2023Crypto Thesis

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2023
Crypto Thesis

Part One

Our predictions for the Ethereum ecosystem.

In the Belly Of The Bear

2022 was primed to be a big year for crypto. The industry seemed to evolve dramatically as institutional capital poured into crypto-focused initiatives, exciting new financial primitives were developed, and its legitimacy as an asset class grew around the world. Unfortunately, these narratives were overshadowed by the main story: successive waves of financial impropriety, which occurred largely at the hands of bad actors in positions of power. This exposure of pervasive fraud, combined with tightening global monetary policies, led crypto markets into a mercilessly bearish winter comparable to 2018.

For crypto, 2022 was the year when mercenary capital took hold - entities and actors that move from opportunity to opportunity as value extractors seeking outsized short term profits without any interest in participating in communities or building the infrastructure of the future. This existed within most stakeholders in the crypto space, ranging from end users to liquidity providers to crypto VCs - all engaging in various forms of rugpulling and dumping. However, the three implosions in particular brought the industry to its knees:

Do Kwon’s Terra-Luna took an inherently flawed algorithmic stablecoin model and bribed people to use it with artificial staking yield. Its de-peg wiped $60B in market value and eviscerated the savings of retail investors around the world.
3 Arrows Capital, founded by Su Zhu and Kyle Davies, was an FX arbitrage fund that borrowed aggressively to fund its directional crypto bets. When the severely over-leveraged firm collapsed under adverse market conditions, its $1B in bad debt left massive holes in the balance sheets of lenders across the crypto space.
Finally, the FTX exchange imploded when it was revealed that Sam Bankman-Fried had been appropriating customer deposits and lending them to his trading firm, Alameda Research. Billions were lost as its FTT token cratered, and multiple lenders have gone bankrupt from their losses.

So what does this mean for the industry in 2023? First, we expect the unwinding of FTX positions and pervasive bad debt to continue to negatively impact the cryptocurrency markets through the entirety of the year. Liquidity issues and insolvencies will likely continue to be discovered in both CeFi and DeFi services as bankruptcy and criminal proceedings move forward. Second, the breach of trust involved in this bankruptcy will significantly set back regulatory progress, investor activity, and consumer confidence.

Looking Forward

Despite the serious setbacks to our industry, our outlook for 2023 is optimistic. While mercenary capital has taken its toll on our credibility, we also have an industry full of devoted builders with substantial sweat equity being invested into this burgeoning Web3 world. These are the actors we call visionary capital, the ones still building while most of the industry speculators have left. The ones investing their long-term efforts to bring Web3 to the cusp of breaking irreversibly into daily life. We believe that 2023 is the year of visionary capital, and the year when cryptocurrencies transition from speculative investments to core components of a society built around Web3.

To some extent, this transition is already underway. Between DeFi protocols integrating with the traditional financial system, DAO treasuries accumulating real world assets, and legacy gaming companies breaking into Web3, one of today’s emerging narratives is the blurring of lines between decentralized solutions and the real world. This process will only continue, and 2023 will likely be the year Web3 projects gain traction into the mainstream.

A few examples. In an age when data breaches are ubiquitous, companies will likely start to employ decentralized identity technology to allow users to self-custody data. Consumer-oriented applications of blockchain technology will appear in media, where marketing, storytelling, and gaming will converge to produce immersive and interactive worlds. By building blockchain networks on top of existing power grids, utility companies will be able to incorporate distributed energy resources into new networks of decentralized energy.

While none of this is news to crypto natives, these examples represent the introduction of massive new user bases and suggest that the cloistered world we have occupied over the past decade is preparing to go public. Behind these radical changes to our daily lives will be a wave of technical developments that advance the capabilities of crypto and prepare it for its place at the center of metaverse life. These events are unfolding in real time, and our expectations are summarized below. The following are our predictions for how crypto and Web3 will leap forward in the year 2023.

EigenLayer Will Be The Most Important Innovation For Ethereum

One of the most noticeable discrepancies in blockchain development is seen in the level of permissionless activities that are possible between the infrastructure and application layers. Infrastructure upgrades and changes are lagging behind the application layer as app deployment is permissionless while core network upgrades are permissioned. Consensus, core, sharding, p2p and middleware layer changes are based on democratic voting of appointed parties, while applications can be freely deployed on the core consensus logic and be experimented with.

