most interesting crypto charts of 2021: 69 of them to be exact.

In the latest Around The Block podcast, we sit down with Elias and discuss some of the most interesting data points from the year, and what it all means for the future. (High level takeaways below)

Metaverse and smart contract assets outperform

Price isn’t everything, but the two top performing assets in 2021 are indicative of broader trends throughout the year. 2021’s best performing assets were:

  • Metaverse gaming tokens
  • Smart contract platform tokens

The governance tokens of gaming worlds Axie Infinity (AXS) and The Sandbox (SAND) each posted 16,000 and 13,000 percent gains respectively. Meanwhile, platform tokens from Polygon, Terra, Solana, and Fantom, all posted 8,000% gains or more.

Given that play-to-earn gaming had a breakout year, and layer 1s not named Ethereum saw strong adoption, these trends should be of no surprise. Now let’s dig a bit deeper.

The state of Layer 1s

Ethereum’s native token (ETH) did a modest 2X over the year, while it was somewhat of a rough year for Ethereum DeFi blue chips, with the DeFiPulse index down 80% over the year vs ETH.

The price of DeFi assets doesn’t tell the entire story, however. TVL of Ethereum DeFi applications showed tremendous growth over the year, and the number of unique Ethereum addresses interacting with DeFi protocols 4x’ed.

DefiLlama and Decentral Park Capital

Regardless, ETH killers and sidechains won the year when measured by growth of overall market share.

DefiLlama and Decentral Park Capital

The great migration & the EVM standard

In May, there was $200M sitting in Ethereum bridges. That number climbed to $20B by the end of the year, underscoring the great migration of value from Ethereum to other ecosystems.

The flipside, however, is that despite this migration away from Ethereum, most value still sits in EVM (Ethereum Virtual Machine) compatible environments.

Remember that the EVM is essentially the brain of Ethereum that performs computations for the network. When other Layer 1s adopt the EVM, it makes deploying existing applications on new networks easier for developers, in addition to making it easier for users to migrate to these new chains.

The dominance of value on EVM compatible chains (Avalanche, Polygon, etc) suggest that a standard is forming around the EVM. This should ultimately keep Ethereum as the gravitational center of the smart contracting world, as ETH applications and assets will be natively interoperable with most other chains.

Rise of the app chains

While EVM chains still dominate the landscape, the end of 2021 saw a rise in value on Tendermint chains. Recall that Tendermint is a standard popularized by Cosmos, that lets developers build application specific blockchains that are capable of interoperating with one another.

Building app-specific chains in the past came with significant opportunity cost, because they were cut off from most liquidity and users. With the growth of Tendermint chains like Osmosis (AMM), Umee (lending), and Stargaze (NFTs), that’s becoming less of an issue.

Now that these app specific chains have a widening array of use cases and liquidity that they can interoperate with, look for more builders to take advantage of customizability that these chains offer in 2022.

The ENS airdrop + DAOs

In 2021, ENS reminded everyone of Web3’s native user acquisition strategy: the airdrop.

ENS (Ethereum Name Service) addresses are best thought of as email addresses that you can send money to (e.g. Jimbo.eth). After 5 years in development, the project shifted to a DAO model, and airdropped ENS governance tokens to every user with an ENS address.

After the drop in November, awareness of ENS and registration of .eth addresses skyrocketed.

Dune Analytics, matoken.eth

Since the ENS DAO treasury collects revenue from new .eth registrations, revenue for the newly minted ENS DAO treasury ramped up significantly: another testament to how much a well orchestrated airdrop can move the needle.

Dune Analytics, matoken.eth

Beyond ENS, DAOs had a strong year, evident by the growing usage in key pieces of DAO infrastructure. Gnosis Safe, which is the most popular multisig wallet DAOs use to manage their treasuries, saw 3x growth in both the number of Safes and transactions executed in 2021. Snapshot, a tool that helps DAOs execute off-chain votes with on-chain verification, exhibited strong growth as well.

EN-EFF-TEES

Activity on the dominant platform for NFTs tells you all you need to know about the breakout year NFTs enjoyed.

Dune Analytics, Richard Chen

OG NFT CryptoPunks saw 60x YoY growth, reaching a total volume of 650K ETH, or $1.7B at current prices. This figure however, includes a flashloan powered $500M wash sale — a powerful reminder of how much subjectivity there is in on-chain data.

The second most notable NFT project of the year was Bored Ape Yacht Club, which went from a niche community to the celebrity NFT of choice, including the likes of Steph Curry, Shaq, Justin Bieber, Jimmy Fallon, Paris Hilton, among others. At one point the BAYC floor (price of the cheapest NFT in the collection) momentarily flipped the CryptoPunks floor.

In the heat of new issuances flooding the market, and older NFT collections achieving billion dollar market caps, the average price of NFTs changing hands did a 150x from 0.1 ETH to roughly 15 ETH by year end.

Dune Analytics, Richard Chen

One of the most interesting NFT launches of the year was Loot (covered here), which let anyone mint 1 of 8,000 NFTs that could form the basis of a Dungeons and Dragon style RPG game. Initial excitement was skyhigh, before fizzling out as time went on.

Dune Analytics

While Loot’s flame may have dimmed, it was still a landmark year for NFT based gaming, with the breakaway success of Axie Infinity bringing play-to-earn and GameFi narratives to the forefront. As the data shows, Axie Infinity NFT volume dwarfs that of any prior NFT based game.

CryptoSlam and The Block

Lastly, while Ethereum was the center of the NFT show, marketplaces appear to be springing up across multiple chains. The data shows that lower fee environments are enabling different types of user activity. Solana’s Magic Eden, for example, has more transactions than OpenSea since users are unencumbered by exorbitant gas fees.

More in Elias’s epic thread

Beyond being chock-full of illuminating data points on the year in crypto and Web3, the full thread underscores the beauty of on-chain data and the increased maturity of the industry. The ability for one person to put together a dataset this rich is a testament to all of the great data providers the industry now has at our disposal.

