Layer-1 Networks: 2022 Overview

 

A look at the competitive landscape of Layer-1 networks and their ecosystems, the growing challenges of an increasingly multi-chain world, and the renewed focus on execution environments for their impact on scalability and user experience.

 

The L1 blockchain landscape underwent frequent evolution in 2022, reflecting the constantly shifting demands of the crypto market in a period of extreme economic volatility. Whereas 2021 was marked by relentless consumer optimism and rapid growth of the crypto industry, 2022 will likely be remembered for the sudden and unexpected breakdown in numerous key components of the crypto ecosystem. The implosion of major centralized entities, including FTX & Alameda Research, Celsius, BlockFi, 3AC, and many more, exposed the web of risks that underlies many of the companies providing financial services in crypto today. DeFi protocols also suffered a host of failures arising from critical design or implementation flaws, with the collapse of Terra and UST, as well as numerous large exploits of cross-chain bridges, lending protocols, yield aggregators, and others highlighting the growing economic interactions between L1 ecosystems.

 

The shocking string of calamities that plagued crypto in 2022 forced the industry to confront the existing limitations of L1 networks that underpin the wide range of on-chain financial activities today. These limitations are best understood within the context of the various functions that L1s serve, which grew increasingly complex with the adoption of smart contracts and DeFi applications in recent years. At a basic level, blockchains allow digital money to be securely transferred and stored in an immutable and permissionless manner.

 

Achieving these capabilities in a production environment is far from trivial; functional blockchains require careful coordination of various tasks that can essentially be broken down into the following: execution, settlement, consensus, and data availability. These four "layers" can be thought of as the key modules within a smart contract-capable blockchain architecture. As such, they also represent the primary variables that influence a particular blockchain's overall scalability. Blockchains today are limited by what is known as the "scalability trilemma," wherein optimizing for scalability, decentralization, or security in conjunction often necessitates sacrificing proficiency in at least one of the three.

It is useful to think about L1 development through the lens of the scalability trilemma, which can help put many of the key decisions and events in 2022 into context. In spite of the abnormally chaotic market environment that persisted for much of the year, many L1 ecosystems nonetheless saw some of their most consequential changes to date. While bull markets tend to obscure major flaws in poorly developed ideas through speculative growth, prolonged bear markets like the one in 2022 can mask some of the tangible innovations occurring at the interface of the modular blockchain layers. In this section, we will review some of the biggest developments in the L1 landscape from the past year, beginning with a general focus on blockchain security, followed by decentralization and scalability.

 

One of the most important things to realize about modern blockchains is that they are highly dynamic by nature. This might seem counterintuitive, especially given the automated feel of making on-chain transactions, but consistently and reliably achieving consensus among miners or validators is a task that entails significant technical, social, and economic coordination. By definition, consensus is a critical part of normal blockchain function. Failure to reach consensus will typically result in forks, and even a single occurrence can pose an existential threat to a network. Often, consensus failures require intensive coordination between developers, validators, and stakeholders to resolve, ending with the selection of a canonical fork that ideally represents the combined interests of the community. Hard forks can be executed deliberately as well, typically during major network upgrades that lead validators to break consensus if they are not on the same client software versions.

 

The most significant upgrade of 2022 by far was the Ethereum Merge, which, on September 15, successfully transitioned the Ethereum network from a PoW to a PoS consensus mechanism. The Merge was, in part, notable for the process through which it "merged" the original Ethereum chain and the PoS Beacon chain, designating the two chains as the execution and consensus layers, respectively. Although the upgrade did not provide any noticeable performance enhancements for Ethereum, it nonetheless reiterated the fact that the world's largest smart contract platform is committed to a rollup-centric roadmap that required it to gradually abandon its previous monolithic architecture in favor of a modular one.

 

The most important aspect of the Merge was its transition to PoS, which made former Ethereum miners irrelevant and eliminated miner ETH subsidies in one swoop. The end of ETH emissions to miners represented a major revamp of the Ethereum monetary policy, drastically reducing daily ETH issuance – now consisting only of validator staking rewards – while retaining the ETH burn feature implemented in EIP-1559. The daily net issuance of ETH hit its first negative day since the Merge on October 8, and as of this writing, the supply of ETH dropped slightly below its value at the time of the Merge.

Figure 96: ETH supply since Merge 
Source: Ultra Sound Money

 

Beyond the quantifiable changes to ETH supply dynamics, the Merge was especially significant because of its shift in Ethereum security policy. With the transition to PoS, the security of the Ethereum network, as with other PoS networks, became dependent on the price of ETH and its ability to continuously accrue value into the future. In theory, a collapse in the price of ETH would significantly increase the probability of a single or group of entities gaining enough stake to control the entire network. With a current market cap of ~$154 billion, it remains highly unlikely that Ethereum could become compromised through the direct accumulation of ETH alone. Still, Ethereum's adoption of PoS consensus brought renewed focus to the economics underlying PoS networks, most of which, by design, rely on value accrual to the native L1 token being staked for security.