Established and well capitalized network systems require prudent risk analysis prior to a core upgrade or change. This results in innovative solutions to consensus problems and core hurdles being constrained and/or late to market. Once the sovereign trust network of a system is established, the protocol becomes very rigid and much less prone to innovative upgrades. When innovative consensus mechanisms or middleware layers such as Snowman, Chainlink, or Nomad emerge there is no way to permissionlessly use an existing trust layer to operate the new network.

Moreover, new networks are often bound by inevitable capitalization boundaries. In order for a decentralized network to ensure security of the core consensus logic, it needs to be cost prohibitive for malicious actors to self-impose changes or take control of assets. Thus, it is not sufficient to have breakthrough technology - builders are also required to source a large capital foundation for network security, often becoming the single biggest hurdle in infrastructure innovation.

Reward distributions further highlight the capitalization issue in network bootstrapping. In the Ethereum validator stack, 96% of total rewards are allocated to capital providers while only 4% are allocated to node operators. The reward distributions are far from arbitrary and reflect the implicit cost of capital in proof of stake networks. The implied risk of staking a volatile asset for network security is fundamentally more expensive than running a generalized node that can be repurposed.

It is important to mention that bootstrapping core infrastructure security is the primary consideration for decentralized networks. That being said, applications built upon it are always constrained by the least secure denominator in their infrastructure stack. Applications that are incorporating middleware layers such as bridges and oracles, which are secured by their own sovereign trust networks, are decreasing the overall security of the system to that of the least secure dependency.

To tackle the core divergence of innovation from infrastructure to the application layer EigenLayer is introducing a simple, yet extremely effective, solution to the prohibitive cost of capital problem: re-staking.

The EigenLayer Approach

EigenLayer is a smart contract layer on Ethereum that allows users to leverage an existing trust network to secure other core infrastructure and middleware layers through the use of re-staking. At its core, re-staking is utilizing the same staked ETH that is used for Ethereum network validation to secure other networks. This allows ETH stakers to have much more flexibility with their staked capital while extending the trust layer to periphery infrastructure like side chains, middleware, or even other non-Ethereum networks.

EigenLayer is introducing a two-sided marketplace where ETH stakers are able to provide services to networks in need of a trust layer. This introduces the ability for new networks to cut the cost of network security while simultaneously gaining access to a vast pool of capital. In practice, this eliminates the least secure denominator problem in the application layer. Oracle and bridge networks would source security and trust from the same infrastructure layer that the applications themselves are built on. EigenLayer allows for consolidation of trust which ultimately increases the security of all networks interacting with the layer. For example, a brand new entrant into the asset bridge sector can interact with EigenLayer and immediately gain access to an $18.7B security base.

Given that ETH stakers do not incur any marginal cost of capital while validating other networks, restaking substantially improves the range of possibilities that stakers have. EigenLayer does come with several leverage and slashing risks as the underlying staked assets could be slashed across multiple secured networks if malicious behavior is encountered. Whenever the same capital is used to validate more than one network, the asset base is intrinsically leveraged, opening the system to potential cascades.

Slashing risk is compounded and can result in slashing contagion. The slashed stake, as a result of malicious behavior or downtime, inherently reduces the security consideration on all validated networks. If not controlled and potentially restricted the contagion can be detrimental to the systems architecture. At launch, EigenLayer will be introducing prudent leverage guidelines and limits to ensure stability of the trust system.

EigenLayer is also developing a data availability layer for Ethereum called EigenDA. This layer is similar to the current danksharding specifications, including features such as data availability sampling (DAS) and proof of custody. However, EigenDA is an opt-in middleware rather than a core component of the protocol. Being a middleware layer allows for stress testing without a need for a hard fork which offers several advantages: permissionless experimentation with the DA layer and allowing validators to participate on an opt-in basis. If the pseudo-danksharding implementation is successful at scale with EigenDA, it could become the de-facto DA layer for all optimistic and zk-rollups built on top of the Ethereum ecosystem ahead of the lengthy process of Ethereum-level protocol changes.

During the protracted 2022-2023 bear market liquidity is expected to continually seek safety within Ethereum, further solidifying the network as a safe haven and central trust layer in crypto. The run for safety will further build out the Ethereum capital base, widening the gap among alt-L1s and pushing the cost of capital for new native validation networks to borderline prohibitive levels.

