Top 5 predictions for the Ethereum ecosystem in 2023

Our five predictions for the Ethereum ecosystem:

The bear market is not over yet;

EigenLayer will be Ethereum’s most important innovation;

Blob transactions don’t fix scalability issues;

In 2023, ZK-Rollups won’t see significant traction;

Layer 3 will be a real competitor to Cosmos;

Image source: Generated by Maze AI

First, the bear market has not passed

2022 is destined to be a big year for crypto. The industry seems to have changed dramatically as institutional capital pours into crypto-focused projects, exciting new financial primitives are developed, and its legitimacy as an asset class continues to grow across the globe. Unfortunately, these narratives are overshadowed by the main story: a succession of financial misconduct, mostly at the hands of bad actors who wield power. The exposure of this pervasive fraud, coupled with the tightening of monetary policy globally, has led the crypto market into a relentless bear market comparable to that seen in 2018.

For crypto, 2022 has been a year of mercenary capital dominance – entities as value extractors, as well as participants moving from one opportunity to another, seeking excess short-term profits but without any interest in participating in the community or building the infrastructure of the future. This is present in most stakeholders in the crypto space, from end-users to liquidity providers to crypto VCs – all of which are involved in various forms of rug pumping and dumping. However, these three implosions have put the industry in a difficult position:

Do Kwon’s Terra-Luna employs an inherently flawed algorithmic stablecoin model and bribes people to use it to earn artificial collateral yields. The depeg of the algorithmic stablecoin wiped out $60 billion in market cap and hollowed out the savings of retail investors around the world.

Founded by Su Zhu and Kyle Davies, Three Arrows Capital (3 AC) is a forex arbitrage fund that funds its targeted crypto stakes through massive lending. When the heavily overleveraged company collapsed in adverse market conditions, its billions of dollars in bad debts left huge holes in lender balance sheets across the crypto space.

Finally, the FTX trading platform collapsed when SBF appropriated customer deposits and lent them to his trading firm, Alameda Research. As a result of its FTT Token crash, which resulted in billions of dollars in losses, several lenders went bankrupt due to the losses.

So, what does this mean for the crypto industry in 2023? First, we expect that FTX position unwinding and widespread bad debts will continue to negatively impact the crypto market throughout the coming year. As bankruptcy and criminal proceedings progress, liquidity issues and insolvencies are likely to continue to be identified in CeFi and DeFi services. Second, the dishonesty involved in this bankruptcy will seriously hamper the regulatory process, investor activity, and consumer confidence.

Looking to the future

Despite the serious setbacks in our industry, we are optimistic about the outlook for crypto in 2023. While mercenary capital has taken a toll on our credibility, our industry is also full of dedicated builders who have put a lot of sweat into this thriving Web3 world. These people are what we call “visionary capital” and are still building at a time when most industry speculators have left. They put in a long-term effort to propel Web3 to the forefront of irreversible entry into everyday life. We believe that 2023 is the year of forward-thinking capital and the year in which cryptocurrencies move from speculative investments to a core component of society built around Web3.

To some extent, this transformation is already underway. Between DeFi protocols that integrate with traditional financial systems, DAO vaults accumulating real-world assets, and traditional gaming companies breaking into Web3, one of today’s emerging narratives is that the lines between decentralized solutions and the real world are blurring. This process will only continue, and 2023 is likely to be the year when Web3 projects enter the mainstream.

Here are a few examples. In an era where data breaches are ubiquitous, companies may begin to adopt decentralized identity technologies that allow users to self-custody their data. Consumer-facing applications of blockchain technology will emerge in the media space, where marketing, storytelling, and gaming will converge to create an immersive, interactive world. By building a blockchain network on top of the existing grid, utilities will be able to integrate distributed energy resources into a new network of new decentralized energy sources.

