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Blockchain Trilemma – These are the possible solutions

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ETH has a scaling problem. This has become clear at various points in time since the beginning of the year: This problem was most noticeable in the first few months. If you wanted to carry out a smart contract transaction, such as a token exchange on a decentralized exchange such as Uniswap or Sushiswap, you were in the unfortunate situation that the transaction costs alone sometimes amounted to more than 100 US dollars.

The reason for this can be found in the so-called Blockchain trilemma. According to this, a blockchain has to make compromises in terms of security, scalability and decentralization. To put it very simply, developers must decide for which of the two of these three properties they want to optimize. For example, if you want to ensure a certain level of security, you have to be aware that scalability is inversely proportional to decentralization in this case. Comparable to BTC, the ETH blockchain has been optimized for security and decentralization while sacrificing scalability.

The Bitcoin Trilemma – Eat Sleep Crypto
Figure 1: The triangle shows the three basic properties of a public blockchain, only two of which can be reached at the same time. 

network congestion

With an increasing number of transactions, the ETH network is increasingly being used to capacity – if users still want to use the ETH blockchain, they are forced to pay excessively high transaction fees. An optimized scaling of the ETH blockchain and the associated lower transaction fees would lead to increased user-friendliness and the development of new use cases. Both would result in new users entering or using the network (see Figure 2).

Blockchain Trilemma - These are the possible solutions
Figure 2: Relationship between fees and new use cases. Source: Vitalik Buterin, SEBA Bank

trade-offs of the competition

Competing blockchains such as Solana, Avalanche, Polkadot and Co., which like to call themselves ETH killers, often optimize in terms of scaling the blockchain and accept an increased level of centrality in return. The following graphic shows a comparison of transactions per second (TPS):

Blockchain Trilemma - These are the possible solutions
Figure 3: Transactions per second comparison of ETH and “ETH killers”. Source: SEBA Bank

Rollups – the solution to the blockchain trilemma?

If ETH wants to keep up with the growing competition, innovations are needed. If you follow that finishes by Vitalik Buterin (co-founder of ETH), the key to ETH’s scaling problem is found in rollups. But what exactly is behind this technology?

Rollups are a scaling solution where transactions are bundled and compressed off-chain before being verified on the consensus layer. Ultimately, multiple transactions can be “summarized” into a single on-chain transaction. The consequence of verifying multiple transactions simultaneously is increased efficiency; At the same time, the number of possible transactions that can be carried out increases, which brings with it increased scalability.

All of a sudden, ETH can scale from formerly 15 transactions per second (tps) to 3000+ tps – without having to compromise on security.

Types of rollups

There are two types of rollups:

1. Optimistic roll-ups use so-called fraud proofs (used by e.g. Arbitrum, Optimism)

Optimistic Rollups assume an “optimistic” world view. The basic assumption is that the data of the rollup, i.e. the compressed bundles of transactions mentioned above, are correct. Based on this basic assumption, this data is published without checking for its correctness. Driven by the prospect of a financial reward for finding a defective publication, every market participant can then use fraud proof provide evidence that the new data published by a rollup is in error. Fraud proofs are therefore only used when it has to be assessed whether fraud has taken place, i.e. whether incorrect transactions have been published, for example. As long as there is no challenge, no fraud proof is required, nor is one necessary.

Assuming the data is correct increases the likelihood that a rollup will release fraudulent bundles of data. To prevent this, a dispute period (so-called dispute window) is inserted. If, for example, the parties involved in a transaction suspect errors in the data, they can start a challenge in this time window.

The longer this challenge period is chosen, the greater the likelihood that incorrect data will be prevented from being published on Layer1 of ETH. Logically, it is directly in the trade-off that it takes longer for the transaction to be finalized on Layer1. In practice, this leads to the consequence that it takes up to seven days if you want to withdraw your funds from Arbitrum. Intermediaries can remedy this situation by paying the user his funds immediately on Layer1 for a fee and accepting this waiting time and the risk of an incorrect transaction.

If there is a dispute after the rollup has been published and the fraud proof turns out to be correct (i.e. the data published by the rollup is incorrect and was proven by the fraud proof), all data will be rolled back up to the last known undisputed bundle. This means that all swaps (exchanges), all transactions and all other interactions that were in the erroneous bundle of the rollup are reversed.

2. ZK Rollups use so-called Validity Profs (used by ZKSync, StarkNet, Polygon Hermez)

Validity proofs assume a “pessimistic” worldview. They are used to prove that a data bundle generated by the rollup is correct. In contrast to fraud proofs, validity proofs are generated with each bundle and presented together with the data of Layer1 to prove that all data is correct. This cryptographic proof (so-called ZK-SNARK) can be easily verified on-chain for its correctness, regardless of the size of the data bundle or how much computing power was required for the transactions it contains. This is where the benefits of rollups come into play; decentralization is maintained by the fact that a conventional laptop, which itself would not have enough computing power to carry out these bundles of transactions, can nevertheless easily check the correctness of the result of this computing power on-chain with minimal effort.

Due to the simultaneous presence of the validity proof, the result is that no challenge period is required here – the transaction receives finality directly on the Layer1 blockchain (therefore no 7-day waiting period if you want to withdraw your funds from Layer2).

The disadvantage here is a loss of efficiency due to the fact that a validity proof must be produced with each rollup – in contrast, a fraud proof is only produced if the correctness of the rollup is contested.

The scalability of ETH – what next?

Everything indicates that the future of ETH scalability lies in rollups. Without a doubt, they are the first and best way within the blockchain industry to achieve mass adoption without having to compromise on security and decentralization at the same time. It remains to be seen how important decentralization really is for end users and the market. When faced with the choice between the horrendous transaction fees on ETH Layer 1 and the less decentralized ETH killers like Avalanche and Solana with extremely low transaction fees, many retail investors and users have opted for the latter option.

In the long term, however, the chances seem good that the decentralized variant will prevail due to its superior properties – it will become dangerous if the layer 2 solutions develop so slowly that new users despite the centrality of these protocols due to the advanced network effects for ETH killers decide.

However, this chance is relatively small – the ecosystem of protocols available on ETH L2 is growing daily. (see below, for example, dydx or loopring, on which enormous volumes are already being processed) And in contrast to ETH’s L1, the transaction fees do not become more expensive as the number of users increases, but cheaper. One of the reasons is that the more user transactions get into a data bundle of rollups, the cheaper it becomes for the individual users because the L1 fee can be shared among more heads.

So we can not only prepare ourselves for a scalable DeFi future, but also for a decentralized one – long live DeFi!

Blockchain Trilemma - These are the possible solutions

 

Figure 4: Comparison of ETH transfer and swap costs on L2 in pink and ETH in white. Source: SEBA Bank

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All content in this article is for informational purposes only and in no way serves as investment advice. Investing in cryptocurrencies, commodities and stocks is very risky and can lead to capital losses.

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