Layer 1 Blockchains: A Tale of User-Owned Cities, Part I of II

Last Update 06/09/2023

What is a Layer 1 Blockchain?

Think of your favorite city: Perhaps it’s New York City, San Francisco, or Los Angeles. Regardless, each city differs geographically, geologically, and culturally, as well as in function: NYC is known for finance, LA for entertainment, SF for tech. City layout also differs significantly; vertical structures paint the NYC skyline and much of transportation occurs underground while in Los Angeles, large freeways connect disparate communities. Whether a resident, tourist, or real estate developer, each of these factors impacts the experience of people and their contribution to the functioning of the whole city.

Credit: Introducing New York and lacounty.gov

A Layer 1 smart contract blockchain is like a software version of a city in that it is the underlying piece of infrastructure that provides the foundation for user interactions–in this case, decentralized applications (DApps) and smart contracts. Similar to cities, architectural and cultural differences directly impact the underlying network interactions and activities. So, too, does the development of the culture, users, and builders that participate in the ecosystem of blockchains. Ethereum, for example, may be thought of as a busy, expensive, congested city that exceeds others in size and finances (think NYC) while Solana resembles Los Angeles in that it prioritizes speed but can experience network outages (comparable to LA’s freeways during rush hour). This analogy extends to explain the variety of different ecosystem participants¹ in a Layer 1 as well:

Figure 1

Source: Dragonfly Capital

In this report we’ll cover (1) Why Layer 1s matter and web2 alternatives, (2) The Blockchain Trilemma, and (3) An overview of smart contract blockchain design factors and resulting use-cases. In Part II of this report, we will focus on Layer 1 performance and user adoption between these different smart contract blockchains.

Why do Layer 1s Matter? What are Web2 Alternatives?

In web2, Apple’s app store has garnered attention for its centralized control and hefty fees, demanding up to 30% of revenue³ from app developers. Apple and similar app stores have monetized user data for the benefit of the platform but not necessarily the user. Under the glossy veneer of free apps and services lies the stark reality that if a service is free, often the user becomes the product.

This brings us to the alternative offered by blockchains. Smart contracts can be viewed as a revolutionary application of the solution to the problem of centralized intermediaries, a concept originally implemented in Bitcoin. In his 2009 whitepaper, Satoshi Nakamoto envisioned a system of peer-to-peer value transfer that could bypass intermediaries, align user-platform interests and facilitate direct user ownership in a manner previously unseen.

Now, this idea might have found initial traction in sectors like banking and payments, but its implications extend far beyond these industries. The centralized intermediary model, whether it’s Apple, Facebook, AWS, or a similar platform, can often disadvantage both the third-party developers who create applications and the consumers who use them. These entities can exploit user data and even boot developers from their own platforms on a whim, as happened with Zynga on Facebook⁴.

FIGURE 2

Sources: Grayscale Research, a16z

However, with smart contract platforms, the power can shift back towards the users and the developers. In this open-source, permissionless environment, users retain control over their data and get to choose which decentralized apps (dApps) can access it. Developers, on the other hand, are not at the mercy of the platform; they cannot be unexpectedly kicked out, and they have more freedom to innovate.

FIGURE 3

Source: Franklin Templeton, For Illustrative Purposes Only

The composability and interoperability offered by these platforms are particularly compelling. Developers can access freely shared, existing code and primitives⁶ and implement them into new applications as “building blocks” allowing for decentralized apps to be seamlessly integrated into other apps without requiring any permission. Unlike the restricted and closed environments of App Stores, web3 interoperability expands the range of tools accessible to developers. This means that each new app created can serve as a foundation for building more advanced applications.

However, these Layer 1 smart contract platforms are more than just havens for developers. They’re beneficial for users at scale for various applications, from finance to social, gaming, and more. Users are not merely customers, but can be active contributors to the growth of a specific ecosystem as builders, users, investors, and even validators. We believe these platforms give rise to a novel dynamic where “your take rate is my opportunity,” as the ability to hard fork code and create a new chain allows for alternative options and naturally exerts downward pressure on pricing on fees that platforms charge users.

While these theoretical advantages seem enticing, it’s crucial to keep performance of the networks in mind. The upcoming discussion will offer an insight into the performance of Layer 1 platforms over the past five years, the important features to be considered, and some of the more notable smart contract platforms in the market.