 

Establishing a valuation model for L1 networks is a difficult task in itself. L1s are comprised not only of the validators who provide consensus and security, but also the core developers who work to improve the network, the application developers building atop the L1, the investors who support these efforts, and the users who actively use the network. Maintaining this system requires a delicate balance of economic incentives through the L1 token, which is typically used for gas payments that go to reward validators and stakers. These tokens are also used by L1 teams to raise money and fund the growth of their respective ecosystems.

 

In 2021, L1 teams raised billions of dollars in funding through the sale of their tokens while also running large incentive programs to reward activity from users, developers, and liquidity providers (LPs). These strategies underscore the growing interdependence between L1 networks and DeFi protocols that emerged in recent years. In addition to funding from treasuries, L1s provide the execution environment in which developers can build applications, while the applications themselves are a major driving force for network activity. While this relationship contributed to the rapid growth of L1 ecosystems in 2021, it also served to accelerate the impacts of negative externalities in 2022.

Figure 97: Layer-1 token price performance in 2022 
Source: TradingView

 

L1 token valuations fell sharply in 2022 alongside the broader drawdown in crypto and traditional equities markets, leading to further additional strain on the many participants in L1 ecosystems. Plummeting valuations for native L1 tokens had a direct impact on the TVL in DeFi protocols across L1 ecosystems, contributing to diminished growth and yield opportunities, as well as an overall reduction in on-chain user activity. L1 DeFi TVL peaked at ~$228 billion in December 2021 and has since declined to around $58 billion as of the end of November, representing a 72% loss YTD.

 

 

Figure 98: Value locked by blockchain since 2020 
Source: The Block Data Dashboard

Ethereum and BNB Chain maintained their dominance as the top two L1 ecosystems by TVL, while Solana fell to the tenth spot amidst the fallout of the FTX collapse. Terra also played a major role in shaking up the distribution of DeFi liquidity, with the complete unraveling of its algorithmic stablecoin protocol leading to one of the largest wealth destruction events in crypto history, as discussed in the Algorithmic Stablecoins subsection. L1 ecosystems that managed to avoid the contagion from the Terra event were able to better retain TVL in relation to their more exposed competitors. For instance, the Tron ecosystem gained significant ground during the second half of 2022 due to the relative outperformance of its native TRX token and its large supply of stablecoins as a percentage of TVL.

 

User growth slowed considerably across L1s in 2022 following a pivotal year in 2021 that saw many L1 networks achieve record-high activity and user counts. Among the top four L1s by active users, assuming 1 address equals 1 user, BNB Chain, and Polygon saw their monthly active users increase between January and November 2022 by ~35% and 25%, respectively. Meanwhile, Solana and Ethereum saw a decrease of 28% and 48%, respectively, by the same metric during this period, reflecting some of the major shifts in L1 market share that occurred in an especially tumultuous year.

Figure 99: Daily active addresses across various Layer-1 networks since 2021 
Source: BSCScan, ChainCrunch, Etherscan, Near, Ava Labs, Artemis, The Block Research

 

Declines in an L1's token price directly impact network security by reducing the theoretical cost of attack. Although such scenarios are rare for larger networks, several L1s faced moments of high vulnerability in 2022 due to their tokens falling in value. The biggest example of this came immediately following the collapse of Terra, which saw LUNA's market capitalization plummet from ~$30 billion to ~$500 million over the course of just one week. This would have made it possible for attackers to coordinate with malicious validators to take control of the network with a few hundred million dollars. By May 12, Terra developers had deemed the risk of attack to be high enough to halt block production entirely in an attempt to protect what remained of the largely defunct chain. A detailed timeline of events can be found in the Macro section.

 

The failure of the Terra network was extreme, but it serves as an insightful demonstration of the risks that come with tying DeFi mechanisms to the supply dynamics of an L1 token used for PoS security. This sort of relationship exists to varying degrees in many L1 ecosystems because of the inherently greater liquidity for native L1 tokens that can be used in DeFi protocols, but Terra's design was particularly vulnerable because LUNA supply was directly affected by the demand for UST. In the aftermath of the collapse of both LUNA and UST, one chain that inadvertently became at risk of attack was Osmosis, which had grown to become the deepest source of stablecoin liquidity in the Cosmos ecosystem through UST over the past year.

Figure 100: USTC liquidity on Osmosis since November 2021 
Source: Osmosis

 

UST, now known as USTC, liquidity grew to over $250 million on Osmosis at its peak, where it was primarily paired with Osmosis's native OSMO token. As both the price of LUNA and UST began to capitulate in early May, the price of OSMO began to fall rapidly as well, losing ~60% of its value within the first two weeks of May. Similar to the case with LUNA, this situation created the potential for malicious actors to quickly gain a significant stake in the Osmosis network. Interestingly, the Osmosis team credited the network's ability to resist a theoretical ⅓ stake liveness attack to its implementation of "superfluid" staking, which essentially allows LPs to stake the OSMO portion of their liquidity positions for additional staking rewards while contributing to network security. While superfluid staking is not exactly the same as liquid staking, which refers to the creation of liquid derivatives for staked assets, the end effect is similar in that it reduces the circulating supply of OSMO and increases the cost of acquiring large sums on the open market. Liquid staking adoption expanded significantly throughout 2022, largely due to the growth of Lido's stETH, most of which came in the earlier half of the year prior to the Merge. As of this writing, the market capitalization of stETH has grown to ~$6 billion, demonstrating the strong demand for unlocking liquidity in otherwise illiquid staked assets.