If you haven’t already, check out the full thread which covers Bitcoin, Ethereum, MEV, L2 adoption, ETH2, staking, Web3, memecoins, DEXes, stablecoins, and a whole lot more.

~Written by Connor Dempsey & Justin Mart.

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.


Crypto’s 69 most interesting charts from 2021 was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.

Reflecting on Coinbase Ventures’ record year in 2021

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Connor Dempsey, Ryan Yi & Justin Mart.

2021 was a historic year for both crypto markets and venture capital funding. Driven in part by institutional inflows, Bitcoin soared to new highs to start the year, the entire market followed suit nearing a record $3T market cap in November. Meanwhile, $30B in venture funding poured into the space: more than all prior years of crypto’s history combined.

2021 was also a record year for Coinbase Ventures, with just under 150 deals, averaging a new deal every 2.5 days. On a cumulative basis, more than 90% of the capital Coinbase Ventures has deployed since inception was deployed in 2021, reflecting an accelerated pace of activity in our fourth year of operation.

Coinbase Ventures is among the most active corporate venture funds in operation, with the mandate of increasing economic freedom around the world by supporting the leading entrepreneurs and projects in the ecosystem. Ultimately, we see crypto and Web3 as a rising tide that lifts all boats, Coinbase included, and Coinbase Ventures is dedicated to making investments that are crucial to the space’s overall growth.

In this edition of Around The Block, we’ll peer into the future through the lens of Coinbase Ventures’ 2021 activity. (Learn how Ventures aligns with Coinbase and its customers here).

Deal split by practice area

Coinbase Venture’s portfolio now consists of over 250 companies, and broadly breaks down across the following verticals.

Let’s break down the pie, slice by slice.

Protocols & Web3 infrastructure

2021 saw crypto reach new heights in terms of utility, particularly in the nascent “Web3” space, which we generally think of as a trustless, permissionless, and decentralized internet that leverages blockchain technology: essentially, the plumbing that underpins everything from DeFi, NFTs, metaverses, and DAOs. At the bottom of the Web3 stack sit Layer 1 protocols, led by Ethereum, but 2021 saw Web3 begin to expand to other Layer 1s like Solana, Polygon, Avalanche, Terra, Flow, among dozens of others.

To help scale existing Layer 1s and enable higher throughput, we supported Layer 2 solutions including Matter Labs, Optimism, and Arbitrum. As multiple Layer 1s have proliferated, so has the demand to safely and easily move funds across blockchains. As such, Ventures’ was active in investing in projects working to facilitate this cross-chain movement, including Biconomy, Movr, LayerZero, Chainflip, and more. We also observed and funded new protocols working to bring better privacy to Web3 through various zero-knowledge solutions (Aleo, MobileCoin, and a third TBA).

We were also active across the infrastructure layer of the Web3 stack: primitives that form the backbone of user applications. Specifically, technologies that introduce standards to Web3 for data storage (Arweave), messaging (XMTP), and identity (Spruce). Given that 2021 was a great year for DAOs, we were active across infrastructure projects focused on enabling DAO creation/incorporation (Syndicate, Utopia), discovery/participation (Snapshot/Consensys’ Metamask), payroll/operations (Diagonal), and coordination (Orca).

Given investments made over the year, in 2022 we expect to see Web3 mature across multiple Layer 1 and Layer 2 ecosystems with UX that more closely resembles Web2 applications. Additionally, we expect to see the continued flourishing of DAOs in the year ahead, as well as better privacy features for Web3 applications.

DeFi

While 2021 hinted at a future where Web3 activity takes place across multiple Layer 1 and Layer 2 platforms, DeFi activity already began its migration over the course of the year. Much of this activity took place within EVM compatible chains (Avalanche, Polygon, BSC etc.) and Layer 2 environments (Arbitrum, Optimism). Meanwhile, non-EVM chains (Solana, Terra, Cosmos, Polkadot etc.) also saw impressive growth.

We’re believers in the multichain future, and although we remained most active within Ethereum’s DeFi ecosystem, we also invested across Solana (Orca, Solend), Cosmos (Umee), Algorand (Folks), Polkadot (Acala, Moonbeam), NEAR, Polygon and Bitcoin. The multichain future of France appears bright, with just about every financial primitive one could imagine in development.

While DeFi made great strides in 2021, exploits of these nascent financial protocols hampered the ecosystem, amounting to over $10B. Better user protection remains paramount, which is why Coinbase Ventures supported DeFi insurance financial protocols including Neptune Mutual, Risk Harbor, Cozy Finance, and Nayms.

In 2022, the smart contract wars will rage on as Layer 1s and Layer 2s fight for user and developer mindshare. Hacking risks will persist but we’ll see increased maturity in DeFi insurance solutions. Lastly, it’s shaping up to be the year we see institutions enter the fray via “permissioned DeFi”, complete with KYC’d user pools and on-chain attestations.

NFT / Metaverse

2021 was also a year that saw the rapid rise of NFTs and renewed interest in “the metaverse.” Projects like CryptoPunks and Bored Ape Yacht Club took NFT sales from $200M in 2020 to a staggering $25B in 2021. Meanwhile, NFT based game Axie Infinity put play-to-earn gaming on the map as people in the Philippines were able to turn the game into a full time job. And elsewhere, Facebook’s rebrand to “Meta” catalyzed excitement around the metaverse.

In large part, NFTs spent 2021 in their “V0” phase, with most activity centered around simple buying and selling on marketplaces like OpenSea and Rarible. 2021 also saw NFTs emerge across L1/L2 ecosystems such as Flow (MomentRanks, Eternal GG) and Solana (Magic Eden, Solanalysis).

