Infrastructure scalability is arguably the most pressing problem in the Blockchain industry. Even though security and UX are big issues, the ability to handle high transactional volumes is key to growth. The current infrastructure is unprepared to deal with the rise of dApps, and crypto games.

The two major networks, Bitcoin and Ethereum, are only capable of 7 and 20 transactions per second, respectively. This capacity pales in comparison to traditional financial infrastructure players such as Visa, without even considering other use cases like Blockchain Games, which usually demand faster and larger transaction volumes.

This creates a bottleneck, and in times of high demand, users start to compete to have priority in transaction execution, i.e., paying higher transaction fees. For instance, in May 2021, the ETH gas fee (transaction fee in the ETH network) reached an all-time high of US$ 71 – when Bored Apes Yacht Club’s metaverse project, the Otherside, was launched. In addition, the BTC average transaction fee has been around US$ 1 - 3, which makes small transactions unattractive.

The combination of low rate of transactions and high transaction fees makes building scalable solutions - that demand high throughputs - challenging, if not impossible.

The Blockchain Trillema

Most blockchain projects are built with a monolithic architecture. This means that they work with a stacked design, where the execution, consensus, and data availability layers are all functioning within a single blockchain network. This imposes a strain on the system and results in blockchain projects that have to compromise between decentralization, security, and scalability. In general, projects manage to meet two out of the three conditions, but not all three together.

To better understand this concept, it's helpful to understand what decentralization, security, and scalability mean in the Blockchain space. The decentralization aspect comes from the way that control over the network is distributed. In order to process new transactions, validators, in the Proof of Stake paradigm, need to attest to the soundness of each transaction - or miners in the Proof of Work paradigm have to execute complex computations to add a new block to the blockchain. In short, there is no single institution controlling the network.

It’s also decentralization that improves the network’s security. To be able to hack most blockchains, someone needs to hack the majority of nodes. The problem is that the more decentralized a network is, the slower it gets, since there are more nodes that are needed to validate all the transactions. However, if decentralization is reduced, security also goes in the same direction.

This is quite a complex problem to be solved, and yet, as we discussed before, its resolution is fundamental to mass adoption. The good news is that there are some good projects in development and interesting concepts being forged and funded which aim to solve this huge Web3 obstacle.

Ethereum’s Ecosystem

Undoubtedly, Ethereum is one of the big bets for a new computational infrastructure layer. It’s the network that attracts most of the new developers in Web3, it’s the second-largest blockchain by market cap, and it’s the first in TVL.

In this context, scaling Ethereum could mean scaling the whole blockchain ecosystem. Fortunately, there are compelling projects that are trying to do this using rollups, which can fall into two different categories: Optimistic Rollups and Zero-Knowledge (ZK) Rollups.

These scaling solutions are already making an impact in the Ethereum network. Currently, rollups represent around 7% of all transaction fees paid in the Ethereum Network. Despite yet small, this trend has been showing consistent growth, especially considering that two years ago this number was practically inexistent.

Both types of rollups have the same basic working principle. They bring together the best of L2 solutions (blockchains built on top of the Ethereum network, enhancing its capabilities), such as channels that are designed for a specific set of applications while benefiting from Ethereum’s security, and sidechains, that support more general-purpose applications, with the downside of not being secured by the Ethereum Network.

Rollup solutions have their own smart contract deployed in the Ethereum Network, which handles interactions between the mainnet and the rollup chains. In this model, transactions are processed by the rollup chain, bundled into batches, compressed, and sent back to the mainnet, reducing the load of the Ethereum Network in processing all these transactions. In this way, they unite scalability, the generalist approach from sidechains, and the Ethereum security that the channels take advantage of.

These scaling solutions are already making an impact in the Ethereum network. Currently, rollups represent around 7% of all transaction fees paid in the Ethereum Network. Despite yet small, this trend has been showing consistent growth, especially considering that two years ago this number was practically inexistent.

The aspect that differentiates optimistic and ZK rollups is the consensus method:

Optmistic Rollups

In this kind of rollup, all transactions submitted are assumed to be correct. In order to guarantee security after submission, there is a built-in dispute phase, a period in which the funds are locked in the rollup chain and cannot be withdrawn to the mainnet until the process is complete.

In the dispute period, which can last from 1 up to 2 weeks, anyone - validator or not - can offer proof of fraud against the transaction. Both parties, the one submitting the transaction batch and the one contesting it, have ETH staked. If the proof of fraud is correct, the party that has submitted the transaction automatically forfeits the staked ETH to the contestant, and vice versa. This mechanism prevents malicious agents from spamming the network with false fraud proofs and creates an economic incentive to keep the network secure.