Scaling Layer 1s and the Blockchain Trilemma

Blockchains, like cities, face trade-offs regarding congestion as utilization increases while capacity remains constrained. As a network attempts to support new users and larger amounts of transactions, increased usage constricts available blockspace and increases transaction costs. By September 2020, increased usage led to exceptionally high gas fees for Ethereum. At certain times, users had to pay upwards of $530 for a single transaction⁷.

Not only did this make user experience on the Ethereum network expensive, difficult, and increasingly time-inefficient for its users, it also underperformed significantly (~14 transactions per second⁸) compared to other networks like Solana (capable of up to 10,000 transactions per second⁹). As a result, users began flocking to alternatives, such as low-fee Solana where total daily addresses went from 384 on September 1, 2020, to over 400,000¹⁰ by January 2021. By the end of 2021, new smart contract networks started to launch such as Avalanche and Polkadot as well as new Layer 2 scaling solutions on Ethereum. While these alternatives challenged the notion of Ethereum’s supremacy among Layer 1s, we believe they also represented early signs that Ethereum could become the settlement layer for many different Layer 2 scaling solutions.

FIGURE 4

Source: Delphi Digital, For Illustrative Purposes Only

As new Layer 1s were introduced, new design philosophies were encoded into the architecture of different blockchains. For example, in contrast to the model of Ethereum, Solana’s design philosophy prioritizes scalability, performance, and ease of use. From a user perspective, Solana’s next-to-instant settlement time is palpable versus Ethereum and more reminiscent of web2 experiences like PayPal or Visa. Solana is able to achieve this level of speed in part due to its parallel processing mechanism, which enables efficient resource allocation to process transactions, versus sequential processing, a slower method of executing one task after another.

Despite the benefits of its processing mechanism, Solana’s model isn’t without its downsides. Solana has struggled with many network outages over the course of its history including over 10 outages¹¹ in 2022. This notion of tradeoffs in blockchain design choices is inherent in the notion of the Blockchain Trilemma¹² (seen below), which presumes that only two of the three factors (decentralization, security, and scalability) can be prioritized while the other factor is compromised.

With factors in mind such as the blockchain trilemma, processing mechanisms, fee models, decentralization, security, and scalability solutions, the following section will provide an overview of each of the top 5 Layer 1 smart contract blockchains by market capitalization¹³ and their design architecture.

FIGURE 5

Source: Grayscale Research

Overview of Layer 1 Smart Contract Blockchains

In the following subsections, we’ll detail in depth how these design decisions and tradeoffs manifest in these protocols, starting with a focus on blockchain design, function, and technical performance, then moving on to adoption within each of these ecosystems.

Ethereum

In a philosophical retort to the centralized, transaction-heavy Solana, Ethereum supporters would probably echo the maxim, “If you want to go fast, go alone–if you want to go far, go together.” At around 27 transactions per second as of June, 1 2023, Ethereum exemplifies the “tortoise” rather than the “hare” among smart contract blockchains. Prohibitively high fees are often considered “a feature, not a bug.” This is possible for a few reasons. First, because transaction fees are given as rewards to validators, high fees directly incentivize demand to provide security to the network. Second, high fees push user and builder activity towards cheaper Layer 2 solutions built on top of Ethereum. Finally, part of fees goes towards burning the supply of ETH, which since the Merge last year has resulted in $9bn worth of ETH burn¹⁹ resulting in a current annualized inflation rate of negative 0.49%²⁰; in other words fees result in supply deflation, essentially making ETH more scarce over time.

In the past year there’s been an explosion of Ethereum Layer 2 development as Polygon announced plans to fully migrate to become a Layer 2 solution²¹ and Optimism, a Layer 2 built on Ethereum, surpassed its settlement layer Ethereum in daily transactions²² for the first time in March 2023. We believe this activity serves as early validation of Ethereum’s long-term scaling vision.

Solana

Solana’s co-founders have dubbed the protocol the “Apple of Crypto”²⁵ due to its focus on performance and user experience. Solana complements its unique consensus mechanism called Proof of History with “massive parallelization” transaction processing in order to reach such extremely high throughput. Besides low latency, Solana’s low transaction fees further underscore user convenience. Solana implements its pricing through local fee markets which mitigate the risk of congestion and high fees during peak demand.