Ventures has now invested heavily in the NFT “utility” phase — one in which NFT assets expand to new types of mediums such as audio (Royal, Mint Songs, Sturdy), avatars (Genies, OFF), AR (Anima, Jambo), and gaming/GameFi (Ancient8, GuildFi). This will allow interesting social features to be layered on top of the programmatic recognition of NFTs (Gallery).

These NFT and gaming investments can broadly be bucketed with the metaverse, as they inch us closer to a possible future where we have a series of decentralized, interconnected virtual worlds with fully functioning economies. In 2022, look for a host of new gaming titles and applications, including those launched by traditional gaming studios. Also expect metaverse applications to expand from both decentralized initiatives like Decentraland and the Sandbox and incumbent Web2 companies like Microsoft/Activision and Meta.

Platform & Developer Tools

Without developers, there would be no crypto or Web3 applications for anyone to use. As such, support for the tooling that developers need to make crypto and Web3 thrive is a critical part of advancing the ecosystem.

Over the year, we followed the “developer journey” from staging (Tenderly), collaboration (Radicle), query (Covalent), audit (Certik, OpenZeppelin, Certora) and real-time simulation/monitoring (Chaos Labs, Gauntlet). We also invested in developer toolkits like API providers (Alchemy, Consensys’ Infura).

We expect the industry’s collective investment made in dev tooling to pay dividends in the years to come. With all of the developers pouring into Web3 from Web2, they’re sorely needed.

CeFi

Much of the value that finds its way into crypto initially does so through centralized platforms, and as such, centralized finance (CeFi) remains an active category. We believe that crypto is inherently global and there is a need for localized platforms that serve as onramps across distinct regulatory, banking, and infrastructure regimes. This is why in 2021, we were active investors in crypto financial service providers everywhere from LatAm, Pan-Africa, MENA, South Asia, Europe, and North America.

The year also saw a move towards traditional vehicles for crypto exposure — IRAs, IAs, ETFs, Trusts, etc. — punctuated by the approval of the BTC Futures ETF in the US. Coinbase Ventures actively invested in asset managers and brokers including AltoIRA, Onramp, Valkyrie, ForUsAll, Ledn, and One River Digital. We were also investors in various CeFi “picks and shovels”, with follow-on investments in TaxBit and CoinTracker, which automate crypto tax reporting across platforms. In addition, we supported projects helping startups integrate crypto with traditional fintech offerings, including Paxos, Tribal Credit, and Meow.

2021 set the stage for more regulated and compliant ways for institutional and individual investor capital to gain crypto exposure through centralized exchanges and traditional investment vehicles and fintech platforms in both the US and abroad. We expect this to be an ongoing theme in 2022.

2022 & beyond

Macro uncertainty has prices falling sharply into the new year, but one thing is certain: this is not the crypto ecosystem of 2018. Between the best performing asset class of the last decade being much more accessible to investors around the world, the maturation of the Web3 stack, and an explosion of exciting new use cases across DeFi, NFTs, DAOs, gaming, and the metaverse, this industry appears to be hitting escape velocity.

Just as the boom of 2017 fueled investments that laid the groundwork for the applications that are thriving today, what do you think the record $30B funneled into crypto and Web3 in 2021 will yield? The market appears uncertain in the near term, but the future appears brighter then it’s ever been.

More great year-end recaps

Top year-end tweets

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.


Reflecting on Coinbase Ventures’ record year in 2021 was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.

A simple guide to the Web3 stack

Web3 is the latest buzzword to see an uptick in interest in recent months — What does it actually mean?

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Connor Dempsey, Angie Wang & Justin Mart.

A lot of definitions have been thrown around, but at Coinbase, we generally think of Web3 as a trustless, permissionless, and decentralized internet that leverages blockchain technology.

Web3’s defining feature is ownership. Whereas the first iteration of the commercial internet (Web1) was read-only for most users, and Web2 allowed users to both read & write on centralized platforms (Twitter, Facebook, YouTube, etc), Web3 gives users full ownership over their content, data, and assets via blockchains. It empowers users to read-write-own.

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Where a third party like Facebook owns your identity and data in Web2, your identity in Web3 can move fluidly between platforms without your data being captured and monetized by service providers. While Web2 apps are centrally controlled, tokens in Web3 grant users the right to help govern the services they use, representing a form of ownership in the platforms themselves.

With that framing in mind, what does the Web3 stack look like?

The Web 3 stack

The Web3 stack is still nascent and fragmented, but with much innovation over the years, it’s beginning to come into focus. What follows is not a mutually exclusive nor completely exhaustive lay of the land. Rather, it’s a framework for thinking about this landscape as it continues to evolve.

Let’s start from the bottom up.

Protocol Layer

At the bottom of the stack, we have the protocol layer. This is made up of the underlying blockchain architecture on top of which everything else gets built.

Bitcoin is the granddaddy of them all, and while it doesn’t play a major role in Web3 today, it pioneered the ability for someone to own a scarce digital asset through the use of public-private key cryptography. Following Bitcoin, came a range of layer 1 smart contract platforms like Ethereum, Solana, Avalanche, Cosmos, etc, that serve as the foundation for many of the Web3 applications currently in production.

Bitcoin and Ethereum each have additional protocols built on top of them. Bitcoin has networks like the Lightning Network (for fast and cheap payments) and Stacks (for smart contracts), among others. To alleviate its capacity limitations, multiple layer 2 scaling protocols have been built on top of Ethereum.

With the rise of many layer 1 and layer 2 networks came the need to bridge value between them. Enter cross-chain bridges that serve as highways that let users move value from one chain to another (useful cross-chain dashboards can be found here and here).

Infrastructure / Category Primitives

The infrastructure layer sits on top of the protocol layer and is composed of interoperable building blocks (what we’re calling “category primitives”) that are highly reliable at doing a specific task.

This is a dense and diverse layer, with projects building everything from smart contract auditing software, data storage, communication protocols, data analytics platforms, DAO governance tooling, identity solutions, financial primitives, and more.

