Ethereum's Future Is About New Technology - WFM #199
Ethereum's Utility: Layered + Sidechains, Smart Contracts and DAOs.
This week’s newsletter is a first draft. The ideas are raw. I wanted to do more research than time allowed this week, but that’s the fun with shipping something every week. We’re one week away from our 200th newsletter (holy cow!). As always, please share feedback!
The Future Of Ethereum Is Utility
Last week, we dug into the Utility vs Store of Value and Payments capabilities of Ethereum. This week, we’re going to more fully flesh out the utility aspects of Ethereum.
This boils down to 3 main topics: Layered / Sidechains, Smart Contracts, and DAOs.
Today, we’re going to take each, break down their purpose, and explore how this will unleash highly valuable technology for the future.
Layered and Sidechains
Of all the sections today, this is the most technical due to the specific definitions for layered and sidechains. If we get anything wrong, please let us know. We intend to dive deeper into this topic throughout March.
At a high level, Ethereum is a powerful blockchain. But as we explore last week, the current number of Ethereum transactions that can be processed is ~30 per second. And the cost for each transaction (aka the gas fee) is expensive. It can range from a few dollars to hundreds of dollars, depending on current transaction volume and the speed / priority at which you want your transaction to process. As a result of this limit, another innovation has been built: The Layered Chain.
A Layered Chain is exactly as it sounds; a blockchain that sits on top of another blockchain. Ethereum is known as a Layer 1 (L1) blockchain, which means that it’s a foundational blockchain with essential features. A blockchain that sits directly on top of Ethereum would be a Layer 2 (L2).
Let’s say that you wanted to reduce the cost of transactions, increase the number of transactions processed, but still have the reliability of Ethereum. Instead of directly improving Ethereum, an L2 chain could be established that is optimized for transactions, processes them independently, and then adds a rollup transaction to the Ethereum blockchain that is validated and a part of Ethereum. Arbitrum is an example of an L2 of Ethereum.
A Sidechain is wholly independent blockchain that connects to the main blockchain (for example, Ethereum), but it has more flexibility than a L2 chain and doesn’t rollup all its transactions on the main blockchain. Instead, a sidechain uses a two-way peg system, that locks a certain amount of assets on one chain (Ethereum), and then releases an equivalent amount of assets on another chain (Polygon).
Polygon is an example of a sidechain of Ethereum, and I remember distinctly when I mentioned Polygon is a L2 of Ethereum and several developers corrected me.
L2s and sidechains are often grouped together since they’re both scaling solutions, but they are different concepts. The primary difference is that a sidechain is more independent than a layered chain from the L1 blockchain.
If that’s confusing, perhaps Coinbase’s FAQs on ‘Layer 2 networks and sidechains’ will help.
So what’s the big deal? Today, there are only a limited number of use cases for blockchains, so L2s (and theoretically L3s and L4) and Sidechains don’t serve a crucial purpose yet. And with Ethereum already making plans to improve its transaction capacity to 100K+ transactions per second in a couple years, there may be even less purpose for Layered and Sidechains. Or so it may seem.
However, having blockchains that are interact with each other have a variety of use cases including creating easier bridges for transactions to be validated while allowing the creator to maintain independence.
Think about your currently loyalty rewards programs. Let’s take your airline miles. Imagine your airline miles being on a L2 of Ethereum, where all of your rewards are documented as a transaction on an L2 that then rolls up the transactions to Ethereum. Assuming Ethereum maintains its credibility as one of the premiere blockchains, you can have confidence that your airline won’t lose records and they won’t get corrupted in some manner (perhaps hackers to attack a blockchain). Similarly, they could set-up a sidechain if they wanted more independence, though there would likely be a higher cost to maintain.
If the airlines stood up their own wholly independent blockchain that wasn’t connected to Ethereum in some manner, there would be more security risks introduced, and you’d have less confidence in their blockchain.
These security features are incredibly important in a decentralized world, because unlike today, where America Airlines owns and controls the security for their entire rewards program, a blockchain opens up the information to the world. It may be encrypted, but a malicious actor could attempt to steal or add extra miles to this blockchain. Security is essential, and L2s and sidechains aid in that effort.
Additionally, as blockchains mature, the cost of moving tokens between an L1 (ie Ethereum) and a layered or sidechain should be noticeably lower, which should make converting American Airlines miles into Delta Skymiles a much easier task. Today, it’s not really possible. You’d have to convert to cash first, and then you’d have to ask if spending the cash to convert to the other miles program was worth it. Often times it wouldn’t be.
Smart Contracts
Smart contracts are what made me initially believe that Blockchain is the future of technology. I heard about them in 2016, and I immediately felt that this was IT. Over the years, I’ve become increasingly convinced that smart contracts are the future, and what we are seeing today only scratches the surface of their potential.
At its atomic level, a smart contract is simply coded logic to execute predetermined commands when certain things happen. The twist is that this is all done in a decentralized environment, so once the contract is deployed, it can’t be altered.
What’s incredible about this is that it allows for business logic in any website that we currently use today to be established in a totally transparent manner. Transparency is valuable since you have a better understanding how your data is being used. While most people today have accepted the tradeoff of data for access, more users are demanding control over their data.
Smart contracts and blockchains will be the first technology where transparency is built into the product at the beginning. It may not stop someone from abusing your data, but it does give you more visibility into whether it can or has occurred.
