Layer 1s versus Ethereum

Last year, the networks that set out to compete with Ethereum for a slice of decentralized applications proved to be profitable. These blockchain networks, also known as ‘Layer 1s’, include Solana, Polygon, Avalanche, Polkadot and Cosmos amongst others.

These protocols are masters of decentralized computation, something that can power any type of software, but is “particularly apt for digital scarcity, property rights and provenance,” writes Lex Sokolin at Coindesk. And as last year showed, they proved to be increasingly profitable for investors. However, they only remain valuable if they are used by the developers who make apps.

They also require users. As Sokolin says, “if there are users in your platform, developers value that as a distribution channel in addition to a technology enabler.” He refers to this creating a viral loop “that can create positive network effects, which allow certain equilibria to hold, and others to collapse.” He adds, “So layer 1s do both – they provide the computational unit as well as the market context in which that computational unit is generated and executed.”

Yet Ethereum is still holding the biggest slice of the market. It is true that its dominance has declined. For example, in September 2020, Ethereum had 90% of the assets on the market, and today it has about 50%. How and why has that happened?

Let’s take Avalanche as an example. It is launching a $290 million incentive program to grow the applications built on its technology. Its market cap is around $30 billion, so this expenditure on platform growth and customer acquisition is only one percent of its cap. And last year, Polygon, targeted DeFi growth with a $100 million ecosystem fund, which worked for it, as you will find quite a number of DeFi projects on its blockchain.

Ethereum by contrast was boosted by Consensys, which “played the role of ecosystem fund in the early days, eventually generating sufficient building and adoption by the community.”

These ecosystem funds are a really important element in the rise of Layer 1 solutions. Success and sustainability comes from spending on marketing, growing your adoption against others, building in profitability and using profitability to grow your market share. Ultimately, it should have been easy for Ethereum to hold onto the lion’s share of the market, but it didn’t factor in investors’ appetite for. As Sokolin says, “there’s a lot more risk capital out there wanting to recreate a layer 1 investment return profile,” which is good news for those protocols.

DeFi will fuel a new Roaring Twenties

The DeFi boom started in 2015 when the Ethereum network went live, and since then it has grown by 33x to 1.2 million per day on the Ethereum blockchain alone, and it would be even bigger if other chains were added to this figure.

The current DeFi sector “represents only 0.1% of its maximum potential,” writes Artem Tolkachev. As he says, “DeFi is a natural product made possible by blockchain technology and has the right and ready infrastructure to propel the technology to a bigger playing field.”

What has contributed to DeFi growth?

The answer is the use of DeFi services such as Uniswap, which facilitates over $1 billion swaps each day, as well as lending and borrowing protocols such as Aave, Compound and BondAppetit. Combined they form a market worth tens of billions.

The TradFi (traditional finance) market is of course much bigger at trillions of dollars, and currently DeFi can’t offer the same extensive list of services as TradFi. At the moment, DeFi is mostly confined to lending, borrowing, decentralized trading and yield-aggregating, but it also has the advantage of playing an important role in the future of NFTs and in Web 3.0, otherwise known as the Metaverse.

The key to DeFi growth

The TradFi market is ripe for disruption, writes Tolkachev, and that is where DeFi can excel. For example, consumer payments are worth $500 billion per year in revenue for banks worldwide, but this could be tapped into with a frictionless UI, a global stablecoin and broad acceptance points.

And in capital markets, security tokens are an inevitable trend that regulators will eventually need to approve and construct the regulatory framework so that centralized and decentralized exchanges – at least the ones that adhere to the know-your-customer (KYC) requirement — can tap into the trillion-dollar TradFi equity market.

There is also the 1 billion plus daily global credit card transactions to be captured, and even moving 1% of them onto the Ethereum blockchain, or another of the DeFi-friendly smart contract blockchains, would multiply the number of its transactions by eight.

And there is the revenue from DeFi protocols. At the moment this is estimated to have a value of $5 billion annually, which is a fraction of the $2.3 trillion global retail banking revenue; $2 trillion global cross-border payment revenue and $35 billion global stock exchange revenue. Tolkachev says, “The TradFi industry is so lucrative that seizing a 1% market share means 10x-ing the DeFi revenue.”

Furthermore, it is estimated that DeFi has not really yet penetrated the general crypto user market, with only 5% of the 221 million global crypto users accessing DeFi services, revealing a massive untapped market for DeFi that can be captured as the UI/UX is improved.

DeFi is only three years old, so it needs to be given time to grow. The DeFi builder community has grown stronger in 2021 with more programmers from the traditional startups and big tech joining the blockchain and DeFi scene. Tolkachev says, “with the resources and talent flowing into the space now, growing 100x in the next 5 years is not a dream, it is inevitable.”