Figure 101: stETH market cap and ETH price in 2022 
Source: CoinGecko

 

Liquid-staked derivatives (LSDs) for other L1 tokens garnered increasing usage in 2022 as well, including stSOL, mSOL, sAVAX, stMATIC, stNEAR, lcDOT, stATOM, and many others. For PoS chains, LSDs became a key part of the strategy to ensure a high staking ratio relative to the total token supply. By incentivizing support for LSDs in various DeFi protocols, L1 teams can allow users to capitalize on yield opportunities in the DeFi market without sacrificing network security. While liquid staking presents an opportunity for PoS networks to improve their marginal security, it can also grow to become a centralizing force over time.

 

Over the past few years, the Cosmos vision of an interconnected network of app-centric blockchains has emerged as a compelling alternative to the DeFi ecosystem that is currently dominated by Ethereum. The Cosmos approach of improving cross-chain communication through the Inter-Blockchain Communication (IBC) protocol became especially relevant in 2022 as a growing number of cross-chain bridges continued to add new connections between L1 networks. TVL in bridges reached a new ATH in April 2022, with ~$54 billion bridged from Ethereum alone.

 

 

Figure 102: Value locked in Ethereum layer-1 bridges since 2020 
Source: The Block Data Dashboard

 

There currently remains ~$19 billion in Ethereum-native assets that exist as so-called wrapped assets on other chains. With only ~$21 billion in DeFi TVL, excluding the Ethereum ecosystem, the extent of Ethereum as the originating source of liquidity in L1 ecosystems is clear. In other words, a significant majority of TVL in L1 ecosystems is backed by the Ethereum network; if Ethereum were to fail or become compromised, all of the wrapped assets backed by collateral on Ethereum would become compromised as well.

 

Of course, the Ethereum network as a whole does not need to fail for bridged assets to become unbacked. As we discussed in our DeFi Exploits subsection, many of the largest hacks in 2022 involved the compromise of cross-chain bridges, with the Ronin, Wormhole, Nomad, BSC Token Hub, and Horizon bridge exploits combining for a total loss of over $1.3 billion. These exploits were carried out by targeting a variety of vectors that included Ethereum and destination chain smart contracts, as well as the off-chain components that typically enable bridges to execute the proper burn and mint commands on each chain.

 

One takeaway from the bridge exploits of 2022 and their current state is that the crypto market is essentially expressing a view of Ethereum as the main settlement layer for smart contract platforms. With potentially hundreds of millions of dollars on the line, protocol exploiters nearly always choose to store the majority of their stolen assets on Ethereum or as native BTC. There could be several reasons for this, such as the availability of liquidity with which assets can be laundered through protocols like Tornado Cash on Ethereum and CoinJoin on Bitcoin, or simply the possibility that the stolen assets are backed by BTC, ETH, or ERC20 assets. This trend also suggests that, aside from Bitcoin, the exploiters generally believe Ethereum to be the network that poses the lowest risk of consensus failure or censorship, both of which could render stolen assets worthless.

 

Ethereum's de facto role as a settlement layer is derived partly from the high economic cost of attacking the network relative to other L1s. Another factor is the network's ability to reach social consensus, which is difficult to quantify but critical for being able to guide developments that improve the network over the long term. A clear example of this dynamic arose in the leadup to the Merge, when a subset of former Ethereum miners – set to lose the entirety of their revenue source – mounted a challenge to the transition to PoS by pledging not to upgrade to the new client version. In doing so, they created an Ethereum fork remaining on PoW, dubbed Ethereum PoW (token ETHW), that effectively went live at the time of the Merge.

Figure 103: Ratio of ETHW to ETH price since inception 
Source: CoinGecko, The Block Research

 

Despite capturing the attention of the market in the weeks surrounding the Merge, contributing to fears of potential DeFi protocol disruptions, adoption of the Ethereum PoW fork largely failed to materialize as major Ethereum protocols and stakeholders overwhelmingly supported the canonical PoS chain. Ethereum PoW's TVL currently sits at just $1.6 million, and its market capitalization of $418 million represents only 0.27% of Ethereum's $154 billion.

 

Along the spectrum of scalability, Ethereum's strengths lie primarily in its security and decentralization at the expense of throughput. Over the past two years, the Cosmos ecosystem has emerged as a major alternative to this system, making notable security trade-offs in favor of decentralization and scalability. Security and governance were a major part of the Cosmos story in 2022, exemplified by a pivotal vote on the ATOM 2.0 proposal in November that ultimately resulted in rejection through on-chain governance.

 

The on-chain governance system used throughout Cosmos/IBC chains is a notable departure from the off-chain system used by Ethereum. Major protocol changes are typically preempted by an on-chain proposal and vote, the latter of which is weighted linearly by staked token amount. The result of this arrangement is that native tokens for Cosmos chains are used for both securing the network and directing governance decisions.

