Unpacking the Blockchain Trilemma
If you've been in crypto long enough, you've probably heard about the Trilemma. It's a rough description of the challenges decentralized networks face to address three major issues simultaneously: decentralization, security, and scalability.
Decentralization is characterized by the level of distributed participation in a network. It's often measured by the number of independent node operators, which are entities or individuals that verify blocks and transactions on the network. This differs from miners or validators, who produce new blocks. Decentralization is also assessed through other metrics like client diversity and supply distribution. People have been harping on Ethereum recently for its overuse of Geth at the consensus layer and the growing monopolization of LSD power in Lido.
Security concerns a blockchain's resilience against attacks, such as disrupting block production, rewriting transaction history, or censoring network activities. The degree of security depends on the collective value stakeholders have invested in the network. For example, Bitcoin's security is bolstered by the extensive computation power (hashpower) contributed by miners, making network disruption prohibitively expensive. Ethereum's security, particularly against reorg attacks, hinges on the amount of ether (ETH) staked in its proof-of-stake system.
Scalability relates to a blockchain's transaction throughput. Bitcoin, for instance, originally had a maximum block size of 1MB, limiting its transaction rate. Despite upgrades like SegWit, Bitcoin's transaction rate remains much lower than centralized payment systems like Visa. Ethereum also faces scalability challenges, even with increases in block gas limits over the years, as user activity often stretches the network to its limits.
Up until recently, the networks had to pick two of the three properties from the Trilemma to solve. Bitcoin chose Security and Decentralization, as did Ethereum. However, with growing demand for on-chain dapps and services, the need for highly scalable block space has now been split out to L2s and other networks. The Trilemma is never going to disappear, but with new modular solutions, it might be able to separate each property into its own part to be mixed and matched to build application specific solutions.
The Modular Blockchain Thesis
The Modular Blockchain Thesis, introduced by Mustafa Al-Bassam, co-founder of Celestia, proposes decoupling core blockchain functions such as consensus and data availability from transaction settlement and execution. This approach, detailed in Al-Bassam's 2019 paper "LazyLedger: A Distributed Data Availability Ledger with Client-Side Smart Contracts," aims to address scalability challenges in blockchain technology.
In a modular blockchain, the four core functions - execution, settlement, data availability (DA), and consensus - are separated. Execution involves processing user transactions and smart contracts. Settlement verifies the validity of transactions and ensures their inclusion in the canonical chain. DA refers to the record-keeping function, ensuring transactions are stored and retrievable. Consensus involves the ordering of transactions in a block and determining how new blocks are added to the chain.
Monolithic blockchains like Ethereum integrate all these functions, which can lead to scalability issues. In contrast, modular blockchains offload one or more functions to different layers. For example, Celestia and Eigenlayer focuses on DA and consensus, while other networks handle transaction execution and settlement. Layer-2 rollups on Ethereum are another example, where they specialize in efficient transaction execution while relying on Ethereum for DA and consensus.
A Network of Trust
With robust demand for DA, execution, settlement and consensus for a growing number of L2s and other networks, its important that Ethereum is able to evolve beyond its monolithic nature to support a diverse set of participants. These L2's rely on Ethereum's security and decentralization to provide scalable execution layers for an ever hungry and growing market of dapps and blockspace.
At the same time, Ethereum's architecture already includes its own execution layer. Native dapps like Frax, Curve, Aave, and Compound, all compete for blockspace against other L2s. This reduces the overall efficiency of Ethereum. Ethereum isn't designed to be modular and its not currently optimized for handling consensus or data availability.
Projects like Celestia and Eigenlayer have stepped in to provide these solutions, with the latter offering ETH validators the ability to lend their security guarantees to Actively Validated Services (AVS) by means of additional slashing conditions. Validators commit to supporting AVS's and in return earn an additional yield in the form of tokens or other revenue through restaking.
With Fraxchain deploying soon, Eigenlayer could be used in conjunction with frxETH to provide decentralized sequencer solutions. For example, rather than having the Core Team run the Fraxchain sequencer, Eigenlayer could be used to provide the security directly from sfrxETH.
We've discussed this before in our interview with Sreeram, founder of Eigenlayer, on a past episode of Flywheel.
The total addresable market for Eigenlayer AVS's is expected to be valued at $25bn within a decade with new demand for modular L2s, L3s and other AVS enabled dapps. Eigenlayer will be able to provide security for any new project that wants to bootstrap its security based on ETH validators.
How frxETH v2 Stands to Benefit
For a quick recap on frxETH v2 lets look at what we wrote previously for Flywheel:
With frxETH v2, node operators deposit ETH as collateral in the smart contract, they then can borrow ETH supplied to the lending market to run a validator. As long as the node operator pays the interest rate, the frxETH loan can remain open, similar to Aave. Connecting to the existing frxETH v1 system, the sfrxETH yield is the dynamic interest rate paid by the node operators borrowing the ETH to stake.
frxETH v2 creates a brand new type of lending market for validators, similar to Fraxlend, where they borrow ETH at a dynamic market set rate, and then are able to stake their ETH within a personally run system. If at any point the ETH on their validator is slashed or goes below liquidation levels, Frax is able to eject the validator and return the ETH to the smart contract.
The key part of what frxETH will offer is the dynamic rate for borrowing ETH to stake.
Right now, all LSDs use a simple solution where the native rewards earned determine the yield. As gas markets rise and fall, the yield adjusts accordingly. LSD protocols earn revenue by charging a fixed fee on top of the native rewards yields.
However, with frxETH v2, the dynamic rates will benefit those who can maximize their validator returns. Rates are market driven, not fixed against a reward rate. If a validator is able to earn a higher yield with their validator by providing modular services or restaking through Eigenlayer, they are incentivized to pay above the native reward rate in interest to maximize revenues.
Lets break this down a bit more. With Eigenlayer, a validator will be able to able to opt-in to various restaking services that attach extra slashing conditions to their validator. In return, they earn a new yield stream from those services for lending their ETH security. So long as the are not malicious and do not get slashed, we could see a future where in addition to the native staking yield, validators could earn an extra 10-20% of additional yield through restaking. By helping the overall crypto ecosystem scale, running a validator might become one of the most profitable infrastructure services to date.
Assuming all this, what it means for frxETH v2 is that there might be significant demand for borrowing ETH to run validators. If you as a validator are able to find restaking opportunities that bring double digit yields, then its in your best interest to borrow as much ETH as possible to run validators. Interest rates for sfrxETH might be pushed significantly higher than other existing LSDs as validators arbitrage the borrow interest rates against their restaking yields.
If the frxETH interest rates are what they are today, then a validator would be able to borrow ETH at 4-5% to run their nodes, and then they would be able to earn an additional percentage for all of the extra AVS's they provide support for. If they can earn 10-20% additional on top of the interest rate, they would probably earn net 12-13% on the entire trade. The beauty of frxETH is that with these additional slashing conditions, if they ever trigger a liquidation, Frax just has to eject the underperforming validator and then the ETH is returned.
A modular future is a boon for frxETH v2 as L2s and other AVS's juice up the yields for running an ETH validator. Frax has once again positioned themselves at the bleeding edge of Ethereum's growth curve and is well positioned for hyper growth in the coming years. Modular scaling will need core services like frxETH v2 to scale crypto into processing billions of transactions, with the growth passed back as revenues to Frax's ETH lending market.