While this is not news to crypto natives, these examples represent the introduction of a large new user base and show that the closed world we’ve seen over the past decade is poised to be made public. Behind these fundamental changes to our daily lives will be a wave of technological developments that will elevate crypto’s capabilities and prepare it for its centrality in metaverse life. These events are unfolding in real-time, and our expectations are summarized below, and here are our predictions for how crypto and Web3 will take a leap forward in 2023.

Second, EigenLayer will be the most important innovation of Ethereum

One of the most significant differences in blockchain development is the degree of permissionless activity that can take place between the infrastructure layer and the application layer. Infrastructure upgrades and changes lag behind the application layer because application deployments are permissionless and core network upgrades are license-required. Changes to the consensus, core, sharding, P2P, and middleware layers are based on democratic votes by specified parties, while applications are free to deploy and experiment on the core consensus logic.

Established and well-capitalized network systems that require a prudent risk analysis prior to core upgrades or changes. This has led to innovative solutions to consensus issues and core barriers being limited or later than the market. Once the system’s sovereign trust network is established, the protocol becomes very rigid and less prone to innovative upgrades. When innovative consensus mechanisms or middleware layers emerge (such as Snowman, Chainlink, or Nomad), it is not possible to use an existing layer of trust to run a new network in a permissionless manner.

In addition, new networks are often constrained by unavoidable capital boundaries. In order for a decentralized network to ensure the security of the core consensus logic, the cost of malicious actors to self-implement changes or control assets would need to be prohibitively high. Therefore, breakthrough technology is not enough, and builders also need to find a large funding base for cybersecurity, which often becomes the biggest obstacle to infrastructure innovation.

The reward distribution further highlights the capitalization problem in network bootstrapping. In the Ethereum validator stack, 96% of the total rewards are allocated to capital providers, while only 4% are allocated to node operators. Far from being arbitrary, the reward distribution reflects the implicit cost of capital in a proof-of-stake (PoS) network. The implied risk of staking unstable assets for network security is fundamentally much more expensive than running a general-purpose node that can be repurposed.

It’s worth mentioning that bootstrapping the security of the core infrastructure is the primary consideration for decentralized networks. That being said, applications built on top of it are always constrained by the most insecure denominator in their infrastructure stack. Applications that include middleware layers, such as cross-chain bridges and oracles, secured by their own sovereign trust networks, are reducing the overall security of the system to the least secure dependencies.

In order to solve the core gap of innovation from infrastructure to application layer, EigenLayer has introduced a simple but extremely effective solution to solve the problem of excessive capital costs: re-staking.

EigenLayer

EigenLayer is a smart contract layer on Ethereum that allows users to leverage existing trust networks to secure other core infrastructure and middleware layers through the use of heavy staking. At its core, restaking is the use of the same staked ETH used for verification on the Ethereum network to secure other networks. This allows ETH stakers to have more flexibility in staking capital while extending the layer of trust to peripheral infrastructure, such as sidechains, middleware, and even other non-Ethereum networks.

EigenLayer is introducing a two-way marketplace where ETH stakers can serve networks that require a layer of trust. This allows the new network to reduce network security costs while gaining access to a huge pool of funds. In effect, this eliminates the most insecure denominator problem in the application layer. Oracles and bridges will gain security and trust from the same infrastructure layer on which the application itself is built. EigenLayer allows for the consolidation of trust, ultimately improving the security of all networks that interact with the layer. For example, a new entrant into the asset cross-chain bridge space can interact with EigenLayer and gain immediate access to a $18.7 billion security foundation.

Given that ETH stakers don’t incur any marginal capital cost when validating other networks, heavy staking greatly increases the range of possibilities for stakers. Of course, EigenLayer does have some leverage and slashing risks, as the underlying staked assets can be slashed across multiple secure networks in the event of malicious behavior. Whenever multiple networks are validated with the same funds, the asset base is inherently leveraged, opening the system to potential cascading.

The risk of forfeiture is complex and can lead to contagion. Losses due to malicious actions or downtime essentially reduce the security considerations of all verified networks. If left uncontrolled or restricted, this contagion can adversely affect the system architecture. At launch, EigenLayer will introduce prudent leverage guidelines and limits to ensure the stability of the trust system.