For example, Uniswap enables the swapping of one asset for another. Arweave enables data to be stored in a decentralized manner. ENS domain names can serve as a user’s identity in the world of Web3. A user can’t do much with each standalone application. However, when combined, these category primitives act like lego bricks that a Web3 developer can use to construct an app.

Use Case Layer

Atop the protocol and infrastructure layers sit the use case layer, where it all comes together.

Take a blockchain based game like Axie Infinity, which uses Ethereum tokens and NFTs that can be bridged to a low-cost/high throughput sidechain called Ronin. Players often use Uniswap to swap ETH for the tokens needed to play the game. Similarly, decentralized blogging platform Mirror uses the storage protocol Arweave to store data. Meanwhile, it leverages Ethereum to let publishers get paid in crypto, often by directing tokens to their ENS address.

You’ll notice that Uniswap appears both in our infrastructure and use case sections. This is because, while at its core Uniswap is simply a series of smart contracts, it also provides a frontend that users can interact with directly. Put differently, it simultaneously serves as a standalone user-facing app as well as infrastructure for other Web3 apps like Axie Infinity.

Access Layer

At the tippy top of the stack sits the access layer — applications that serve as the entry point for all manner of Web3 activities.

Want to play Axie Infinity or get paid for your content on Mirror? First thing you’ll need is a wallet, which serves as the main point of entry for most Web3 applications. Fiat onramps like Moonpay, Wyre, or exchanges like Coinbase help users trade their fiat money for crypto in order to get started.

With some crypto in a wallet, users can head to an aggregator like DappRadar to browse through and connect to all kinds of Web3 applications in one place. Other projects like Rabbithole help users discover and learn how to use various Web3 applications. There are also aggregators like Zapper, Zerion, and Debank that help users track all of their activities and assets across various apps.

Lastly, we’re close to a future in which Web2 platforms where cryptonative communities already gather, like Reddit and Twitter, serve as an entry point for Web3. Reddit’s long-awaited crypto initiative will let certain communities tokenize, rewarding users with tokens and likely NFTs for active participation. Twitter already boasts an integration with Bitcoin’s Lightning Network to let users tip others in BTC.

The ever-evolving stack

The protocols, infrastructure, user applications, and access points named above make up the nascent, yet evolving world of Web3: an internet owned by its users. Beyond ownership, the power of Web3 lies in its modularity and interoperability. Essentially, this means that there are endless ways that the above stack can be combined to create new and interesting use cases — a feature that we expect will lead to a Cambrian explosion of new, world-changing applications.

While the framework and layers we highlighted will likely stay unchanged, we expect the projects and opportunities within them to evolve dramatically in the coming years.

Web3 Reads

Web3 Tweets

Previous editions of Around The Block

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.


A simple guide to the Web3 stack was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.

DAOs: Social networks that can rewire the world

Exploring the new world of decentralized autonomous organizations

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Justin Mart & Connor Dempsey.

What the internet did for communication, DAOs can do for capital.

The internet and social networks have made it easier for like minded individuals to communicate than ever before, regardless of geographic location. The advent of digitally native money and finance have now enabled a new kind of social network that allows for like minded individuals to not just communicate, but also coordinate around capital. As with their predecessors, these new networks are unconstrained by geographic borders, capable of forming at massive scale or across a small number of select participants.

The most optimistic thinkers believe that decentralized autonomous organizations can reinvent how humans organize and eventually eclipse the size and scope of the world’s largest corporations and even nation-states.

In this edition of Around The Block, we explore the current DAO landscape and big questions surrounding their future.

What is a DAO?

Simply put, DAOs are software enabled organizations. They allow people to pool resources toward a common goal and share in value creation when those goals are achieved.

Just as the LLC (limited liability corporation) was the preferred organizing primitive of the industrial revolution, DAOs can be the same for Web3. Where corporations are rooted in the legacy financial system and organized through legal contracts, DAOs run on top of open blockchain networks like Ethereum, organized by tokens with their rules encoded in smart contracts.

DAOs aren’t tied to a physical location, which allows them to mobilize quickly and attract talent from all over the world — a notion that was on full display when the ConstitutionDAO recently raised over $40M from 17,000 contributors in less than a week in a failed bid to buy one of the original copies of the US constitution.

But DAOs can do so much more than mobilize internet friends to collectively bid on historic documents — they can transform how we organize any manner of economic activity.

What do DAOs do?

There are already over 180 DAOs (tracked by deepdao.io) with $10B+ in assets under management and nearly 2 million members. These range from DAOs that help manage some of the largest protocols in crypto, to smaller DAOs organized around investment, social communities, media, and philanthropic pursuits.

Protocol DAOs

Ethereum led to an explosion of new crypto assets. From there, developers created protocols that let people trade and lend these new assets (like Uniswap, Compound, and Aave). However these protocols were intended to be decentralized, which created a need to figure out how to govern their growth and evolution.

Rather than put every key decision in the hands of a small team of developers, protocol DAOs emerged as a way to give a protocol’s users a collective say in its future direction. Typically, users are issued governance tokens, often directly based on past usage and contributions, that convey voting rights. Any user can propose ways to improve the project, and token holders can vote on whether or not the developers should move forward with the proposal. More tokens = more voting power.

For example, Uniswap token holders are currently voting on which layer 2 networks the decentralized exchange protocol should be deployed on. Token holders also propose and vote on anything from marketing initiatives to how Uniswap’s $2B+ treasury should be managed.

Governance tokens align the community around the future success of the protocol, as they should appreciate in value as the protocol grows — or fall should it fail.

As of December 7th, the largest protocol DAOs by AUM are Uniswap, Lido, Radicle*, Compound,* Olympus, and Aave.