 

The ATOM 2.0 vote keyed into the ATOM token's role in network and social consensus, with liquid staking and token issuance at the center of discussion in the proposal. Voters generally expressed little opposition to the plan to expand liquid staking offerings to bolster network security. As in the example with Osmosis above, ensuring a high percentage of staked native token supply is an important defense against network attacks, and is especially true for relatively smaller market capitalization Cosmos chains.

Figure 104: Percentage of ATOM bonded since July 2021 
Source: Cosmoscan

 

The percentage of bonded (staked) ATOM increased steadily throughout 2022 after reaching a six-month low of 58% in January. The current 62% bonded ratio equates to a theoretical cost of ~$2 billion to acquire more than two-thirds of the staked supply. For comparison, the same task would cost ~$12.9 billion on Ethereum at current market valuations. In some ways, the lower cost to attack IBC chains versus Ethereum is balanced by the relatively greater ability of stakeholders to affect governance, which can ultimately supersede even state consensus in extraordinary circumstances.

 

This decentralization of governance exists on a spectrum among sovereign chains in the Cosmos ecosystem, with newer chains generally more centralized as a necessity for producing updates quickly enough to attain user adoption and relevance. Because IBC chains are primarily intended to exist as application chains (app-chains) within the broader ecosystem, the entities that make up the set of validators, stakers, and developers often overlap, which effectively gives more stake and governing power to developers compared to L1s that do not intertwine governance and security to the same extent. On the extreme end, some IBC chains can have a highly centralized form of governance. For instance, the DeFi-centric Canto network passed 27 governance proposals with over 99% vote in favor in 2022.

 

One of the more contentious governance debates within the Cosmos ecosystem occurred in March when the Juno community elected to take the unprecedented step of forking the chain in order to confiscate the JUNO holdings of a large stakeholder who voters believed to be a potentially malicious actor. While the outcome remains fairly controversial, the incident nonetheless demonstrates the power of governance and social consensus in Cosmos chains.

 

In the ATOM 2.0 vote, one of the primary disagreements was over the proposed changes to ATOM issuance, which would reduce the amount of ATOM paid to validators as a security subsidy over time while inflating ATOM supply in the short-term to allocate to a new Cosmos Hub treasury that would have an increasingly greater ability to dictate the future of the chain.

Figure 105: Percentage of votes on proposal 82 by top 30 Cosmos hub validators
Source: Mintscan, The Block Research

 

In the end, the 29.1% NoWithVeto votes from validators that contributed to the rejection of the proposal are a clear demonstration of how on-chain governance can be an effective decentralizing force for a network, particularly when it has grown in size and reach of the Cosmos Hub. While ~70% of the vote was controlled by the top 30 Cosmos Hub validators, the wide range of stances, even among the top validators, speaks to the diversity of opinion that exists among the Cosmos Hub governing body.

 

In a sense, the Cosmos Hub community's dismissal of the proposed issuance schedule can be interpreted as a rejection of policies that would decrease the marginal security of the network (i.e., by removing subsidies) while increasing the centralization of governing entities. This is a subtle point, as the community's broad acceptance of ATOM liquid staking growth also represents a contrast to the situation on Ethereum, where one liquid staking provider, Lido, has grown to the extent of becoming a potential central point of failure for the network.

Figure 106: Lido stETH share of staked ETH 
Source: Dune Analytics, Lido

 

The share of staked ETH deposited in Lido has grown to 29.7%, representing a ~70% increase YoY. Whereas Ethereum proponents grew increasingly concerned about a centralized attack vector through stETH in 2022, the Cosmos Hub community appeared to be primarily focused on increasing the marginal security of the network through liquid staked ATOM while rejecting the idea of potentially centralized entities (i.e., the Hub Treasury) capturing additional governing influence through increased value accrual to ATOM.

 

On a similar note, the centralizing impacts of optimized MEV capture came into greater focus in 2022 with the continued success of Flashbots products, which primarily serve to democratize consumer access to MEV captured from on-chain activity. With the transition to the PoS consensus, the Flashbots team demonstrated the economic implications of lopsided competition in the MEV market by releasing its MEV-Boost relay software, which gives a major financial advantage to validators who use the software to sell blockspace to block builders.

 

As mentioned in the Mining section, the growing dominance of entities like Flashbots can also pose a threat to network censorship resistance, especially when Flashbots is now censoring transactions originating from Tornado Cash to comply with OFAC sanctions. Questions about Ethereum's long-term future are starting to rise less than three months after the Merge.

 

MEV opportunities arise wherever on-chain value and activity exist, most commonly as arbitrage and liquidation opportunities presented in DeFi markets. In monolithic blockchain ecosystems, these MEV opportunities typically revolve around activity originating from decentralized exchanges (DEXs) and lending protocols, and they become magnified during periods of heightened volatility.

