Hack VC: Is modularity a mistake? Examining Ethereum's strategy based on data

Authors: Alex Pack, Alex Botte, Partners at Hack VC

Compiled by Yangz, Techub News

Summary

The performance of Ethereum (ETH) in this cycle is not as good as Bitcoin (BTC) and Solana and other Mainstream Tokens. At least in the eyes of opponents, the main culprit is Ethereum’s modular strategic decision. But is this true?

In the short term, the answer is definitely yes. We found that the transition of ETH workshop to a modular architecture has had an impact on the price of ETH due to the drop in fees and Token consumption.

If we add the Market Cap of Ethereum and its modular ecosystem together, the situation will change. In 2023, the value generated by the modular infrastructure Tokens of Ethereum is similar to the entire Solana, both at 500 billion dollars. However, in 2024, the overall performance of these Tokens is not as good as Solana’s. In addition, the profits from these Tokens mainly go to the teams and early investors, not to ETH Tokenholders.

From a business strategy perspective, the modular transformation of Ethereum is a reasonable way to maintain its dominant position in the ecosystem. The value of blockchain depends on the scale of its ecosystem. Although Ethereum’s market share has dropped from 100% to 75% over the past nine years, this share is still significant. We compared it with Web2 cloud computing company Amazon Web Services, whose share has dropped from nearly 100% to 35% in the same period.

From a longer-term perspective, the greatest benefit of ETH modular approach is to enable the network to withstand technological advances that may make it obsolete in the future. Through L2, ETH has successfully overcome the first major ‘disaster’ of L1, laying a good foundation for its long-term resilience (although with some trade-offs).

What’s the problem?

Compared to BTC and Solana, ETH has performed poorly in this round of market. Since 2023, ETH has pumped 121%, while BTC and SOL have pumped 290% and 1452% respectively. There have been many explanations for this phenomenon, claiming that the market is irrational, and that the technical roadmap and user experience are lagging behind peers. The market share of ETH’s ecosystem is being taken away by competitors like Solana. So, is ETH destined to become the AOL or Yahoo of the Cryptocurrency field?

The culprit behind the poor performance of Ethereum is actually a very deliberate strategic decision made by Ethereum nearly five years ago, that is, to switch to a modular architecture, and subsequently the Decentralization and splitting of its infrastructure roadmap.

In this article, we will explore the modular approach of the Ether square, using data-driven analysis to assess how this strategy affects the short-term performance of ETH, the market position of Ether Square, and its long-term prospects.

The strategic shift of the ETH community towards modular architecture: How crazy is it?

In 2020, Vitalik and the Ethereum Foundation (EF) made a bold and controversial call to split various parts of the Ethereum infrastructure stack. Ethereum will no longer handle all aspects of the platform (execution, settlement, data availability, ordering, etc.), but intentionally allow other projects to provide these services in a composable manner. Initially, they encouraged new Rollup protocols to handle the execution problem as Ethereum L2 (see Vitalik’s 2020 article ‘A Rollup-Centric Ethereum Roadmap’), but now there are hundreds of different infrastructure protocols competing to offer what was once considered exclusive L1 technology services.

To better understand how radical this idea is, consider the situation in Web2. A similar Web2 service to Ethereum is Amazon Web Services (AWS), the leading cloud infrastructure platform for building centralized applications. Imagine if 20 years ago when AWS was just launched, it decided to focus only on its flagship products like storage (S3) and computing (EC2), instead of the dozens of services it now offers. AWS would have missed out on a great revenue opportunity, unable to market its expanding suite of services to customers. With a full range of product services, AWS could have created a ‘walled garden,’ making it difficult for customers to integrate with other infrastructure providers and locking them in. And that’s exactly what happened. AWS now offers dozens of services, making it hard for customers to leave its ecosystem, and its revenue has risen rapidly (from early billions to around $100 billion in annual revenue).

However, in terms of market share, over time, AWS’s market share has gradually been taken over by other cloud computing providers, with competitors such as Microsoft Azure and Google Cloud steadily expanding their market share each year, and AWS’s market share has dropped from the initial 100% to around 35% now.

What if AWS took a different approach? What if AWS acknowledges that other teams may be better suited to build certain services and opens up its APIs, prioritizes composability, and encourages interoperability instead of creating a closed environment? AWS could allow developers and startups to build complementary infrastructure for a better and more professional infrastructure, creating a more developer-friendly ecosystem and a better overall experience. This may not bring in more revenue for AWS in the short term, but it can give AWS a larger market share and a more vibrant ecosystem compared to its competitors.