EigenLayer is also developing a data availability layer for Ethereum called EigenDA. This layer is similar to the current danksharding specification and includes features such as Data Availability Sampling (DAS) and Managed Attestation. However, EigenDA is an optional middleware rather than a core component of the protocol. As a middleware layer, it can be stress-tested without the need for a hard fork, which provides several advantages: permissionless experimentation at the DA layer, and allowing validators to participate on an opt-in basis. If the implementation of pseudo-danksharding succeeds on EigenDA, it could become the de facto DA layer for all optimistic and zk-rollups built on top of the Ethereum ecosystem before the lengthy process of Ethereum-level protocol changes.

During the long 2022-2023 bear market, liquidity is expected to continue to seek security within Ethereum, further cementing the network as a safe haven and central trust layer for crypto. Secure competition will further expand Ethereum’s capital base, widen the gap between alt-L1s, and push the cost of capital for new native validation networks to prohibitive levels.

Obtaining heavily staked ETH security will significantly reduce the cost of scaling middleware, sidechains, and general decentralized technology stacks. We believe that Eigen will bring the most significant changes to the way decentralized networks are built since Ethereum was first introduced in 2015.

Third, blob transactions will not solve the scalability problem

Until modularity is achieved, blob transactions will not be a magic fixer for Ethereum’s scalability. Achieving modularity will have considerable technical hurdles and delays. The drastic increase in on-chain data will also drive state expiration to alleviate the need for state bloat, and may even lead to changes in Ethereum’s peer-to-peer structure. Blob transactions introduce a new data format for calldata (which rollups rely on) that contains a large amount of additional data that is not accessed by EVM executions, but only by commitments.

As the demand for rollups and modular execution grows, this new data marketplace will become increasingly competitive. This means that we may see price competitiveness, just as we see competitive gas prices on Ethereum, we may see competitiveness around Data_gas, which is a new type of gas that is being implemented. There are also a lot of questions that need to be addressed, such as whether gas should be time-based or slot-based, because if it’s based on a slot, there’s a chance that you can miss a slot without a blob transaction, which can make the demand look like an increase in demand, which affects the gas price.

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There’s also the issue of actual gossiping of blob transactions on a peer-to-peer (P2P) network, as these blobs are much larger in size than anything that’s currently gossiping. This requires further research and is currently being explored by Paradigm. It will be interesting to see what happens to this and whether the Ethereum network can handle this further state bloat and data. In any case, it is likely that state expiration will be needed to limit the growth of the Ethereum state – which currently has grown at an insane 1079 GB for full blockchain synchronization and is growing every day. State expiration will be achieved through state rent, so state can be rented out to off-chain storage, or by deleting the state on a monthly or weekly basis and then storing it on an archive node (which is unfortunately very centralized at this point).

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As the positioning of Ethereum and many L1s in the coming years becomes clearer, it is clear that in order to remain decentralized and “keep up with the times”, they must move to modularity.

Four, ZK-Rollups won’t see significant traction in 2023

ZK-Rollups won’t gain significant traction in 2023 because they lack production readiness and can’t achieve adequate decentralization. When we say production readiness, we specifically refer to their VMs and the proof time of the proof.

Instead, ZKP is expected to be widely used, especially in non-interactive proofs of state. Projects such as Herodotus, Axiom, ETHStorage, and Lagrange will use them for a variety of data-sharing purposes that require proof of on-chain or cross-chain storage.

It is expected that a number of cross-chain bridges will start using ZKP for interoperability purposes, and some of them are already moving in this direction, including Wormhole, Polymer, and the ZKBridge collective.

Applications for these ZKPs are almost ready and are expected to be validated on-chain at a reasonable price. These uses of ZKP increase efficiency through recursion, which involves aggregating multiple proofs into one smaller proof. Most protocols have recognized the need for recursive ZKP to reduce costs and increase efficiency, although some proven schemes are more effective than others. However, it also has some caveats, as some proven scenarios are more effective than others.