Polygon

Built as an Ethereum sidechain, Polygon helps Ethereum scale by providing users a lower cost and faster option within the same network (7K transactions per second vs 27 for Ethereum)²⁶. The downsides of Ethereum’s model, as mentioned previously, in terms of scalability and high fees created an opportunity for scaling solutions (sidechains and Layer 2s) to build on Ethereum in a manner that is mutually beneficial and helps mitigate some of its deficiencies. Polygon functionally is able to address Ethereum limitations via its parallel processing model to provide high throughput and low fees²⁷ (currently at ~$0.0002 per transaction as of June 2023) while still being able to rely on the strength of Ethereum, its security and transaction settlement.

Structurally, we believe Polygon is a great illustration of the long-term value prop of Ethereum–where high-throughput, low-fee chains batch their transactions and use Ethereum as a settlement layer. Because the two chains are connected, developers can easily build Polygon-based assets that users can interact with for lower fees while being portable and compatible with Ethereum²⁸.

Avalanche

Avalanche enables developer customization while striking a balance between speed and security. Avalanche’s unique consensus model enables the protocol to process multiple transactions simultaneously, leading to faster confirmation times (0.79 second time to finality³⁰) than all other Layer 1s besides Solana while retaining a slightly higher level of security.

In contrast to Ethereum scaling solutions, Avalanche subnet developers have greater levels of customizability in that developers can determine their own consensus and security framework. Finally, Avalanche utilizes a “divide and conquer” method in its three primary chains (one that sends and receives funds, one for blockchain creation and staking, and one for smart contract deployment) which optimizes network efficiency³¹.

As can be seen in the graphic below, alternative Layer 1s such as Avalanche, Polkadot, and Cosmos involve variations of “app-chain” models, each enabling developers to customize their own blockchains within the context of a larger network and retain various degrees of sovereignty for builders as well as interoperability across chains.

Figure 7: App-chain models

Source: Burak Arikan, For illustrative purposes only

Conclusion

In the future, there could be a large opportunity for protocols that provide the best infrastructure for dApps serving high-opportunity emerging use cases. For example, Ethereum’s reliance on security has helped it become one of the most desirable options for DeFi while the customizability and low fees on Avalanche and Polkadot could make them attractive options for dApp developers. The same could be said in other areas such as DePIN and gaming for Solana and consumer brands for Polygon.

As New York City, Los Angeles, and San Francisco each compete for talent and offer different appealing elements to attract and retain potential residents, Layer 1s compete for users with the strategies we’ve explored in this piece. In the second part of this two-part report, we’ll compare progress and adoption across each of these chains.

^{1. Dragonfly Capital}

^{2. Non-Fungible Tokens (NFTs) are unique digital tokens that prove ownership of one-of-a-kind items or content, like art or collectibles, using blockchain technology.}

^{3. Apple Insider}

^{4. Venture Beat}

^{5. The capability to copy underlying code and apply it to create a new chain.}

^{6. Core elements or basic units in technology that are used as a foundation for creating more complex systems}

^{7. YCharts}

^{8. The Defiant}

^{9. Crypto News}

^{10. Artemis.xyz}

^{11. Cryptoslate}

^{12. CertiK}

^{13. Coinmarketcap as of June 2023}

^{14. Ledger, as of December 2022}

^{15. A method of validating and securing a blockchain network by holding and showing ownership of a certain amount of cryptocurrency}

^{16. A way to record events in a digital system in a chronological and tamper-proof manner}

^{17. Wiki.Polkadot.network}

^{18. “Market cap” label for represents market cap specifically on Ethereum network as of June 1, 2023}

^{19. Cryptoslate}

^{20. Ultrasound.money}

^{21. The Defiant}

^{22. Artemis.xyz}

^{23. Messari}

^{24. Helium.com}

^{25. TechCrunch}

^{26. Cointelegraph}

^{27. Polygonscan.com as of June 4, 2023}

^{28. While Polygon is technically considered a Layer 1 “sidechain” for Ethereum at the moment, it is anticipating the full migration into an Ethereum Layer 2 in the future}

^{29. GMX.io}

^{30. Avax.network}

^{31. Avax.network}

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