However, this may not be worth it for Amazon. Because it is a publicly listed company, what needs to be optimized is revenue, not ‘a more vibrant ecosystem’. For Amazon, splitting up and modularizing may not be reasonable. But for Ethereum, it may be reasonable because Ethereum is a Decentralization protocol, not a company.

Decentralization protocol, not a company

Like any company, Decentralization protocol also has usage fees, or to some extent can be called ‘revenue’. But does this mean that the value of the protocol should be based solely on these revenues? No, that’s not the case.

In Web3, the value of a protocol depends on the overall activity on its platform, which is determined by the most active builders and user ecosystem. Here is our analysis of the relationship between Token prices and the Metcalfe value (a measure of the number of users in the network) for BTC, Ethereum, and Solana. In all cases, Token prices are highly correlated with Metcalfe value, and this relationship has persisted for several years, with BTC having maintained this relationship for over a decade.

Why is the market so focused on following ecological activities when pricing these Tokens? Stocks are priced based on rise and profit. Currently, the theory of how blockchain accumulates value for its Tokens is still very immature, with little explanatory power in the real world. Therefore, it is reasonable to value them based on the strength of the network (such as the number of users, assets, activity, etc.).

More specifically, the price of a Token should actually reflect the future value of its network (just like the stock price reflects the future value of a company, rather than its present value). This brings us to the second reason why Ethereum may want to modularize, which is to use modularity as a ‘future guarantee’ and increase the possibility of Ethereum maintaining its dominant position in the long term.

In 2020, when Vitalik wrote ‘The Rollup-Centric Roadmap’, ETHereum was in its 1.0 phase. ETHereum was the first smart contract blockchain in history, but it is clear that there will be several orders of magnitude (OOM) improvements in scalability, cost, and security of the blockchain in the future. The biggest risk for pioneers is that they adapt to new technological paradigms at a slower pace, thus missing the next OOM leap. As for ETHereum, this is the transition from PoW to PoS, and the transition to a blockchain that is 100 times more scalable. ETHereum needs to nurture an ecosystem that can scale and make significant technological progress, otherwise it may become the Yahoo or AOL of that era.

In the world of Web3, Decentralizationprotocol has replaced the position of companies. Ethereum believes that in the long run, nurturing a strong modular ecosystem is more valuable than controlling all infrastructure, even if it means giving up control of the infrastructure roadmap and core service revenue.

Next, let’s take a look at how this modular decision is implemented through data.

Modular Ethereum ecosystem and its impact on ETH

We will examine the impact of modularity on Ethereum from the following four aspects:

Short-term price (unfavorable)

Market Cap (which is advantageous to a certain extent)

Market share (favorable)

Future Technology Roadmap (To be discussed)

Fees and prices: unfavorable

In the short term, Ethereum’s decisions have had a significant impact on the price of ETH. Although the price of Ethereum has been pumping significantly since its low point, at certain times, its performance has been worse than many competitors such as BTC, SOL, and even the Nasdaq Composite Index.

This is undoubtedly largely due to its modular strategy.

The first way the modular strategy of Ethereum affects the price of ETH is to drop the fee. In August 2021, Ethereum introduced EIP-1559, which means that excess fees paid to the network will lead to the burning of ETH, thereby restricting supply. This is somewhat equivalent to stock buybacks in the public stock market, which will exert positive pressure on the price. In fact, it did play a role for a period of time.

However, with the introduction and development of L2 solutions for execution and alternative data availability (DA) layers like Celestia, the fees of Ethereum (ETH) have decreased. The fees and revenue of Ethereum (ETH) have both decreased by giving up core revenue-generating services. This has had a significant impact on the price of ETH.

Over the past three years, the correlation between Ethereum fees (in ETH) and the price of ETH has been statistically significant, with a weekly correlation of +48%. If the fees generated by Ethereum decrease by 1000 ETH within a week, the average depreciation of ETH price would be $17.

Of course, these fees are not nowhere to go, they flow to new blockchain protocols, including L2 and DA layers, and so on. This also leads to the second reason why a modular strategy may harm the price of ETH, namely, that most of these new blockchain protocols have their own native Tokens. Previously, investors only needed to buy one infrastructure Token to access all the exciting rises happening in the Ethereum ecosystem, and now they must choose from many different Tokens (CoinMarketCap lists 15 Tokens in its ‘modular’ category, with dozens of Tokens accepting venture capital in private markets).

The new category of modular infrastructure Token may damage the price of ETH in two ways. First, if the blockchain is seen as a company, it should be fully zero-sum, and the total Market Cap of all ‘modular Tokens’ will become the Market Cap of ETH. This is usually the case in the stock world. When a company splits, the Market Cap of the old company usually decreases as the Market Cap of the new company increases.