Figure 107: MEV transaction share in Solana non-vote transactions in 2022 
Source: Jito labs

 

For example, MEV activity became a constant presence on Solana in 2022, ramping up during extreme market events like the Terra and FTX collapses in May and November, respectively. Cross-chain MEV capture in the Cosmos ecosystem and beyond also became a key topic of discussion in 2022 when the authors of the Cosmos 2.0 whitepaper proposed the concept of the "Interchain Scheduler" as a primary way of bringing revenue to the Cosmos Hub in the future. The Interchain Scheduler is essentially a cross-chain blockspace marketplace of which the Cosmos Hub would theoretically be the main beneficiary, provided it can first accrue value through an upcoming IBC upgrade dubbed Interchain Security. It remains unclear whether the planned Interchain Security feature, which aims to lease the security of the Cosmos Hub to newer and/or smaller IBC chains, will result in tangible growth of cross-chain activity dependent on the Hub, especially in light of the strong presence of Osmosis and its native DEX in the Cosmos ecosystem.

 

 

Ultimately, the challenges being tackled in MEV research today are an extension of more fundamental questions on the economics of value distribution across chains. Namely, who captures the value generated by cross-chain activity, and what attracts this activity to specific protocols over others? For monolithic blockchains, the answer to the first question consists partly of LPs and security providers, who are relevant both on an application and blockchain level. LPs generally take the risk of price exposure and smart contract failure in exchange for trading fees or lending fees, while network validators take on the cost of computational resources and the risk of price exposure in exchange for validator fees, either directly from transaction fees or from token subsidies.

 

Similar to its use of on-chain governance, the Cosmos Hub attempted to codify this security-based system of value accrual by tying the security of so-called "subscriber" chains to its own as a "provider" chain in the Interchain Security design. However, security provision alone is typically insufficient to drive activity to specific protocols or chains. In the IBC ecosystem, the Cosmos Hub's idea of a group of chains secured by a single validator set is largely untested, but it also resembles the concept of shared security that underpins the Polkadot ecosystem.

 

In 2022, development in the Polkadot ecosystem was punctuated by a notably subdued pace of critical feature releases from the core Polkadot team, particularly with regard to its flagship cross-chain message passing (XCMP) protocol, which is intended to enable seamless communication secured by the Polkadot relay chain, including asset transfers, between Polkadot parachains. Persistent delays to the release of XCMP forced many parachain teams to use workarounds such as horizontal relay-routed message passing (HRMP), which allows parachains to transfer assets between one another but also requires individual one-way channels to be opened between parachains in order to function. Furthermore, the opening of HRMP channels is subject to the governance process of the Polkadot relay chain, which serves as yet another bottleneck for parachain developers looking to expand their connectivity with other Polkadot parachains and L1 chains outside the ecosystem. Clearly, one of the major flaws of the shared security model is the strong dependence of consumer chains (i.e., parachains) on the provider chain (i.e., relay chain), which can become progressively limiting over time if application development begins to outpace core protocol development.

 

One way to roughly gauge the market value of the security provided by the Polkadot relay chain is through the parachain auctions, which are essentially a bidding process for blockspace secured by the relay chain. Over time, the average amount of funds raised to secure a parachain slot has decreased significantly.

 

Figure 108: Winning bids for parachain slot auctions in 2022 
Source: Parachains.info

 

The steep dropoff in average crowdloan sizes throughout 2022 reflects a palpable decrease in interest for blockspace in the Polkadot ecosystem. When the first five Polkadot parachain slot auctions began in mid-November 2021, the average size of a winning parachain slot auction bid was ~$109 million based on the price of DOT at the time of this writing. By the 12th to 18th parachain auctions that spanned from March through May, the average winning bid had dropped to $4 million. For the latest round of completed auctions spanning from late August to mid-November, the average winning bid was just $690,000.

 

At this point, it is worth revisiting our original question of how value is captured by cross-chain activity, and by whom. Within individual L1 ecosystems, LPs and validators collect a significant portion of the value from various possible DeFi activities. MEV extractors also capture a chunk of this value by taking advantage of market inefficiencies. For now, the competitive landscape for cross-chain value capture remains in its infancy, but the surge of inter-chain connections enabled by bridges and cross-chain messaging protocols in 2022 indicates a significant value in reducing inefficiencies in cross-chain capital flow.

 

Arguably, MEV extraction is one of the main ways to resolve cross-chain capital inefficiencies, wherein arbitrage and liquidation activities reduce discrepancies between prices and interest rates between chains. The proposed Interchain Scheduler introduced in the Cosmos 2.0 whitepaper reflects this desire on the part of the Cosmos Hub team to capture some of this value that is essentially open for claim by the most competitive MEV searchers. In a sense, the parachain slot auctions for Polkadot blockspace also resembles the blockspace marketplace described in the Interchain Scheduling thesis. Yet aside from the strategies currently being explored by MEV research teams such as Skip and Mekatek in the IBC ecosystem, the state-of-the-art for MEV value capture cross-chain remains largely undefined.

 

Another approach to improve cross-chain capital efficiency is to increase the amount of accessible liquidity across chains, which also involves reducing the latency of cross-chain capital movement. On this front, cross-chain bridges played an increasingly important role in 2022, though, as we've seen throughout the numerous bridge exploits of the past year, they grew to become high-value targets through which malicious actors seek to extract value from honest participants. As such, cross-chain messaging protocols originally designed with blockchain scalability in mind are gaining increased relevance as well. From a broader perspective, the questions of how value is captured from cross-chain activity and what drives capital accumulation can essentially be boiled down to differences in execution and user and developer experience. We explore some of these key differences between L1 networks in the following section.