Investment / Collector DAOs

The second largest category is investment and collector DAOs. These let people pool capital with the aim of investing in specific assets. They range from venture investments in things like DeFi protocols or NFTs, to increasingly ambitious efforts like buying rare historic documents or even professional sports franchises.

Similar to other forms of crypto crowdfunding, these DAOs offer a fast and simple means of capital formation when compared to costly and complex legal setups associated with a typical venture capital fund. These funds are also more transparent than traditional venture funds, since members can audit all transactions on chain.

PleasrDAO, MetaCartel Ventures, Flamingo, Komerabi, are all great examples of DAOs pooling resources, collectively making investment decisions, and sharing in the upside when those investments appreciate. In a similar vein, Syndicate* is a project building a suite of tools that let anyone easily spin up their own investment DAO.

Social DAOs

Social DAOs intend to bring like minded people together in online communities, coordinated around a token. The leading example is Friends With Benefits and its $FWB token. To join, members must submit an application and acquire 75 FWB tokens. Entry comes with access to a community full of prominent crypto builders, artists, and creatives as well as exclusive events.

By organizing around a token, members have the incentive to create a valuable community — share insights, host meetups and throw great parties etc. For example, as more people understood the benefits of joining the FWB community, the token appreciated in lockstep, sending the $FWB price from $10 to $75 and therefore membership cost from around $750 to around $6,000.

Other social DAOs use NFTs as the mechanism for unlocking access to a broader community. Owning a Bored Ape NFT for example, unlocks access to the Bored Ape Yacht Club discord, events, NFT airdrops, and merchandise. In this case, the perceived value of the community drives value to the collection of NFTs.

This category of DAOs are all still in their infancy and it will take time to learn which models work and which don’t, but the rapid rise of these communities suggest that they represent a powerful new powerful form of social organization.

Service DAOs

Service DAOs look like online talent agencies that bring strangers together from all over the world to build products and services. Perspective clients can issue bounties for specific tasks and once completed, pay the DAO treasury a portion of the fees before rewarding individual contributors. Contributors also typically receive governance tokens that convey ownership in the DAO.

Most of the early service DAOs, like DxDAO and Raid Guild, are focused on bringing talent together to build out the crypto ecosystem. Their clients consist of other crypto projects and protocols that need everything from software development to graphic design and marketing.

Service DAOs can reinvent how people work, allowing a global talent pool to work on their own time and receive ownership stakes in the networks they care about. While early service DAOs are crypto focused, one can envision a future where Uber is replaced by UberDAO that pairs drivers with riders, while paying drivers an ownership stake in the network (though it will be while before DAOs integrated beyond the purely digital realm).

Media DAOs

Media DAOs aim to reinvent how both content producers and consumers engage with media. Rather than rely on advertising based revenue models, these DAOs use token incentives to reward producers and consumers for their time with an ownership stake in a given outlet.

The idea of decentralized media dates back to 2013 with the “Let’s Talk Bitcoin” podcast, but BanklessDAO is a leading example in 2021. Bankless is an Ethereum-focused media outlet that produces a popular podcast and newsletter. Recently, the Bankless team airdropped the BANK token to its audience. With BANK acquired, readers can take an active role in the media outlet and earn additional BANK by producing content, research, graphic design, article translations, marketing services as well as vote on key decisions to direct the DAO.

At a time when many agree that the current ad-based media model is broken, media DAOs present a compelling alternative for realigning the interests between readers and producers.

Grants/Philanthropy DAOs

Grant and philosophy DAOs, similar to investment DAOs, pool capital and deploy it to various endeavors. The only difference is that allocations are made without the expectation of a financial return.

Gitcoin is a pioneer of this model, supporting grants for critical open source infrastructure that may otherwise have trouble getting funded. Similarly, large protocols like Uniswap, Compound, and Aave have specific grant DAOs that let the community vote on how their treasuries can be deployed to pay builders and developers to further the protocol.

Philanthropy DAOs are also starting to emerge to re-imagine how charitable donations can be made. Dream DAO for example, issued NFTs to raise funds before letting NFT holders vote on how those funds should be allocated towards the DAO’s mission (funding civic leaders in Gen Z).

The hurdles for DAOs

As this increasingly diverse landscape shows, DAOs can become the organizational primitive of Web3, reinventing how we govern, invest, work, create, and donate. Expect to see the categories, number, and quality of DAOs evolve dramatically in the future.

That said, they have a long way to go. Consider that DAOs are essentially tasked with reverse engineering hundreds of years of lessons learned from democracy and corporate governance! The scale of the challenge is palpable, and today we recognize 4 main deficiencies:

  • Lack of legal/regulatory clarity
  • Lack of efficient coordination mechanisms
  • Lack of infrastructure
  • Smart contract, fragmentation, & sustainability risks

Lack of Legal/Regulatory Clarity

Corporations have always been rooted in a specific place, with their right to exist bestowed first by monarchs, and eventually by cities and states. Those same municipalities have always set the rules that corporations in their jurisdiction must abide by. Given that DAOs don’t exist in any one place and don’t operate like corporations, they don’t fit cleanly into existing regulatory frameworks.

Where the rules around forming a new corporation while protecting members from certain liabilities are well defined, DAOs have to grapple with all sorts of thorny regulatory and legal issues. How are DAO tokens and treasury activities treated from a tax perspective? How should income paid to a DAO member be reported?

In the US, DAOs are currently faced with a faustian bargain of forming an LLC in a specific jurisdiction or being treated as a general partnership. The former undermines a DAOs ability to be governed by rules encoded in smart contracts in favor of standard LLC articles of incorporation (and being restricted by the constraints of existing LLC law). The latter potentially exposes members to liabilities through the partnership, which would otherwise be protected by the “limited liability company (LLC)”.