Another part that I love about smart contracts is that it does not require both parties to behave honestly and in good faith. Once the smart contract is deployed, the execution of what happens next is predetermined by unemotional code. This is comforting for anyone who’s had a counterparty back out of something they had previously agreed to.
However, this technology presents some obvious limitations, most acutely felt by the Akutar founders who lost access to $30M+ when their NFT mint smart contract had a bug that incremented an important number so that all the money they raised by selling their NFT was LOCKED in their smart contract. Forever. There’s no way undo what they did, and the $30M+ in funds (at the price when the NFT minted) will forever be locked away.
At some point, smart contracts will need to evolve so that there are more failsafes and ways to alter them with the proper consent of all parties. For instance, today, real-life contracts can be amended if all parties (or the designated parties in the contract) agree to new terms. The same optionality should be native to smart contracts.
One tangible example is your car keys. At some point (and this is already happening with some luxury cars), car keys will no longer be used to operate a car. Instead, you’ll receive an NFT that is the digital embodiment of a smart contract. And as the car owner, you’ll be able to share access to your car via a smart contract that determines who else can drive the car. Perhaps your significant other has full access, but your teenager can only drive the car between 6am and 11:59pm. Can you do that with certainty today? Nope. But in 5-10 years, it will be a novelty, and in 20 years it will be the established standard and movies with car keys being tossed about will feel nostalgic to those of us reading this today and weird to younger generations. Like phone booths in today’s movies.
DAOs
DAOs (Decentralized Autonomous Organizations) are special smart contracts that govern a group of people. An easy mental model may be to think of a DAO like flat-hierarchy company or not-for-profit. It’s a structure that helps organize people who are working together for some common purpose.
You’re probably thinking, so why do we need a DAO if companies already exist? Great question! This comes back to transparency, which is one of the central tenets of blockchain.
Imagine today a startup that raised a lot of money, paid it’s CEO $800K per year (substantially more than any other employee), and yet wasn’t outputting much of anything. Sure, there may be a board of directors with authority to act, but what about the employees who may hold a small amount of stock? What about someone who’s aware of the situation but has no way to communicate this to the board without fear of retaliation? How would this situation resolve itself today?
Well, it probably wouldn’t for several years, because each party either doesn’t have the right information or their incentives are not aligned. And the vital information for getting rid of this CEO or pressuring them to step down isn’t transparent enough.
This could help companies become more equitable and foster better working environments. Granted, the current structure of DAOs is unclear. They are not legally-recognized companies in most states. And the controls are not in place to make them as functional as they’re needed.
But you know what? The scenario above actually just happened at a Squiggle DAO. They had raised a TON of money by selling the Chromie Squiggle NFT, but Greg (the leader) was paying himself $800K+ and was mismanaging the organization. This was publicly called out in the Squiggle Discord (screenshots were eventually posted on Twitter), and eventually Greg chose to resign.
Tell me of a startup or any company that within its first 18 months moved as quickly with this level of transparency. I won’t hold my breath.
Another example of how DAOs can serve a valuable purpose is with LinksDAO (full disclosure: I own a couple of their NFTs). This DAO was created as a part of the LinksDAO NFT collection where owners of the NFTs will exclusively be allowed to purchase memberships in a golf course that the DAO will be purchasing. The team behind it includes Mike Dudas and Chris Maddern, prolific founders who are deeply involved in the Web3 space as both investors and entrepreneurs (Chris is also the founder of Floor which is one of my absolute favorite NFT communities). Mike has spent many Twitter Spaces discussing the intentional legal structure they created, and their thought leadership has likely helped establish solid principles on DAO creation and operation. If you’re looking for people to emulate, look up LinksDAO.
This past week, LinksDAO took a vote from among all of the NFT holders to decide whether to place a bid on a golf course in Scotland. Only owners of the NFT were eligible to vote and the number of NFTs you owned in your wallet determined how many votes you received. This vote was done transparently using the DAO structure and a blockchain. And it didn’t cost me anything to vote ‘yes’.
This level of transparency is either incredibly hard to pull off in today’s world or it simply doesn’t happen. With DAOs and blockchain, it’s not only possible but it’s easy and fast.
Wrapping Up
Ethereum has ushered in new, foundational technologies that are going to make how we operate in today’s world more transparent. This transparency will not only provide the advantage of openness but also speed and decreased costs. However, like any new technology, the speed and cost are not reality yet. If you look at whatever device you’re reading this on, just remember that 20 years, that device didn’t exist or was 1/100th as powerful and likely 2-3x the cost you paid today.
The future that Ethereum is showing us will change nearly everything about how we operate today. And we cannot wait to see that world come into focus.
News of the Week
Base is a new Ethereum L2, incubated by Coinbase and built on the open-source Optimism Stack. Coinbase announced the upcoming development yesterday, notably adding that they have no plans to issue a new network token. Coinbase also released a commemorative NFT, that can be claimed free on Zora.
U.S. federal judge Victor Marreo denied a motion from Dapper Labs CEO Roham Gharegozlou to dismiss a class-action lawsuit claiming its NBA Top Shot NFTs are securities. Marrero said his decision was supported by how Dapper restricted trading to its Flow blockchain, and had a financial interest in the platform's success.
Last Friday, Opensea announced some massive changes. The OpenSea fee has been lifted for a limited time, and the platform has shifted to a minimum 0.5% creator earnings model. These changes are viewed to be largely in response to the disruption the NFT marketplace ecosystem has seen from Blur.