Thus far, our discussion on the state of L1 ecosystems in 2022 has primarily focused on differentiating factors with respect to blockchain security and decentralization that have become clear among the largest networks in recent years. However, improving blockchain scalability remains one of the paramount challenges for the blockchain industry today, particularly due to the severe negative consequences of sacrificing either security or decentralization. Let's take a look again at the Cosmos ecosystem, whose primary method of scaling optimization echoes throughout the L1 landscape in varying forms.

 

One of the biggest step changes in functionality for chains in the Cosmos ecosystem came in Q1 2021 with the activation of IBC transfer functionality, which effectively opened the floodgates for liquidity to flow freely between IBC-enabled chains. With the introduction of this feature following the passage of Cosmos Hub proposal 41, the path was paved for the Cosmos ecosystem to move closer than ever before to the vision of interconnected app-chains first laid out in the original Cosmos whitepaper. Within this vision, the Cosmos approach to blockchain scalability can essentially be thought of as a distribution of key blockchain responsibilities, more specifically execution and consensus, to sovereign blockchains connected by a standard cross-chain messaging protocol (i.e., IBC).

 

 

A similar version of this approach to scalability has emerged independently outside of the Cosmos ecosystem over the course of 2021-2022, with a host of Ethereum-alternative L1 networks now connected by a variety of cross-chain bridges. Compared to the collection of bridges that currently provide channels for asset transfers between otherwise siloed L1 chains, the Cosmos IBC protocol's key differentiator is its standardization of cross-chain communication between all IBC-enabled chains. This seemingly minor improvement bears significant practical consequences in terms of security, implementation, and user experience.

 

Cross-chain bridges generally exist on a spectrum of decentralization, ranging from single custodial entities controlled by a multi-sig to decentralized sets of validators responsible for verifying transactions. Most bridge processes, including IBC transfers, use a lock-and-mint model to transfer assets cross-chain, whereby native assets are locked on their origin chain, and an equivalent amount is minted on a destination chain. Users are typically required to place their trust in several components of standard bridges, including the validators (if any) and the off-chain relayers. In February, the Wormhole bridge was exploited for ~$323 million through a simple implementation error, demonstrating the fragility of even robust security practices relative to the tremendous stakes that are often at play. More information on various bridges can be found under the Blockchain Interoperability Solutions subsection.

 

IBC transfers look similar to common third-party bridges at a high level, relying on relayers to transmit messages between chains. However, the main difference with IBC transfer security is that users and developers only need to trust in the security of the chains with which they are interacting, as light clients always verify state proofs from the interacting chain before assets are transferred. Therefore, even a fully compromised set of relayers could only do damage to the extent of pausing IBC transfers between two chains. For developers in the Cosmos ecosystem, an additional benefit of the IBC protocol is its standardization across chains, which dramatically reduces the risk of fatal implementation errors.

 

The IBC protocol is a fundamental part of the Cosmos ecosystem value proposition, which otherwise improves blockchain scalability only by splitting up transaction execution across multiple app-chains. Faced with sudden spikes in blockspace demand, individual Cosmos chains would unlikely be able to produce measurable improvements over other monolithic chains in terms of throughput or cost. Without the existence of cross-chain transfer functionality enabled by IBC, liquidity and user activity on Cosmos chains would also be prohibitively isolated.

 

This hypothetical situation is largely representative of the state of scaling in the Avalanche ecosystem, which leaned heavily into the concept of subnets as a scaling solution in early 2022. In theory, subnets are designed to be similar to app-chains in the Cosmos ecosystem, with independent validator sets to secure the network and customized fee structures to suit specific applications. One subtle difference is that subnet validators must also be validators for the Avalanche C-Chain, which is intended to drive additional demand for Avalanche's native AVAX token but is highly dependent on the market demand for becoming new subnet validators. Despite this requirement, subnets do not inherit the security of the C-Chain, nor do they have the ability to directly transfer assets between one another via a standard messaging protocol.

 

As a result, Avalanche subnets in their current state mostly function as sidechains, alleviating congestion on the primary C-Chain by executing transactions and performing validation on a separate chain entirely. For the most part, existing subnets served this purpose well, hosting the high-volume, low-value transactions from on-chain gaming protocols that would otherwise drive up gas costs on the C-Chain.

Figure 109: Daily average transaction fee on Avalanche C-chain vs. Crabada transaction count 2021 - 2022

Source: Snowtrace, DappRadar, The Block Research

 

In May, the launch of the Swimmer Network subnet and subsequent migration of the Crabada gaming protocol led to a substantial decrease in average transaction fees on the C-Chain. Alongside the launch of another gaming subnet, the DeFi Kingdoms' DFK Chain, the Swimmer Network launch led to a significant reduction in Avalanche C-Chain network activity, which became relatively stagnant for the remainder of 2022. As a result, subnets effectively contributed to a reduction in demand for AVAX. Meanwhile, the limits to the scalability of single subnets became readily apparent in the latter half of the year.