Access to re-staked ETH security will result in a dramatically reduced cost of scaling for middleware, sidechains, and the general decentralized tech stack. We believe Eigen will offer the most dramatic change to how decentralized networks are built since the initial introduction of Ethereum in 2015.

Blob Transactions Will Not Fix Scalability Issues

Blob transactions aren’t going to be the magical fix to Ethereum scalability until modularity is reached. Reaching modularity will come with considerable technical hurdles and delays. The dramatic increase in on-chain data is also going to drive the need for state expiry to alleviate state bloat and might even lead to changes in the peer-to-peer structure of Ethereum. Blob transactions are introducing a new data format for calldata (on which rollups depend) which contains large amounts of additional data that won't be accessed by EVM execution, but rather only accessed for commitments. This new data market is going to become increasingly competitive as the amount of rollups and modular execution demand grows. This implies that we will likely see price competitiveness just like we've seen competitive gas prices on Ethereum, we will likely see competitiveness around Data_gas, which is the new type of gas being implemented. There's also quite a few kinks to iron out, such as whether the gas should be time or slot based, since if slot based there's the possibility of missed slots without blob transactions which would make it look like demand has increased, and this would affect gas prices.

https://www.eip4844.com/

There's also the problem of the actual gossiping of blob transactions on the peer-to-peer network since the sizes of these blobs are much larger than anything currently being gossiped. This needs further research which Paradigm is currently exploring. It will be interesting to see where this lands, and whether or not the Ethereum network can handle this further state bloat and data. Regardless, state expiry will most likely be needed to limit the growth of the state of Ethereum - which currently sits at a wild 1079 GB for a chain full sync, and grows larger every day. State expiry would either be implemented with state rent, so renting out state to be stored off-chain, or through removing state on a monthly or weekly basis, that then gets stored on archival nodes (which are sadly quite centralized at this point).

https://ycharts.com/indicators/ethereum_chain_full_sync_data_size

What becomes clear as Ethereum and many others position themselves for the coming years is that in order to retain decentralization and “keep up with the times”, they have to move towards modularity.

ZK-Rollups Will Not See Significant Traction in 2023

Zero-knowledge (ZK) rollups will not gain significant traction in 2023 due to their lack of production readiness and inability to achieve sufficient decentralization. By production readiness, we mean especially their VMs and the proving times of proofs.

Instead, it is expected that ZKPs will see widespread usage, particularly in non-interactive state proofs. Projects such as Herodotus, Axiom, ETHStorage and Lagrange will use them for various data sharing purposes that require on-chain or cross-chain storage proofs.

Many bridges are expected to begin using ZKPs for interoperability purposes, with several already moving in this direction, including Wormhole, Polymer, and the ZKBridge collective.

These applications of ZKPs are almost ready for use and are expected to have reasonable pricing for on-chain verification. These uses of ZKPs improve efficiency through recursion, which involves aggregating multiple proofs into a single, smaller proof. Most protocols have recognized the need for recursive ZKPs to reduce costs and increase efficiency, though some proof schemes are more efficient than others. However, it does come with some caveats, as some proof schemes are more efficient than others.

https://ethresear.ch/t/reducing-the-verification-cost-of-a-snark-through-hierarchical-aggregation/5128

Many existing ZK schemes and algorithms with succinct proof sizes experience high overhead during proof generation time (also known as proving) which limits their efficiency and scalability. To address this issue, projects such as Supranational, Ingonyama, and DZK are working to improve the efficiency of proof generation. However, what's important to realize is that this hardware acceleration is only partially responsible for efficient proving. There's optimisations to be made on the algorithm level, software level and others. It is also important that said systems are kept sufficiently decentralized, which is hard to achieve in practice.

https://eprint.iacr.org/2022/1010.pdf

Lastly, the proving time also increases with the complexity of the ZKPs in question. Considering all the factors mentioned, it is undoubtedly difficult to build a sufficient ZKRollup that will gain significant traction in 2023. For now, the most efficient use of ZKPs are in smaller scale operations such as the non-interactive state proofs and interoperability mentioned earlier.