But for ETH, the situation may be worse than this. Most cryptocurrency traders are not particularly sophisticated investors. When they are faced with a scenario where they have to buy dozens of tokens to get all the cool rises on the ETH platform instead of just one token, they may be at a loss and simply not buy any tokens. This psychological cost and the transaction cost of buying a basket of tokens instead of just one token may damage the price of ETH and modular tokens.

Market Cap: Favorable (to some extent)

Another way to estimate the impact of Ethereum’s modular roadmap on its success is to look at the change of its absolute market capitalization over time. In 2023, Ethereum’s market capitalization increased by $128 billion. In comparison, Solana’s market capitalization rose by $54 billion. Although the absolute number is higher, Solana’s rising base is much lower, which is why its price has risen by 919%, while ETH only rose by 91%.

However, if we take into account the Market Cap of all the new ‘modular’ Tokens brought about by Ethereum’s modular strategy, the situation will change. In 2023, this number rose by 510 billion dollars, which is basically on par with Solana’s Market Cap rise.

What does this mean? One explanation is that with the shift in modular strategy, the Ethereum Foundation has created value equivalent to Solana’s for the modular infrastructure ecosystem that aligns with Ethereum. Not to mention the $128 billion Market Cap value it has created for itself. Imagine how envious Microsoft or Apple would be of Ethereum’s achievement, spending years and billions of dollars trying to build their own developer ecosystem around their products.

However, the situation in 2024 is not so. SOL and ETH continue to rise (although the rise is not significant), while the Market Cap of modular blockchain is declining overall. This may be the market losing confidence in the value of Ethereum’s modular strategy in 2024, or it may be the pressure from Token unlocking, and of course, it may be the psychological cost of the market buying a basket of TokenLong Ethereum-related infrastructure is unbearable, in contrast, they only need to buy one Token to Long Solana technology ecosystem.

Let’s switch from the information told by PA and the market to the actual fundamentals themselves. Perhaps the market in 2024 is wrong, while the market in 2023 is right. Has Ethereum’s modular strategy helped or hindered it from becoming the leading blockchain ecosystem and Cryptocurrency?

Ethereum’s ecosystem and the dominance of ETH: advantageous

In terms of fundamentals and usage, the infrastructure is exceptionally outstanding, consistent with Ethereum. Among similar products, Ethereum and its L2s have the highest Total Value Locked (TVL) and fees, 11.5 times that of Solana, and even 53% higher than Solana with just L2.

If we consider it from the perspective of the TVL market share, when Ethereum was launched in 2015, it had 100% market share. Despite the hundreds of L1 competitors, Ethereum and its modular ecosystem still maintain about 75% market share.

In 9 years, the market share has dropped from 100% to 75%, which is already very good! You should know that AWS’s market share has dropped to about 35% in roughly the same period.

But does ETH really benefit from the dominant position of the “Ethereum ecosystem”? Or is it the case that Ethereum and its modular parts are thriving, but not necessarily as an asset itself? The fact is that ETH is an ubiquitous part of the wider Ethereum ecosystem. This is true even when Ethereum expands to L2. Most L2s use ETH to pay for gas, and ETH makes up at least 10 times the TVL of other tokens in most L2s. By looking at the table below, you can see the dominant position of ETH assets in the Mainnet and L2 instances of the three largest Decentralized Finance applications in the Ethereum ecosystem.

Technical level: to be discussed

From a technical roadmap perspective, the decision of ETH to modularize the L1 chain into independent components allows projects to specialize and optimize within their specific domains. As long as these components remain composable, DApp developers can build using the best existing infrastructure, ensuring efficiency and scalability.

Another major benefit of modularization is to provide ‘future guarantee’ for protocols. Consider this, if a new technological innovation changes the game rules, then only the protocol that adopts this innovation can survive. This situation frequently occurs in the history of technology, for example, America Online fell from a valuation of 200 billion dollars to 45 billion dollars for missing the transition from dial-up internet to high-speed broadband internet. Yahoo also fell from a valuation of 125 billion dollars to 50 billion dollars because of the slow adoption of new search algorithms (such as Google’s PageRank) and missing the transition to mobile internet.

However, if your technical roadmap is modular, as an L1, you don’t need to catch every new wave of technological innovation. Your modular infrastructure partners can catch it for you.