Whenever there is a fraud claim, the transaction batch is executed again, this time in the mainnet, to ensure the soundness of the transaction. In this model, if there is only one good willing agent at a given time the network is secured.

Optimistic rollups projects are a simpler implementation than the alternatives and, in fact, work similarly to the way Ethereum does, making it easier for new developers to start building and contributing to these projects. However, there are major UX considerations regarding this technology. The dispute period forces the user to wait 1-2 weeks in order to withdraw the funds, which creates a lot of friction in the process. And despite the existence of some workarounds, like Hop, it creates yet another element of complexity in the user’s journey.

Optimism and Arbitrum are maybe the best contestants in the optimistic rollups space. They have, respectively, US$ 949M and US$ 2.29B in TVL. Furthermore, they are very well funded, Optimism raised $150M with a $1.65B valuation in 2022 from A16z, and Paradigm, and, in 2021, Offchain Labs, Arbitrum’s developer, raised $120M with a $1,2B valuation led by Lightspeed.

ZK Rollups

This type of rollup doesn’t assume the soundness of the transaction, thus, does not possess a dispute resolution mechanism. In a ZK rollup, with every transaction batch submitted to the mainnet there is a cryptographic proof (SNARK, Succinct Non-Interactive Argument of Knowledge), which is verified by the rollup smart contract deployed in the Ethereum network. The contract is in charge of maintaining the state of all transfers on the rollup chain, only being altered with a validity proof. This makes transactions cheaper and faster, since only the validity proof needs to be stored on-chain to guarantee network security.

In layman’s terms, ZK proofs enable one party (the prover) to prove to another (the verifier) that they know a secret, without actually revealing what the secret is. And that's why it’s called Zero-Knowledge since the verifier doesn’t learn anything about the secret.

A simplified example of how a ZK proof happens is as follows:

1. The prover has a secret (let's call it X) and wants to prove knowledge about it without revealing what X actually is.

2. The prover creates a mathematical problem that involves X, and solves it, creating a "proof" that they know X, given that the problem can only be solved with knowledge about X.

3. Using a SNARK algorithm, the prover can "compress" the proof into a few hundred bytes.

4. The prover shares the SNARK with anyone who wants to verify that the prover knows X. They can use the SNARK to check that the proof is valid, without ever seeing X itself.

ZK Rollups is a relatively new concept. Despite ZK projects outside the Ethereum ecosystem, such as Zcash, having been around since 2016, the concept is still maturing. In the next few years, the technology should reach some maturity in order to provide a higher level of abstraction to developers, making its implementation easier.

Due to its novelty, ZK projects are still hard to build, and ZK developers are scarce. However, it has better security when compared to optimistic rollups, since it doesn’t require an “honest” agent as a validator, and it's faster, due to the relatively small time of computation required to verify the SNARK proof.

In fact, there are exciting projects being developed at this moment. Polygon zkEVM might be one of the most well-known. Their zkEVM went beta on March 27th and it already had around 14k unique depositors by April 17th. Polygon has raised in 2022 US$ 450M with a US$ 13B valuation, in order to keep building scalability solutions for Ethereum.

They are a strong contestant in the race for zkEVM scalability solutions. Apart from its technology, the Polygon team is known for their strong business development capabilities, partnering with companies such as Nubank and Stripe.

Other good projects are zkSync, StarkWare and Scroll. Matter Labs, zkSync developer raised, US$ 200M in November 2022. StarkWare raised US$ 100M in a Series D with a valuation of US$ 8B in May 2022 and Scroll, which has its testnet in Alpha, raised, US$ 50M with a valuation of US$ 1.8B  in March 2023.

Furthermore, ZK technology is improving at a fast pace. The time required for a ZK proof to be created/validated and the proof size has been diminishing in a “Moore’s Law” like pace, this reduces the mainnet processing and storage burden, which results in the increasing usage of the technology.

At first glance, the ZK rollups project might seem the best bet. However, it’s feasible to think that, in the future, the consensus layers might be separated from the rollup. Projects like Optimism could provide solid rollup technology, with good UX for developers, and let them decide which kind of consensus mechanism they prefer.

Layer Zero Protocols

Apart from Ethereum, there are many other ecosystems and solutions for the scalability problem. Layer 0 protocols, for instance, are also a promising workaround to the Trilemma while also tackling the interoperability problem in blockchain.

Without diving into the project's specificities, these protocols provide the infrastructure in which developers can build parallel L1 chains that communicate with the L0 mainchain, delegating the primary responsibility of the 3 functions to these separate and independent blockchains. For instance, one chain (the execution chain) can be optimized for handling high transactions per second for decentralized applications, like play-to-earn games, without worrying about decentralization. A second chain can then be optimized for decentralization and serve as a final consensus layer for the execution chain to enable withdrawals and anchor its data, thus making these blockchains more scalable.