Layer 3s Will Be The True Competitor To Cosmos

Layer 2s (L2s) improve Ethereum's scalability by lowering gas fees and increasing throughput. Due to these scalability factors, tradeoffs exist, and L2s must choose to optimize for particular items. Layer 3s (L3s) are application-specific blockchains built on L2s, purposed to mitigate these tradeoffs and make more improvements. They are similar to app-chain environments like Cosmos, Avalanche, and Polkadot but benefit from being built on modular blockchain protocol stack instead of monolithic ones. Thus, deploying a fully modular blockchain infrastructure stack that includes a general-purpose L2 with customizable L3s will mark the end of the monolithic app-chain ecosystem era and the beginning of a new era in decentralized application development.

At the moment, monolithic app chains are the preferred choice for many applications because of the freedom it allows them to create their custom logic and smart contracts while achieving better execution. Additionally, app chains own their block space, so they do not have to compete with other chains on execution. But this is not as efficient as it could become. Utilizing any piece of monolithic blockchain architecture like app chains built on modular software (e.g., Cosmos) or as an entirely monolithic app chain (e.g., Avax Subnets) limits their ability to decrease transaction costs and increase computational throughput.

Comparatively, app chains built on fully modular blockchain protocols deduct unnecessary frictions since they can leverage optimized blockchain layers constructed for a specific function. Suppose you compare an L3 built on top of the L2 zkSync, utilizing Celestia for data availability and Ethereum for settlement proofs and consensus, to a monolithic app chain that combines all or some layers. In that case, the only way forward is to build modularly to achieve better scalability while retaining decentralization.

Notably, the measure of these benefits outweighs what monolithic app chains can theoretically achieve. For example, An L2 receives a 100x cost reduction compared to an L1, and an L3 can receive a 10,000x cost reduction compared to an L1. A real-world implementation is being built by zkSync—their zkPorter L3 increases scalability with a ~100x fee reduction and 20,000+ max TPS. L3s offer not only improved performance, but also the ability to be customized for specific purposes. This includes adding privacy features in using ZKPs, designing custom DA models, and enabling efficient interoperability solutions.

Almost every related EVM L2 plans to develop customizable L3s on top of their L2. Further, opportunities will arise for more modular blockchains to be built using Celestia's shared data availability base layer. Yet, for this prediction, the vital thing to note is that the future development of app chains will occur as L3s on modular blockchain stacks, not monolithic ones. Combining the EVM's decentralization and security with scalable L3s makes the modular environment far better than monolithic app-chain ecosystems. Significant interoperability issues still need to be addressed, particularly for cross-rollup transactions. However, progress is being made, and it is anticipated that L3s will be available in late 2023.

Thus, if L3s can solve interoperability issues, deploying app chains built on a modular blockchain tech stack will be the monolithic app-chain thesis killer. L3s will retain a certain extent of Ethereum security, increase speed and scalability, and allow the Dapps to be customized toward specific use cases. App-chain ecosystems like Cosmos are positioned to continue gaining traction in 2023. However, with the eventual deployment of L3s in 2023, we will see the app-chain narrative switch from monolithic to modular ecosystems.

End of Part One

Part Two

Cosmos: The Current Version of ICS Will Struggle in 2023

Interchain Security's (ICS) popularity and implementations won't see a market fit in its current state, but will do so through more customized and marketable solutions like Saga. This is because simply getting a validator set isn't enough for smaller teams like indie game studios and projects that can’t afford a Golang developer with CosmosSDK experience (something that is in big demand these days, as the popularity of app-chains grow). With a customizable app-chain solution that provides all the building blocks such as agnostic VM choice, validator sets, and easy setup, ICS is going to see real adoption, something that it deserves. It's great tech, after all.

This thesis is further solidified by the fact that the Cosmos Hub's community recently voted no to the Atom 2.0 Vision. Interchain Security is definitely going to see some use within the Hub, and might get a few chains on boarded - if they can get it through governance. The Cosmos Hub has quite a few hardliners that have been pushing it to stay as free of state and bloat as possible. This might make it difficult to pass certain proposals. We saw this issue with large with the large Atom 2.0 proposal failing to pass. This is another reason why ICS might not be able to fully flourish on the Hub itself. Regardless, the fact that teams still have to do most of the initial work (apart from the validator setup) means that it is out of reach for the vast majority of applications and protocols. Most of these teams don’t have the funds to pay over $300K a year for a blockchain engineer with Golang (CosmosSDK) experience. This means that they’re highly likely to pick a solution which provides a customisable and out of the box solution, which requires no actual developer work on the blockchain side. This is why solutions such as the one-click developer deployment of app-chains are going to be extremely important if we want to see the Interchain ecosystem grow beyond what it is now.