CBDCs: Is privacy important to the people?

According to a public consultation on the possibility of a digital euro conducted by the European Central Bank (ECB), the responses of over 8,000 individuals and businesses suggested that privacy was the number one concern for 43% of them, when talking about the issuance of a central bank digital currency.

Fabio Panetta, an ECB board member, declared that the digital euro could meet those requirements without relaxing security standards. The survey also revealed that 18% wanted any CBDC to provide secure payments, while 11% focused on cross-border payments within the European Union. Panetta said, “As I have already mentioned, privacy emerges as the most important feature of a digital euro. Protecting users’ personal data and ensuring a high level of confidentiality will therefore be a priority in our work.”

Cointelegraph reports that the ECB has been exploring privacy enhancing techniques, even before the concept of a digital euro emerged and its research indicated “that a digital system could still be monitored for illicit activity, while still allowing for transparency and privacy.”

A decentralized CBDC is preferable, but unlikely

However, while the ECB may be working on privacy for its CBDC, Anne Fauvre-Willis, chief operating officer at Oasis Labs, thinks that even though the EU has supported the concept of consumer privacy in the past, “that won’t count for much if the digital euro is issued on a centralized system.”

She asked, “Instead of enabling this via a centralized bank, why not empower a decentralized protocol to do this instead?” The obvious answer would be to use the Ethereum blockchain for a digital Euro, so that it would have the same level of decentralization and autonomy as ETH. But if she is right, it appears there is little chance of a central bank allowing all control of its money to be decentralized.

The public will vote for ‘Ease’ over privacy

However she points out that the public’s behaviour may simply go for whatever is easiest, rather than worry about privacy. “In regards to people adopting the digital euro, unfortunately I think ease will win over privacy alone,” said Fauvre-Willis. She added, “Privacy is a feature but it’s not enough to drive people on its own to change their behaviour. Instead for those of us who really believe in privacy we have to simultaneously strive to make compelling and life changing products and as we do we need to put privacy at the centre of what we make.”

Currently, the ECB is still in its research stages regarding a digital Euro, with a final decision expected some time during summer 2021. The region is somewhat behind others in the CBDC race, and need to pick up their pace if it is to compete with other nations’ digital versions of the national currency.

Has China really changed its tune on crypto?

I am of course talking about China’s recent turnaround regarding cryptocurrencies. The change of tone coming from Beijing and the People’s Bank of China (PBoC), with regard to cryptocurrencies makes you pause to think, ‘What’s all this about?’

China’s central bank is now referring to bitcoin as an ‘alternative investment’, signalling something is afoot in the country that cracked down on digital assets four years ago.

Of course it is a welcome shift in perspective from the Chinese, and many are describing it as ‘progressive’. At the same time, they are closely monitoring the PBoC for signs of forthcoming regulatory changes in relation to the crypto sector.

During a panel hosted by CNBC at the Boao Forum for Asia on Sunday,

Li Bo, deputy governor of the PBOC, said, “We regard Bitcoin and stablecoin as crypto assets … These are investment alternatives.” He went on to say, “They are not currency per se. And so the main role we see for crypto assets going forward, the main role is investment alternative.” This indicates an unwillingness to see bitcoin and other similar tokens, such as Litecoin, as a means of payment, but at least it is a move towards a broader acceptance of cryptocurrencies in China.

As CNBC points out, China was once one of the world’s biggest buyers of bitcoin, before banning ICOs in 2017 and closing down crypto exchanges in the same year, both moves prompted by a perceived financial instability in the digital asset sector.

Li said, in explaining more about what he meant by calling them investment alternatives: “Many countries, including China, are still looking into it and thinking about what kind of regulatory requirements. Maybe minimal, but we need to have some kind of regulatory requirement to prevent … the speculation of such assets to create any serious financial stability risks.”

Flex Yang, CEO and founder of Babel Finance, called the comments “progressive”, while Vijay Ayyar, head of business development at cryptocurrency exchange Luno said, “I think it is quite significant and is definitely different to their previous statements or positions on public cryptocurrencies.”

When asked about what he thought had changed China’s thinking following the PBoC announcement, Ayyar said, “Governments are realizing that it is a viable and established, yet growing, asset class and need to regulate it. China regulating crypto would be another massive boost to the industry in China and globally.”

At the moment, China is still trialling its digital yuan, which will eventually replace the cash and coins in circulation, and there is a rumour that the country may wish to trial with foreign visitors to the Beijing 2022 Winter Olympics.

As with everything to do with China and finance – watch this space!