This design choice has another implication, which is enabling secure interoperability between different chains. With the development of blockchain technology, many interesting projects have emerged. The big problem is that these protocols were not built to communicate with each other. This creates a silo effect, making it harder to exchange messages between networks.

One of the earlier and most common solutions to this problem are bridges built between two networks. However, this approach has some issues, mainly the fact that they serve specific use cases, do not provide general interoperability, and have been presenting systematic security issues.

In this context, “Layer 0” protocols are better alternatives. They use clever techniques to enable a secure transfer of arbitrary data across chains built upon their infrastructure, Cosmos and Polkadot being the most well-known. For instance, a common technique is using a middle chain focused on providing consensus and validation services that facilitate the exchange of messages between chains, just like Polkadot’s Relay Chain.

According to Crunchbase, Polkadot has raised a total of US$ 336.7M from its ICO and investors, such as Pantera Capital and Fabric Ventures. Despite that, there is a big concern regarding projects like Polkadot and Cosmos; the lack of demand. Despite being around for a while, they do not have anywhere near the same demand as Ethereum has. Maybe, with the development of the technology and the emergence of more applications, this will change.

Another project that has been attracting a lot of attention is LayerZero, which has the main goal of enabling generic interoperability between different blockchains while being cheap and secure. LayerZero uses the light node approach. This is a type of node that stores only a part of the ledger’s transaction history while being connected to a full node that has the role of strengthening security. For cross-chain messaging applications, it validates every block header – a de facto summary of a block – received from an opposing chain.

The end result is providing a single code interface upon which developers can build their cross-chain applications. It has a profound impact on swapping, lending, borrowing, tokenization applications, and more. These applications have the potential to reshape how the financial system works.

On April 4th, LayerZero raised US$ 120M in a Series B round with a valuation of US$ 3B, totaling almost US$ 300M in funding from investors such as A16z and Sequoia, making the company well-supported to build what could be a good solution for the interoperability problem.

Venture Capital State and Infra Funding

Venture Capital funding to Web3 has been declining since the beginning of the current bear market. In the last quarter of 2022, funding declined to Q1.2021 levels. This is an interesting metric to follow, since VCs are now funding what will be the future of technology.

Despite the overall decline in blockchain funding, infrastructure companies are still receiving a lot of capital. This becomes clear when looking at the trend of funding infrastructure projects and the recent mega rounds that we discussed previously, such as Scroll and LayerZero.

Furthermore, most of the VC leaders in Web3 funding are still investing and growing the amount invested in these companies. It’s also interesting to note that, as we discussed in our previous article, Web3 VCs have a lot of dry powder that will probably be deployed in the next few years, which will contribute greatly to the development of the blockchain ecosystem.

Conclusions

Despite the current bear market, the blockchain industry is experiencing a fast pace in infrastructure development, especially regarding scalability and interoperability. Promising projects are in development and are being funded by specialized investors. This creates an environment similar to the pre-Web2 era, in which the transition from dial-up technology to broadband, together with other developments, enabled companies such as YouTube, Facebook and Instagram to emerge.

The current scenario presents good opportunities for funds investing in infrastructure in a broad sense. There are already good, well-funded projects in the market. However, there are still infrastructure opportunities, such as infrastructure for private blockchains, providing corporations with technology to develop their own solutions, or infrastructure for stablecoin issuance and tokenization.

We understand that the future of decentralized blockchains doesn’t abide by a “winner-takes-all” logic; there are many networks specializing in specific use cases. For instance, the Ethereum network has been known for security, and Polkadot for customization.

For these reasons, interoperability is our bet. We believe that there will be a “winner-takes-most” dynamic inside verticals. As a network matures, it attracts more developers, and as a consequence, open-source libraries of applications become more available. New endeavors may prefer to take advantage of this ecosystem, then build solutions in new networks, which would create a significant entry barrier.

Furthermore, when the infrastructure problem is overcome, quality block space in the blockchain will become cheaper, fostering experimentantion/innovation, and the emergerce of new applications. In this context, investment opportunities will arise in the application layer.

While today infrastructure companies still book the majority of revenues - it might remain true for a while - at some point, probably after the next bull run, we imagine that the reverse will happen, with applications becoming much larger, just as happened with the internet. However, until we reach that inflection point, we believe that it is in infrastrucure that most returns will come from in the short and medium term.

If you like this content, you can find a deeper discussion about the state of crypto on our Crypto Paper, or if you are an entrepreneur with a Web3 / Fintech / Embedded Finance product, contact us, we are investing!

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