All of this uncertainty makes it difficult for DAOs to interact with non-crypto/Web3 entities, which is a major detriment. Wyoming has pushed forward legislation that will allow DAOs to operate on the same legal footing as traditional LLCs while allowing them to be governed by their own smart contracts but has been met with SEC resistance. Meanwhile, a16z, and OpenLaw have proposed clear legal frameworks for governing DAOs, but DAOs will have to continue to operate in a grey area for the foreseeable future.

All of this uncertainty underscores the notion that in the near term, DAOs growth will likely be concentrated purely in the digital realm — the legal complexity gets amplified when DAOs attempt to crossover to the physical realm (e.g UberDAO).

Lack of efficient coordination mechanisms

There’s a reason corporations and governments don’t have every employee or citizen weigh in on every decision — it’s a highly inefficient way of getting things done and not everyone is qualified to do so.

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Corporate hierarchies exist because you often need qualified people making the hard decisions. Many DAOs today exist under somewhat crude governance structures where 1 token equates to 1 vote. In larger DAOs with thousands of token holders, this can lead to chaotic decision making processes where voting power is more a function of buying power than expertise. Similarly, unappointed but high-profile members can gain oversized influence over decision making.

Most agree that for DAOs to be truly effective, they’ll have to explore advancements in governance structures, like shifting to a delegated authority model, where token holders can vote in qualified leaders to make key decisions in a transparent manner (something Orca Protocol* is exploring). In the near term, it’s likely that DAO governance will remain messy and chaotic as they experiment with different models before ultimately figuring out what works (much like the long experimental path from monarchies to democracy).

Lack of developed infrastructure

Just as corporations enjoy clear legal frameworks and efficient decision making processes, they also benefit from highly developed infrastructure on which to operate. DAOs on the other hand, are tasked with building most of that same infrastructure from scratch.

DAO tools for governance, payroll, reporting, treasury management, communication, and every other resource at the disposal of modern day corporations are still nascent. Thankfully, the DAO tooling landscape runs deep, and there are hundreds of teams working on tackling these deficiencies across a range of approaches.

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There’s too many great teams to name but on the governance tooling front, we’re excited about Messari’s* new aggregator for monitoring and participating in governance all from one interface.

Smart contract, fragmentation, & sustainability risk

It’s hard to discuss DAOs without referencing “The DAO:” The first ever DAO on Ethereum, designed around venture investing in 2015, that had 40% of its treasury hacked and drained of $60 million. As the recent $130 million exploit of BadgerDAO showcased, DAO treasuries remain vulnerable to smart contract risk.

Similarly, the largest crypto networks have a history of fragmentation caused by division from within the community. The Bitcoin/Bitcoin Cash split was caused by a technical dispute over blocksize. The Ethereum/Ethereum Classic split was caused by disagreements over how to respond to the above mentioned hack of “The DAO”. It’s reasonable to think that we’ll see the largest DAOs face similar headwinds.

On the other side of that coin, how sustainable are DAOs come another possible crypto winter? Will people continue to be excited about DAOs when token prices are continually falling, treasuries constrict, and both participation and membership dwindles?

Re-wiring the world with DAOs

While obstacles abound, DAOs represent a paradigm shift in economic organization. If Web3 is to become an internet collectively owned by its users, DAOs will be the organizational primitive in which that ownership is metered out.

2021 has seen a renaissance in new DAO experiments and models. Meanwhile, the landscape of projects and companies building out the tooling needed for DAOs to reach their true potential is among the richest in the industry. (Coinbase Ventures is actively investing in the DAO landscape, with a number of deals in the pipeline — reach out if you’re a project pushing the DAO landscape forward!)

Should these trends continue, we may one day see the biggest organizations, venture firms, media outlets, and institutions built not on legal contracts, but on open crypto networks. As crypto UX improves, DAOs may very well usurp the LLC as the preferred mode of organization in an increasingly digitized world.

PS — Look for more DAO focused products and services coming from Coinbase in the near future.

Further DAO listening from the Around The Block Podcast:

Previous editions of Around The Block

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.


DAOs: Social networks that can rewire the world was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.

Bitcoin & cryptocurrency news

Scaling Ethereum & crypto for a billion users

A guide to the multi-chain future, sidechains, and layer-2 solutions

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Justin Mart & Connor Dempsey.

As of late 2021, Ethereum has grown to support thousands of applications from decentralized finance, NFTs, gaming and more. The entire network settles trillions of dollars in transactions annually, with over $170 billion locked on the platform.

But as the saying goes, more money, more problems. Ethereum’s decentralized design ends up limiting the amount of transactions it can process to just 15 per second. Since Ethereum’s popularity far exceeds 15 transactions per second, the result is long waits and fees as high as $200 per transaction. Ultimately, this prices out many users and limits the types of applications Ethereum can handle today.

If smart-contract based blockchains are to ever grow to support finance and Web 3 applications for billions of users, scaling solutions are needed. Thankfully, the cavalry is beginning to arrive, with many proposed solutions coming online recently.

In this edition of Around The Block, we explore the crypto world’s collective quest to scale.*

To compete or to complement?

The goal is to increase the number of transactions that openly accessible smart contract platforms can handle, while retaining sufficient decentralization. Remember, it would be trivial to scale smart contract platforms through a centralized solution managed by a single entity (Visa can handle 45,000 transactions per second), but then we’d be right back to where we started: a world owned by a handful of powerful centralized actors.

The approaches being taken to fix this problem come twofold: (1) build brand new networks competitive to Ethereum that can handle more activity, or (2) build complementary networks that can handle Ethereum’s excess capacity.

Broadly, they break out across a few categories:

  • Layer 1 blockchains (competitive to Ethereum)
  • Sidechains (somewhat complementary to Ethereum)
  • Layer 2 networks (complementary to Ethereum)

While each differs in architecture and approach, the goal is the same: let users actually use the networks (eg, interact with DeFi, NFTs, etc) without paying exorbitant fees or experiencing long wait times.