Figure 110: Daily gas used on Avalanche Subnets (nAVAX) since November 2021 
Source: Avalabs

Beginning in July, daily transactions on DFK Chain rose at a rapid pace, leading to a commensurate increase in the amount of gas used per day. In November, the average daily gas used by DFK Chain reached a new monthly high of ~760 billion gwei, more than 3.5x higher than any single day of gas usage on the C-Chain over the past year. This trend highlights one of the key issues with adopting a multi-chain model as a primary means of addressing blockchain scalability. In the absence of any modifications to directly increase transaction throughput, monolithic blockchains – even those that comprise a larger multi-chain scaling approach – can generally be expected to perform comparably to those that utilize the same execution environment. For reference, both DFK Chain and Swimmer Network use an implementation of the Ethereum virtual machine (EVM), which continues to be the most popular execution environment among smart contract platforms today.

 

Execution environments are critical components of any blockchain architecture and are largely responsible for dictating the behavior of assets, transactions, smart contracts, and more. Among those being actively used in blockchains today, the EVM is by far the most dominant, setting the standard for transaction execution and user interactions across a range of L1 chains. In fact, as of this writing, 9 of the 10 largest smart contract platforms by TVL feature the EVM or an EVM-compatible VM as their execution layer.

 

In 2021, EVM compatibility played a significant role in the meteoric rise of major Ethereum-alternative L1 ecosystems such as BNB Chain, Avalanche, and Polygon, among others. By co-opting the execution environment familiar to both DeFi users and developers in their own blockchain designs, EVM-compatible L1s were able to onboard communities and attract activity originating from Ethereum with relative ease. These ecosystems largely maintained their positions among the top in TVL throughout 2022 despite enduring significant drawdowns in line with the broader crypto market.

The BNB Chain ecosystem has been a particularly substantial beneficiary of the spread of DeFi from Ethereum to other L1s. BNB Chain is now the second-largest L1 ecosystem behind only Ethereum, with a TVL of ~$5.4 billion. Its share of overall DeFi TVL remained relatively steady throughout the turmoil of 2022 and increased steadily from May onwards.

Figure 111: BNB Chain share of DeFi TVL 
Source: DeFiLlama

 

With its large on-chain supply of ~$10.5 billion in stablecoins, the BNB Chain ecosystem was well-positioned in November to capture significant DeFi market share in the fallout of the FTX collapse. On November 27, the ecosystem reached a YTD-high of 11.5% of overall DeFi TVL. The key trade-off made by the BNB Chain network with respect to scalability is its decentralization. As of this writing, the BNB Chain features an active validator set of just 2G, with many of them speculated to be affiliated with or funded by Binance. By comparison, Ethereum currently has an active validator set of ~484,000.

BNB Chain's disregard for decentralization within its validator set poses significant risks with respect to security and censorship resistance, but this tradeoff has yielded major advantages in terms of throughput as well. In 2022, BNB Chain processed an average of 4.37 million transactions per day, which equates to a throughput of roughly 50 TPS. Meanwhile, Ethereum's throughput typically averages ~13 TPS.

Figure 112: Daily transaction count by blockchain 
Source: Artemis

 

The advantages of BNB Chain's high transaction throughput relative to Ethereum are clearest when viewed through the lens of user experience. With the ability to process transactions on BNB Chain at nearly 4 times the speed of Ethereum on average, there is little doubt that users who are unconcerned with the risks of validator centralization would be drawn to the former's high-speed, low-cost environment for making DeFi transactions. In some senses, the design of BNB Chain can be viewed as a maximization of the transaction execution capabilities of the EVM, wherein the latency bottleneck imposed by the need for validators to reach consensus is reduced to the bare minimum at the cost of decentralization. When pushed to its maximum capacity, the latest estimates for BNB Chain's throughput in the context of DEX trades (considered common user behavior) indicate that the network would be able to process ~195 DEX trades per second.

Excluding the use of L2 rollups, attempts to scale L1 blockchains beyond the limitations of the EVM require customization of the execution environment by necessity. Alternative environments such as WebAssembly (WASM) became popular in recent years through multi-chain ecosystems, including Cosmos and Polkadot, due to their support for a wide range of programming languages. However, the act of changing execution environments alone is not sufficient for substantially increasing execution capabilities.

 

In 2022, the Solana network and its Sealevel runtime remained at the forefront of development in terms of maximizing transaction throughput on a monolithic blockchain. The main trade-off made in Solana's blockchain architecture for the sake of increasing execution speed is decentralization. Unlike the case with BNB Chain, Solana has an active validator set that totals more than 1,800. The fact that the top 29 validators currently control over 33% of the total stake is also not ideal from a decentralization perspective, but the main centralizing force in Solana is a result of the network's design itself.

 

Transaction execution on Solana involves a complex interplay between client software and the underlying hardware used by validators. The reference to its execution environment as a "runtime," as opposed to a VM, specifically alludes to the fact that Solana's transaction execution leverages the processing power of validator hardware in order to maximize throughput. As a result, Solana validators have significantly higher hardware and network requirements than validators for any other major L1s. This maximization of hardware capabilities enables unique features like parallel processing of transactions, but it has also led to situations where validators became overwhelmed by sudden surges in network demand.