Cosmos: Mesh Security Will Lead To Validator Centralization

Mesh Security is going to increase power within certain validator cliques, leading to centralization and collusion. While the NATO example given by Sunny in his speech around Mesh Security makes sense, it doesn't take into account that the “nation states” of the Interchain community aren’t particularly nationalistic and tend to support chains across the Cosmos tech stack. This means that while some of these chains are incredibly popular, some are less so, and if mesh security were to become the go-to security measure, it will severely centralize the power into a certain few validators (some of which already have incredible amounts of power).

We should rather look at methods for furthering decentralization among validators, such that it is not the few that have power, but rather the many. Mesh Security is an answer to ICS in theory. It aims to solve some of the issues that ICS might bring to the table. Let’s quickly explain what mesh security is, what it does well, and where it might fall short. The primary issue with the way ICS is supposed to work with the Cosmos Hub is the fact that by being opt-in by nature, it makes it so subsets of validators validate various chains. In this case, you’re not deriving security from Cosmos, but rather from a subset of validators, which might be less secure and fall prey to malicious actions in case of increasing centralization. Regardless, if it is not the entirety of the stake that protects the consumer chain, it falls short.

Going back to our previous thesis, it clearly shows that an ICS Hub should be built for the specific purpose of ICS, not for a Hub to make a pivot that the majority don’t agree with — such as with the Cosmos Hub. Now for Mesh Security, you allow delegators on provider chains (such as the Hub) to delegate to validators in the consumer chain's own validator set, which offsets some of the subset problems. However, what you get now is increasingly fragmented security spread across several chains, of which some staking providers (validators) might become increasingly entangled and grow their power base.

If this is to be implemented it needs clear UX that shows exactly what is being validated by who, how much stake they hold, and much more. Mesh Security has the chance to fragment and distribute more than need be. It is also entangling, which could have catastrophic consequences if done incorrectly. However, at this point the correlation between validators is extremely large across chains, as seen below with the Juno/Osmosis example. So from that perspective, mesh security seems like a natural extension of what is already happening. The question is, should we really be glorifying that?

Celestia: Data Availability Sampling Will Revolutionize the Development of Blockchains

Data Availability Sampling (DAS) is set to become the biggest innovation for building out multiple aspects of blockchains. DAS enables you to increase decentralization (node count) without losing throughput. For example, block verification in Celestia works quite differently from other current blockchains since blocks can be verified in sub-linear time. This means that throughput increases with a sub-linear growth in cost, compared to linear growth in cost. This is possible since Celestia’s light clients do not verify transactions, they only check that each block has consensus and that the block data is available to the network.

By optimizing a part of the network (with Data Availability and Consensus, in Celestia’s case) or just one of them, we can allow other networks and layers to specialize in what they deem most important. This means that we overall get a much more specialized and focused blockchain ecosystem with various layers and nodes that are great at their specific task. This means that throughput, data availability, and much more won’t be much of a problem for much longer. By focusing on what makes layers other than execution best, we can allow for execution to become more efficient. As others have said before us, execution is now the bottleneck - so how will you increase it? There are various layer 2 teams working on exactly that, and it’s going to be very interesting to see what happens in the next year or two for execution layers in particular.

Now for some bold predictions for Celestia - We expect a thriving ecosystem on top of Celestia with Total Value Locked that would put the ecosystem in the top 10 of ecosystem TVL. We also expect to see some Celestiums (Ethereum for everything but DA, DA on Celestia rollups) see significant traction pre-danksharding for Ethereum.

After all, Ethereum must realize a modular future for decentralization to be upheld while simultaneously increasing throughput.

Something else we would like to note is that we also expect to see DAS and Erasure Encoding getting usage beyond just data availability sampling for DA in Ethereum and Celestia. For example, another use case is clearly described in an excellent paper by Joachim Neu from Stanford on the ability to use DAS for Information Dispersal with Provable Retrievability for Rollups. This is a storage and communication efficient protocol using linear erasure-correcting codes and homomorphic vector commitments. It also requires no modification to on-chain contracts and can even provide some privacy assumptions against storage nodes. This is a fascinating application that only scratches the surface of what these technologies are capable of.