Layer 1s

Ethereum is considered a layer 1 blockchain — an independent network that secures user funds and executes transactions all in one place. Want to swap 100 USDC for DAI using a DeFi application like Uniswap? Ethereum is where it all happens.

Competing layer 1s do everything Ethereum does, but in a brand new network, soup to nuts. They’re differentiated by new system designs that enable higher throughput, leading to lower transaction fees, but usually at the cost of increased centralization.

New layer 1s have come online in droves over the last 10 months, with the aggregate value on these networks rocketing from $0 to ~$75B over the same time period. This field is currently led by Solana, Avalanche, Terra, and Binance Smart Chain, each with growing ecosystems that have reached over $10 billion in value.

Leading non-ETH L1s by TVL

All layer 1s are in competition to attract both developers and users. Doing so without any of Ethereum’s tooling and infrastructure that make it easy to build and use applications, is difficult. To bridge this gap, many layer 1s employ a tactic called EVM compatibility.

EVM stands for the Ethereum Virtual Machine, and it’s essentially the brain that performs computation to make transactions happen. By making their networks compatible with the EVM, Ethereum developers can easily deploy their existing Ethereum applications to a new layer 1 by essentially copying and pasting their code. Users can also easily access EVM compatible layer 1s with their existing wallets, making it simple for them to migrate.

Take Binance Smart Chain (BSC) as an example. By launching an EVM compatible network and tweaking the consensus design to enable higher throughput and cheaper transactions, BSC saw usage explode last summer across dozens of DeFi applications all resembling popular Ethereum apps like Uniswap and Curve. Avalanche, Fantom, Tron, and Celo have also taken the same approach.

Conversely, Terra and Solana do not currently support EVM compatibility.

TVL of EVM compatible vs non-EVM compatible L1s

Interoperable Chains

In a slightly different layer 1 bucket are blockchain ecosystems like Cosmos and Polkadot. Rather than build new stand-alone blockchains, these projects built standards that let developers create application specific blockchains capable of talking to each other. This can allow, for example, tokens from a gaming blockchain to be used within applications built on a separate blockchain for social networking.

There is currently over $100B+ sitting on chains built using Cosmos’ standard that can eventually interoperate. Meanwhile, Polkadot recently reached a milestone that will similarly unite its ecosystem of blockchains.

In short, there’s now a diverse landscape of direct Ethereum competitors, with more on the way.

Sidechains

The distinction between sidechains and new layer 1s is admittedly a fuzzy one. Sidechains are very similar to EVM-compatible layer 1s, except that they’ve been purpose built to handle Ethereum’s excess capacity, rather than compete with Ethereum as a whole. These ecosystems are closely aligned with the Ethereum community and host Ethereum apps in a complementary fashion.

Axie Infinity’s Ronin sidechain is a prime example. Axie Infinity is an NFT game originally built on Ethereum. Since Ethereum fees made playing the game prohibitively expensive, the Ronin sidechain was built to allow users to move their NFTs and tokens from Ethereum to a low fee environment. This made the game affordable to more users, and preceded an explosion in the game’s popularity.

As of this writing, users have moved over $7.5B from Ethereum to Ronin to play Axie Infinity.

Polygon POS

Where sidechains like Ronin are application specific, others are suited for more general purpose applications. Right now, Polygon’s proof-of-stake (POS) sidechain is the industry leader with nearly $5B in value deployed over 100 DeFi and gaming applications including familiar names like Aave and Sushiswap, as well as a Uniswap clone called Quickswap.

Again, Polygon POS really doesn’t look that different from an EVM compatible layer-1. However, it’s been built as part of a framework to scale Ethereum rather than compete with it. The Polygon team sees a future where Ethereum remains the dominant blockchain for high value transactions and value storage, while everyday transactions move to Polygon’s lower-cost blockchains. (Polygon POS also maintains a special relationship with Ethereum through a process known as checkpointing).

With transaction fees of less than a penny, Polygon’s vision of the future looks plausible. And with the help of incentive programs, users have flocked to Polygon POS with daily transactions surpassing Ethereum (though spam transactions inflate this number).

Layer 2s (Rollups)

Layer 1s and sidechains both have a distinct challenge: securing their blockchains. To do so, they must pay a new cohort of miners or proof of stake validators to verify and secure transactions, usually in the form of inflation from a base token (e.g. Polygon’s $MATIC, Avalanche’s $AVAX).

However, this brings notable downsides:

  • Having a base token naturally makes your ecosystem more competitive rather than complementary to Ethereum
  • Validating and securing transactions is a complex and challenging task that your network is responsible for indefinitely

Wouldn’t it be nice if we could create scalable ecosystems that borrowed from Ethereum’s security? Enter layer 2 networks, and “rollups” in particular. In a nutshell, layer 2s are independent ecosystems that sit on top of Ethereum in such a way that relies on Ethereum for security.

Critically, this means that layer 2s do not need to have a native token — so not only are they more complementary to Ethereum, they are essentially part of Ethereum. The Ethereum roadmap even pays homage to this idea by signaling that Ethereum 2.0 will be “rollup centric.”

How rollups work

Layer 2s are commonly called rollups because they “rollup” or bundle transactions together and execute them in a new environment, before sending the updated transaction data back to Ethereum. Rather than have the Ethereum network process 1,000 Uniswap transactions individually (expensive!), the computation is offloaded on a layer 2 rollup before submitting the results back to Ethereum (cheap!).

However, when results are posted back to Ethereum, how does Ethereum know that the data is correct and valid? And how can Ethereum prevent anyone from posting incorrect information? These are critical questions that differentiate the two types of rollups: Optimistic rollups, and Zero Knowledge rollups (ZK rollups).

