Time to Look Up and Face the New Reality
Blockchains that are launched today are transacting real world value. Looking further up, there are big rocks out there to solve around Centralization, MEV and Shared Security.
Thesis
Layer 2 blockchains (L2s) are meant to solve the problems of scaling — by generating blocks faster, with increased capacity for transactions within each block and lowering fees making it highly cost effective.
Layer 2s, which are entirely new blockchains, have transactions running on them in an entirely different chain (database). Some examples of L2s are Polygon, Avalanche, Optimism and Arbitrum. L2s ultimately rely on Layer 1’s security, in this case Ethereum, where all transactions must be arranged and settled (recorded), like checkpoints, into Ethereum.
We believe that this L1 to L2 relationship and scaling solution has largely been solved. Our hypothesis is that the focus now shifts to the next big rocks around Sequencers and Staking, which is Centralization, Maximal Extractable Value (MEV) and Shared Security.
The Three Problems
The following are a subset of issues which we think are crucial big rocks to tackle in the foreseeable future.
Centralized Sequencers
There are two fronts. First and foremost, there is a centralization on the L2 infrastructure itself, where the Sequencers are centrally operated by the L2 foundations themselves. Secondly, there’s an economic centralization where, for Ethereum, there’s a minimum 32 ETH staking which is segregating the staking community to an affluent set of stakers (whales, institutions, and early adopters), plus liquid staking protocols such as Lido (commanding 30% of market share for staked ETH and growing).
Blockchain sequencers helps process transactions (also arranges the order of the transactions), produces rollup blocks, and submits rollup transactions to the L1 chain
Maximal Extractable Value (MEV)
This again surrounds Sequencers, which dictates how transactions are arranged and therefore front-run transactions and backfill them to extract the value of a spot trade within the same block. There are software patches that can be written to either mitigate MEV or to maximize it. Hence, in the near future when sequencers are a decentralized network of operators, they can decide on whether or not to allow MEVs (benefiting block operators) or to block MEVs (benefiting DeFi spot traders to get the best exchange rates).
Shared Security
It is becoming increasingly difficult to fund bootstrapping of a new set of network operators and incentivizing them to run blockchain nodes for new L1 or L2 chains. There are way too many blockchains out there and each and every one of them, if they require such a mechanism, could dilute both the attention and viability of such a business model for infrastructure providers. We are entering a new phase of extending the existing blockchains with a concept of shared security (popularized by Polkadot, Cosmos IBC and recently EigenLayer) by borrowing what we have today and running new networks secured by the existing underlying Proof-of-Stake networks.
Solutions
The following are plausible solutions described in succinct excerpts.
Decentralizing Sequencers
A blockchain Sequencer is an essential component of a blockchain system, particularly in Layer 2 scaling solutions. Its primary function is to order transactions and include them into blocks, which are then added to the blockchain.
Sequencers help improve the throughput and efficiency of blockchains, as they can process transactions off-chain before submitting them to the main chain, reducing the load on the main network.
The economic incentive model for running Ethereum L2 sequencers in a decentralized ecosystem is still being proposed and reviewed. When such a solution is developed, network operators can offer multiple sequencers that operate in a decentralized fashion. They can follow the consensus algorithms to agree on transaction ordering, thereby reducing the reliance on a single sequencer.
Solving for MEV
In order to effectively block MEV, there are a couple of popular methodologies:
Threshold encryption: Techniques like threshold signatures can be used to distribute the responsibility of transaction ordering and validation among multiple parties, enhancing the robustness and decentralization of the system by mitigating sequencer MEV. Osmosis on the Cosmos ecosystem has adopted this methodology.
Proposer / Block-producer Separation (PBS): The reason MEV is possible is because the arrangement of blocks (by block producers) and the act of signing the blocks (block proposers) is the same validator party. The Ethereum community is proposing to have the block producer and proposer be separated by using the PBS methodology, and interact only in a marketplace environment, where the commit-reveal scheme can help make this work without sacrificing security.
There are benefits of allowing or enabling MEV, where it is arguably a methodology to improve market efficiency by encouraging third parties to search for the best market rates and make the necessary re-arrangements in a block’s transaction to match trades efficiently.
Shared Security
This is surfacing as a popular topic, amongst most blockchain ecosystems. The Cosmos, Polkadot and Ethereum ecosystem all share the same ideology where there is sufficient stake in the L1 chains that additional applications running on top of them should be taken care of by the L1 chains themselves, without the need to create new L2 blockchains and go through the same cycles of recreating the validator bootstrap playbook to sufficiently decentralized a blockchain ecosystem, on top of the existing L1s.
EigenLayer is one such solution on Ethereum, where builders that are building bridges, oracles and data availability layers do not need to seek out a sufficient set of validators to create a decentralized distributed network.
The Cosmos ecosystem has also recently passed a proposal on to echo the spirit of shared security (called Replicated Security), where a new chain Neutron will run on the 95th-percentile of the Cosmos Hub elected validators.
Summary
Sequencers are an essential component for blockchains to essentially operate. There are arguable challenges related to Centralization and MEV surrounding sequencers. Decentralizing sequencers may be crucial to maintain security and trustlessness. Managing the balance of MEV is important to ensure between the spectrum of fair transaction ordering and market efficiency. Finally, Shared Security is in its early stages where EigenLayer is in Testnet (Mainnet estimated Q3 2023), while the first smart contract platform secured by Cosmos Hub, Neutron, is scheduled to launch within a few days.
We’re in early days of blockchain technology. We hope you’ve enjoyed this piece and find this interesting. Follow us on Twitter @layer7ventures, subscribe to this Substack and share this article with a friend. We’d love to hear from you and hope to see you back here again soon.
Images are courtesy of Don’t Look Up, distributed by Netflix