Key infrastructure Will Be Built to Address the Bottleneck of Liquidity Fragmentation in 2023

Fragmentation of liquidity - both interchain and cross chain - creates apparent price discrepancies that result in unfavorable environments for both liquidity providers and traders. Liquidity providers struggle to correctly predict favorable trading venues with the highest volumes and lowest fees to maximize capital utilization and revenue. While traders suffer from high slippage resulting in materially worse trade pricing and user experience.

Introduction of concentrated liquidity provision and stableswaps are driving the market towards specialization, though a large portion of emerging token markets are unable to find a consistent edge dispersing among various xyk bonding curves. Such token markets rely on trading aggregators to efficiently route their trading order to the best execution environment while navigating the fragmented liquidity on trading venues.

To analyze pathways to consolidation, we should break down the grand issue of fragmentation into layers. Such layers include the following: Application, Middleware, and Infrastructure.

Applications are decentralized exchanges with accompanying bonding curves that serve as the bottom most level in the trading hierarchy. Examples of such protocols include Curve, Uniswap, SusiSwap etc.

Middleware layers serve as chain-specific DEX aggregators and Liquidity optimizers. The most prominent examples are 1inch as an aggregator, and concentrated/ single sided liquidity provisioning as optimizers. This layer introduces chain specific efficiency optimization, but does not solve fragmentation of capital within a chain and cross-chain.

On the other hand, trading infrastructure includes liquidity direction engines and communication protocols that allow for efficient cross chain asset and message transfers. Examples for this top most layer include Layer 0, Polymer, Socket etc. The infrastructure layer tackles fragmentation directly by providing a toolkit for cross chain liquidity direction. This allows liquidity providers to allocate capital based on prediction models around capital utilization, slippage, and fees incurred. Such infrastructure allows for liquidity to be allocated to environments that are experiencing the largest trading volume, hence maximizing capital utilization for liquidity providers and minimizing price impact for traders.

Consolidation of liquidity is largely believed to be bound by bonding curve innovation, where liquidity providers are seeking the highest capital utilization with the lowest exposure to impermanent loss. We argue that the primary bottleneck is liquidity infrastructure, trumping application and middleware layer constraints. Solutions for mending fragmented liquidity, enabled by advanced infrastructure, will see unprecedented growth in 2023. Two overarching approaches will be standard in achieving liquidity unification.

Asynchronous cross-chain communication: enhanced cross-chain messaging solutions that afford native composability for dissimilar execution environments, e.g., chain-agnostic IBC
Shared liquidity layers: liquidity hubs that allocate liquidity to various marketplaces (satellites) on different chains and applications based on predictive volume demand (ex. SLAMM cross-chain liquidity model)

The Most Important Problem to Solve in 2023: Exclusive Orderflow

The block builder's primary goal is to extract the maximum amount of value from a collection of “orders,” or orderflow. They ultimately have the incentive to receive as much private orderflow as possible. This is known as the exclusive orderflow (EOF) problem. It is detrimental to blockchain networks because a builder who receives order flow exclusivity, i.e., toxic order flow, gains an outsized advantage over their counterparts and creates a point of centralization on the network which can lead to market manipulation and transaction censoring. Additionally, this value, known as MEV, that is extracted from EOF remains entirely with the extracting parties (builders/searchers) without redistributing rewards to some of the other participating parties (validators/users). This situation will likely result in a small group of colluding builders eliminating all other competitors and gaining control over the orderflow throughout the entire blockchain stack. While there are numerous working solutions to prevent EOF from damaging the network, none are currently fully operational. This threat is truly existential when it comes to the long-term prospects of any blockchain network.

The MEV supply chain comprises a collection of actors (see image above) that play a role in executing transactions. However, these actors often do not act in good faith and extract mercenary value from the $1B+ pool of capital that is up for grabs. Specifically, mercenary value extraction is when value extraction is not equitably distributed among parties that helped facilitate the transaction in the first place. This usually occurs when there are collusive agreements between block builders and relays or proposers, but it can also happen directly between a relay and proposer as outlined here. Yet, the mercenary MEV problem stems from exclusive order flow to various centralized, collusive actors who act only in their interest.