Optimistic Rollups

When submitting results back to Ethereum, optimistic rollups “optimistically” assume that they’re valid. In other words, they let the operators of the rollup post any data they want (including potentially incorrect / fraudulent data), and just assume it’s correct — an optimistic outlook no doubt! But there are ways to fight fraud. As a check and balance, there is a window of time after any withdrawal where anyone watching can call out fraud (remember blockchains are transparent, anyone can watch what’s happening). In the event that one of these watchers can mathematically prove that fraud occurred (by submitting a fraud proof), the rollup reverts any fraudulent transactions and penalizes the bad actor and rewards the watcher (a clever incentive system!).

The drawback is a brief delay when you move funds between the rollup and Ethereum, waiting to see if any watchers catch any fraud. In some cases this can be up to a week, but we expect these delays to come down over time.

The key point is that optimistic rollups are intrinsically tied to Ethereum and ready to help Ethereum scale today. Accordingly, we’ve seen strong nascent growth with many leading DeFi projects moving to the leading optimistic rollups — Arbitrum and Optimistic Ethereum.

Arbitrum & Optimistic Ethereum

Arbitrum (by Off-chain Labs) and Optimistic Ethereum (by Optimism) are the two main projects implementing optimistic rollups today. Notably, both are still in their early stages, with both companies maintaining levels of centralized control but with plans to decentralize over time.

It’s estimated that once mature, optimistic roll ups can offer anywhere from a 10–100x improvement in scalability. Even in their early days, DeFi applications on Arbitrum and Optimism have already accrued billions in network value.

Optimism is earlier in its adoption curve with over $300M in TVL deployed across 7 DeFi applications, most notably Uniswap, Synthetix, and 1inch.

Arbitrum is further along, with around $2.5B in TVL across 60+ applications including familiar DeFi protocols like Curve, Sushiswap, and Balancer.

Arbitrum has also been selected as Reddit’s scaling solution of choice for their long awaited efforts to tokenize community points for the social media platform’s 500 million monthly active users.

ZK Rollups

Where optimistic rollups assume the transactions are valid and leave room for others to prove fraud, ZK rollups do the work of actually proving to the Ethereum network that transactions are valid.

Along with the results of the bundled transactions, they submit what’s called a validity proof to an Ethereum smart contract. As the name suggests, validity proofs let the Ethereum network verify that the transactions are valid, making it impossible for the relayer to cheat the system. This eliminates the need for a fraud proof window, so moving funds between Ethereum and ZK-rollups is effectively instant.

While instant settlement and no withdrawal times sound great, ZK rollups are not without tradeoffs. First, generating validity proofs is computationally intensive, so you need high powered machines to make them work. Second, the complexity surrounding validity proofs makes it more difficult to support EVM compatibility, limiting the types of smart contracts that can be deployed to ZK-rollups. As such, optimistic rollups have been first to market and are more capable of addressing Ethereum’s scaling woes today, but ZK-rollups may become a better technical solution in the long run.

ZK Rollup Adoption

The ZK rollup landscape runs deep, with multiple teams and implementations in the works and in production. Some prominent players include Starkware, Matter Labs, Hermez, and Aztec. Today, ZK-rollups mainly support relatively simple applications such as payments or exchanges (owing to limitations on what types of applications ZK-rollups can support today). For example, derivatives exchange dYdX employs a ZK rollup solution from Starkware (StarkEx) to support nearly 5 million weekly transactions and $1B+ in TVL.

The real prize however, is ZK rollup solutions that are fully EVM compatible and thus capable of supporting popular general applications (like the full suite of DeFi apps) without the withdrawal delays of optimistic rollups. The main players in this realm are MatterLab’s zkSync 2.0, Starkware’s Starknet, Polygon Hermez’s zkEVM, and Polygon Miden, which are all currently working towards mainnet launch. (Aztec, meanwhile, is focused on applying zk proofs to privacy).

Many in the industry (Vitalik included) are looking at ZK rollups in conjunction with Ethereum 2.0 as the long term solution to scaling Ethereum, mainly stemming from their ability to fundamentally handle hundreds of thousands of transactions per second without compromising on security or decentralization.The upcoming rollouts of fully EVM compatible ZK rollups will be one of the key things to watch as the quest to scale Ethereum progresses.

A fragmenting world

In the long run, these scaling solutions are necessary if smart contract platforms are to scale to billions of users. In the near term, these solutions, however, may present significant challenges for users and crypto operators alike. Navigating from Ethereum to these networks requires using cross-chain bridges, which is complex for users and carries latent risk. For example, several cross-chain bridges have already been the target of $100+ million dollar exploits.

More importantly, the multi-chain world fragments composability and liquidity. Consider that Sushiswap is currently implemented on Ethereum, Binance Smart Chain, Avalanche, Polygon, and Arbitrum. Where Sushiswap’s liquidity was once concentrated on one network (Ethereum), it’s now spread across five different networks.

Ethereum applications have long benefited from composability — i.e. Sushiswap on Ethereum is plug-and-play with other Ethereum apps like Aave or Compound. As applications spread out to new networks, an application implemented on one layer 1/sidechain/layer 2 is no longer composable with apps implemented on another, limiting usability and creating challenges for users and developers.

An uncertain future

Will new layer 1s like Avalanche or Solana continue to grow to compete with Ethereum? Will blockchain ecosystems like Cosmos or Polkadot proliferate? Will sidechains continue to run in harmony with Ethereum, taking on its excess capacity? Or will rollups in conjunction with Ethereum 2.0 win out? No one can say for sure.

While the future is uncertain, everyone can take solace in the knowledge that there are so many smart teams dedicated to tackling the most challenging problems that open, permissionless networks face. Just as broadband ultimately helped the internet support a host of revolutionary applications like YouTube and Uber, we believe that we’ll eventually look at the winning scaling solutions in the same light.

* This post focuses on scaling smart-contract based blockchains. Bitcoin scaling is best saved for a future post.


Scaling Ethereum & crypto for a billion users was originally published in The Coinbase Blog on Medium, where people are continuing the conversation by highlighting and responding to this story.