So, has this strategy of ETH Bank worked? Let’s take a look at the infrastructure that has been actually built to match ETH Bank:

L2 with best-in-class scalability and execution costs. At least two novel technical approaches have been successful here: optimistic rollups, represented by Arbitrum and Optimism, and Zero-Knowledge Proof-based rollups, represented by ZKSync, Scroll, Linea, and StarkNet. In addition, there are many more high-throughput, low-cost L2s. Cultivating two Block Chain technologies that bring scalability and OOM improvements to the ETH workshop is no easy task. The dozens, if not hundreds, of L1s that were launched after ETH have yet to launch version 2.0 with 100x scalability and cost improvements. With these L2s, ETH has survived the “first mass extinction event” of the Block chain, successfully scaling to a hundredfold volume per second (TPS).

New security mode for the Block chain. Innovation in blockchain security is crucial for the survival of a protocol, as can be seen today with every mainstream L1 using PoS instead of PoW. EigenLayer’s pioneering ‘shared security’ mode may be the next major transformation. While other ecosystems have also launched other shared security protocols, such as Babylon for BTC and Solayer for Solana, Ethereum’s EigenLayer is the pioneer.

The new Virtual Machine (VM) and programming language. One of the biggest criticisms of Ethereum (ETH) is its Virtual Machine (EVM) and its programming language, Solidity. Solidity is a low-level programming language that, although easy to code, is prone to vulnerabilities and difficult to audit, which is one of the reasons why Smart Contracts based on Ethereum have been targeted by hackers. For non-modular blockchains, it is almost impossible to attempt to use multiple Virtual Machines or replace the initial Virtual Machine with another one, but this is not the case for Ethereum. A new wave of alternative Virtual Machines is being built in the form of L2, allowing developers to code in alternative languages without using the EVM, but still being able to build within the Ethereum ecosystem. Examples in this regard include Movement Labs, which is adopting the Move VM built by Meta and promoted by Sui and Aptos; zk-VM, such as RiscZero, Succinct, and implementations built by the a16z research team; and teams introducing Rust and Solana VM to Ethereum, such as Eclipse.

New scalability methods. Like other internet infrastructure or artificial intelligence, we can expect OOM scalability improvements every few years. Even now, Solana has been waiting for several years for the next major improvement, called Firedancer, developed by a team (Jump Trading). In addition, there are some new highly scalable technologies under development, such as parallel architectures from L1 teams like Monad, Sei, and Pharos. If Solana cannot keep up, these technologies may pose a threat to its survival, but Ethereum will not, as it can simply incorporate these technological advancements through new L2 solutions. This is exactly what new projects like MegaETH and Rise are trying to do.

These modular infrastructure partners help Ethereum integrate the biggest technological innovations in Crypto Assets into its ecosystem, avoiding disaster and innovating together with its competitors.

However, this also comes at a cost. As Composability Kyle pointed out, when ETHereum adopts a modular architecture, it adds a lot of complexity to the user experience. Ordinary users will find it easier to get started with a single-chain like Solana, because they don’t have to deal with cross-chain interaction and interoperability issues.

Summary

So, in summary, what does Ethereum’s modular strategy bring?

The modular ecosystem has expressed a strong ‘opinion’. In 2023, the market gave the same rise to modular infrastructure tokens as ETH gave to Ethereum, and the same rise to Solana, but the situation in 2024 is not the same.

At least in the short term, the modularization strategy has caused less cost damage to the price of ETH.

But if we consider the modular approach from a business strategy perspective, things start to make more sense. In the 9 years since the establishment of Ethereum, its market share has decreased from 100% to 75%, while its Web2 competitor AWS has seen its market share decrease to around 35% during the same period. In the world of Decentralizationprotocol, the scale of the ecosystem and the dominant position of Token are more important than costs.

If we consider the modular strategy from a long-term perspective, as well as the fact that Ethereum needs to resist potential OOM technological improvements that could make it become the AOL or Yahoo of the cryptocurrency field, then Ethereum’s performance is also quite good. With L2, Ethereum has already passed the first ‘great extinction event’ of the L1 chain.

Of course, all of this comes at a cost. The modularity of Ethereum makes it less composable than a bundled single chain, which damages the user experience.

It is unclear when (if ever) the benefits of modularity in terms of actual ETH prices will offset the cost of loss and competition with modular Ethereum infrastructure tokens. Of course, this is good news for early investors and teams behind these new modular tokens, as they can benefit from the ETH market capitalization. However, in many cases, modular tokens are launched with unicorn valuations, which means that the distribution of these economic benefits is uneven.

In the long run, Ethereum (ETH) may become a stronger participant by investing in nurturing a more extensive ecosystem. It will not lose ground like AWS in the cloud computing market, nor will it lose everything like Yahoo and AOL in the internet platform war. It is laying the foundation for adaptation, expansion, and prosperity for the next wave of blockchain innovation. In an industry driven by network effects, Ethereum’s modular strategy may be the key to maintaining its dominant position as a Smart Contract platform.