The users and the validators are the two most important parties in the entire chain, so they should be compensated fairly. Users represent the sole source of block demand, and should be rewarded with fair execution and a MEV rebate for the amount of blockspace their transaction(s) use. Similarly, the validators are the source of block security; without them, there would be no block supply. They should be rewarded with market priced gas payments and a majority portion of the MEV. Thus, value extraction from block space should primarily accrue to the edges instead of the middle parties (Builders and Searchers).

The best solution to EOF is to create an optimal blockchain-based financial economy that decentralizes all components of the MEV supply chain and aligns the actor’s incentives toward extracting and redistributing MEV. To this extent, the fundamental question is how to prevent malicious actors from exploiting the system for their gain while maintaining the most critical network properties: security, fairness, and efficiency.

There have been efforts to address some aspects of the problem, but none have completely resolved it. For instance, Flashbots and Bloxroute are off-chain searcher-builder marketplaces that aim to minimize harmful MEV. While they provide some benefits, they also contribute to the risk of centralization, which is a more significant concern. The routers and builders of Flashbots and Bloxroute create a point of centralization that, if exploited, would have meaningful consequences for all actors in the value chain. Additionally, it creates opportunities for cartelization, as sole entities can hold multiple roles across the value chain and create a system of oligopolistic competition.

Despite these challenges, there are several approaches that projects are using to address the EOF problem. In general, there are three primary ways: transaction fee auctions, fair ordering, and randomness. Transaction fee auctions enable builders to bid on transactions, and the highest bidder will receive the fees as a reward. Fair ordering employs a priority-based transaction ordering system that ranks transactions based on specific criteria, such as the size, time, or sender's reputation of the transaction. Finally, on-chain randomness makes it difficult to predict the outcome of transactions, which helps reduce the profitability of front-running and enhances the overall security of the network. The most effective solution is likely a combination of these factors, but it is not possible to determine this until all working solutions are fully operational.

While there have been some positive developments, more focus on the issue is needed. Flashbots, a leading block builder in the industry, open-sourced their builder to promote competition, which has had some success as its market share declined from 75% to 25%. However, more measures are necessary to prevent collusion. One potential solution is a mechanism that decentralizes sequencers, validators, and builders to prevent vertical integration. Two projects, in particular, stand out from the rest: Flashbots SUAVE and DFlow.

Flashbots SUAVE is an app chain that can serve as a plug-and-play mempool and decentralized block builder for any blockchain. The team has identified EOF and cross-domain MEV as the primary risk factors for centralization in the MEV supply chain. SUAVE aims to address this issue by developing three components: Universal Preference Environment (a chain and mempool aggregator), an Optimal Execution Environment (a network of executors who compete to provide the best transaction execution), and a decentralized block building network. With SUAVE, users’ transactions are private and accessible to all participating block builders, and users are entitled to any MEV they generate. Futhermore, to neutralize the impact of cross-domain MEV, block builders across different chains can integrate in an open and permissionless way. The combination of these components aims to address the entire exclusive orderflow (EOF) and centralization problem.

As the name suggests, DFlow is building a decentralized payment-for-order-flow (PFOF) marketplace. Specifically, the project is a Cosmos application-specific blockchain that facilitates decentralized first-price sealed-bid auctions that run in parallel and sequentially. Like SUAVE, DFlow is blockchain-agnostic, meaning that any application, regardless of the blockchain it is on, can sell its order flow, and DFlow will facilitate the PFOF auction.

Other potential solutions or contributing factors to the EOF problem include encrypted mempools (e.g., Shutter), side pools (e.g., EIP-4337), and app-specific mempools via Batch Auctions (e.g., CoW Protocol).

It is probable that a few players will eventually dominate the builder market due to the high upfront cost and technical requirements needed to be profitable in this industry. Vitalik agrees with this idea and has emphasized the need to carefully consider the levels of decentralization in block production that are realistically achievable. In 2023, the need for decentralization in critical areas of block production will become even more evident as the exclusive orderflow problem continues to result in centralized actors colluding and gaining control over a significant amount of value in the network. Collaboration among a wider range of participants working on various approaches will be crucial in identifying the most pressing issues and finding effective solutions. Without a robust decentralized value chain, the consequences could be catastrophic.