Figure 113: Overview of incidents on Solana in 2022 
Source: Artemis, Solana Foundation

 

Network performance issues plagued the Solana ecosystem throughout 2022, with several incidents severe enough to halt the network entirely. The common denominator with most of these incidents was an overabundance of spam transactions submitted by bots in an attempt to capitalize on MEV opportunities. Due to the negligibly low cost of sending transactions on the network, malicious actors were insufficiently penalized for spamming requests, and validators often became unable to separate them from legitimate user requests.

 

To make matters worse, the Solana ecosystem became one of the largest victims of the FTX and Alameda collapse in November and was forced to cope with the loss of one of the biggest market makers in its ecosystem. Major stakeholders and investors in the Solana ecosystem also suffered direct losses from the FTX/Alameda debacle, in addition to the laundry list of destructive events from the fallout that included the potential loss of underlying collateral in the Sollet bridge, direct losses borne by the Solana Foundation, and the general exodus of liquidity from the ecosystem. Between the start of the year and November 30th, the Solana ecosystem's TVL fell by over $7.9 billion for a shocking loss of 95% YTD.

 

The spate of troubles for the Solana ecosystem throughout 2022 ultimately proved to be an exceedingly frustrating experience for users, developers, validators, and investors. As a result, the Solana team's eventual rollout of critical features for combatting its prior network issues, including QUIC packet filtering and the activation of fee markets, went largely unnoticed by most market participants.

Figure 114: Solana additional revenue from free market (SOL) 
Source: Dune (@rawrmaan)

 

Use of the preliminary release of the fee market spiked in mid-November during the FTX debacle, coinciding with a rare streak of network stability during one of the most volatile periods in crypto history, which offers hope that the ecosystem will be prepared for a rebound in user activity if and when the time comes. One of the newest L1 chains of 2022 that has drawn comparisons to Solana is Aptos, which officially deployed its mainnet on October 12 and went live for public use on October 17. The relationship between Aptos and Solana mostly exists in the form of investor and developer overlap between the two ecosystems, as well as a parallel transaction processing mechanism that has yet to be fully battle-tested.

 

Aptos, along with another protocol that emerged from the formerly Meta-backed Diem project, Sui, primarily drew attention in 2022 for its use of the Move VM. Originally conceived at Meta during Diem development, the Move language and VM are the latest entrants to the blockchain development landscape still largely dominated by Solidity and the EVM. One of the most notable aspects of Move is that it has been designed with the intent of enabling a more streamlined experience for developers and a safer on-chain environment for users through the implementation of common-sense linear logic rules. As alluded to throughout this report, thoughtfully designed user experiences in blockchain development are paramount to attracting user activity and enabling further growth in the space. For now, efforts are underway to create tools that make it easier for developers to translate their efforts in the EVM to the Move VM.

 

Looking ahead, bridging the technical gap between networks, including the EVM and other emerging execution environments, is one of the major challenges that remain in blockchain development. A near-endless list of existential wealth destruction events throughout 2022 has served as a wake-up call for the broader crypto industry to critically consider its security and trust assumptions at every location where capital resides, whether on-chain or off-chain. Meanwhile, connections between blockchains continue to be built at a rapid clip, which now makes it easier than ever to transfer capital between chains. Developments in cross-chain tooling also continue to bring the EVM to a growing number of networks through cross-compatible chains like Canto and Evmos in the Cosmos IBC ecosystem, at once deepening the influence of Ethereum as a social consensus layer and increasing the range of possible DeFi interactions between chains.

 

However, L1 teams will also need to consider the additional risks that come with increased asset composability and access to DeFi. In 2022, we saw how L1 adoption of faulty DeFi mechanisms could damage the health of an ecosystem if exploited, exemplified by the collapse of Terra's UST and later replicated on a smaller scale with decentralized stablecoins like aUSD on Acala and USN on Near. We also saw how deep L1 integrations with liquidity originating from exploited cross-chain bridges, like Moonbeam and Evmos with the Nomad bridge, can wreak havoc on the health of an ecosystem. Clearly, breaking consensus is not the only way to damage an L1 network; commingling large amounts of liquidity with corrupted protocols can be damaging as well.

 

Cross-chain messaging protocols are likely to continue growing in importance. How exactly the value of facilitating cross-chain communication is ultimately distributed remains an open question, whether it be to MEV extractors, bridges, cross-chain messaging protocols like IBC, LPs, or others. The abundance of available blockchain dev tools has simplified the process of launching app-chains even outside the Cosmos and Polkadot ecosystems, with L1s like Avalanche and Polygon now embracing the concept of application-focused blockchain development as well. Execution environments will ultimately play a significant role in defining the typical end-user experience, as well as quality-of-life improvements to cross-chain UI enabled by increasingly feature-rich cross-chain messaging protocol. L1 ecosystems became increasingly connected and interoperable throughout 2022, and the continuation of this trend in the coming years provides more reason than ever to ensure robust security and decentralization in crypto's most popular protocols.


Source: The Block Research