Many existing ZK schemes and algorithms with concise proof sizes incur high overhead during proof generation time (also known as proofs), which limits their efficiency and scalability. To address this issue, projects such as Supranational, Ingonyama, and DZK are working to improve the efficiency of proof generation. However, it is important to recognize that this hardware acceleration is only part of the reason for efficient proofs. Optimizations are needed at the algorithmic level, at the software level, and in other areas. It is also important that said system remains sufficiently decentralized, which is difficult to achieve in practice.

Finally, the proof time also increases with the complexity of the ZKP in question. Considering all the factors mentioned, there’s no doubt that it’s hard to build a sufficient ZKRollup to gain significant traction in 2023. Currently, the most effective use of ZKP is in smaller-scale operations, such as the aforementioned non-interactive proof of state and interoperability.

Fifth, Layer 3 will be a real competitor to Cosmos

Layer 2 (L2) improves Ethereum’s scalability by reducing gas fees and increasing throughput. Because of these scalability factors, as well as the trade-offs that exist, L2 must choose to optimize for specific projects. Layer 3 (L3) is an application-specific blockchain built on top of L2 that aims to mitigate these trade-offs and make more improvements. They are similar to appchain environments such as Cosmos, Avalanche, and Polkadot, but benefit from being built on a modular blockchain stack rather than a monolithic chain stack. Therefore, deploying a fully modular blockchain infrastructure stack, including a common L2 as well as a customizable L3, will mark the end of the era of monolithic appchain ecosystems and the beginning of a new era of decentralized application development.

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Currently, monolithic appchains are preferred by many applications because it allows them the freedom to create custom logic and smart contracts while enabling better execution. In addition, appchains have their own block space, so they don’t have to compete with other chains for execution. But this does not achieve the efficiency it could achieve. Using monolithic blockchain architectures, such as appchains built on modular software (e.g., Cosmos) or as fully monolithic appchains (e.g., Avax subnets), limits their ability to reduce transaction costs and increase computational throughput.

In contrast, applicationchains built on a fully modular blockchain protocol reduce unnecessary friction because they can leverage an optimized blockchain layer built for specific functions. Let’s say you’ll build an L3 on top of zkSync (L2) that leverages Celestia for data availability and Ethereum for proof-of-settlement and consensus, compared to a monolithic appchain that combines all or some of the layers. In this case, the only way forward is to build modularly for better scalability while retaining decentralization.

It is important to note that these benefits are measured beyond what is theoretically achievable for a monolithic application chain. For example, L1 costs 100 times less for L2 and 10, 000 times less for L3 compared to L1. zkSync is building the zkPorter L3 with about 100x lower fees, and a maximum TPS of 20, 000+. L3 not only offers improved performance, but it can also be customized for specific purposes. This includes adding privacy features when using ZKP, designing custom DA models, and enabling efficient interoperability solutions.

Almost every relevant EVM L2 is planning to develop a customizable L3 on top of its L2. In addition, opportunities will arise to build more modular blockchains using Celestia’s shared data availability base layer. However, an important thing to note about this prediction is that the future development of appchains will be as L3s on a modular blockchain stack, rather than monolithic chains. Combining the decentralization and security of EVM with scalable L3 makes the modular environment far superior to a monolithic appchain ecosystem. There are still important interoperability issues that need to be addressed, especially for cross-rollup transactions. However, we are making progress, and L3 is expected to be available by the end of 2023.

Therefore, if L3 can solve the interoperability problem, then deploying application chains built on a modular blockchain technology stack will be a killer for monolithic application chain theory. L3 will retain a level of Ethereum security, increase speed and scalability, and allow dapps to be customized for specific use cases. Appchain ecosystems like Cosmos will continue to gain traction in 2023. However, with the final deployment of L3 in 2023, we will see a shift in the appchain narrative from a monolithic ecosystem to a modular ecosystem.