End of Part Two

Part Three

Native Cross-Chain Assets: The Decline Of Wrapped Assets Has Begun

Wrapped assets have been a core component of DeFi architectures since generalized composability and cross-chain transactions were first implemented. Unfortunately, they carry significant fragmentation and security risks that compound as interoperability increases. Through 2021 and 2022, new permissionless messaging technologies made native asset issuance across multiple chains possible. In 2023, we expect generic messaging and omnichain tokens (such as those made possible by LayerZero) to proliferate across the DeFi sector. Wrapped assets will eventually become a thing of the past as developers recognize the immediate efficiency gains and security advantages of cross-chain native asset issuance. The gradual unwinding of the complex web of wrapped assets has begun.

Surprisingly, major stablecoins issuers have been some of the first to adopt this new token standard. Circle, the issuer of USDC and EUROC, recently announced its Cross-Chain Transfer Protocol. This protocol allows users of Circle-issued stablecoins to seamlessly transact with truly native USDC and EUROC across all supported chains. Native issuance and secure cross-chain mint and burn mechanisms will reduce fragmentation and unify the overall system liquidity of these stablecoins.

So what does this mean for systems and assets outside of the stablecoin space? Moving into 2023, generalized messaging protocols like LayerZero or Chainlink’s upcoming CCIP will have far reaching implications on the deep structures of all protocols. Now that a clear path to the end of wrapped assets is here, builders across crypto will need to progress through the painful, albeit necessary, process of re-architecting fundamental flows of value within DeFi. We expect major infrastructure revisions to foundational DeFi assets that exist across multiple chains in 2023 (ex. Uniswap, Compound, Lido). The changes coming in 2023 won’t stop simply at token deployments - expect governance, DAO tooling, and liquidity systems to become increasingly focused on cross-chain capabilities.

DeFi: Stablecoins & Pegged Assets Will Dominate DeFi

Throughout 2022, we saw the rise of liquid-staked derivatives (LSDs) such as stETH and mSOL, DApp-branded stablecoins like crvUSD and GHO, and Convex style liquid lockers like auraBAL. The yield category is not the only market that got completely taken over by pegged assets, we saw these yield-bearing alternatives to vanilla tokens get introduced as collateral for stablecoins, become the deepest pairs on DEXes, and inspire an array of pegged-asset focused DeFi alternatives such as Y2K Finance and Voltz.

Compared to earlier incarnations of DeFi, which focused disproportionately on governance tokens and stablecoins, the new era of DeFi has transitioned to markets where protocols do not prioritize yield if it is not generated by the collateral itself.

Obviously, this has its downfalls - new smart contract risk, new centralization risk, and even new systemic risk. stETH provides a good example. Introduced to Maker earlier this year, it quickly grew to over 10% of the collateral backing Maker’s DAI stablecoin. The ETH-stETH pool has become the deepest pool on Curve, and stETH’s parent company, Lido, has the highest TVL of any DeFi protocol. The point is this: while there have been no problems so far, there is an inherent risk in the DeFi system becoming so intertwined with such a young smart contract.

For what it's worth, Lido is on the better end of the spectrum of pegged assets. Every week, new competitors launch with the possibility to become blackholes for major L1 and governance tokens, given the right incentive scheme. Unfortunately, the race to become the new Convex or Lido put millions of dollars at risk through exploits such as Ankr’s aBNB and Lodestar’s plvGLP. Oddly similar to the original run of DeFi exploits, where over-incentivization attracted millions of dollars of these same tokens, just through different forms like Compound and Uniswap forks. Expect to see this race to dominant pegged assets to evolve in 2023.

DeFi Landscape: Consolidation Of Power Amongst A Few Dominant Players

https://defillama.com/

The DeFi market's Total Value Locked (TVL) is currently around $39B, and the proportion controlled by its largest applications is large and poised to get larger. According to DeFi Llama, the top five DeFi applications command nearly 50% of the total DeFi TVL, while the top ten control around 86%. It is anticipated that in 2023, market dominance by the top DeFi dapps will become even more pronounced due to the emergence of app-specific blockchains and the development of composable applications that leverage the capabilities of the dominant apps.

https://defillama.com/

Even as the number of DeFi applications has increased to around 1400 dapps, the top five Dapps still control a sizable portion of the total market. This occurrence is largely due to certain applications dominating specific sectors within the DeFi market. For example, Uniswap is the dominant player in the decentralized exchange (DEX) market, holding a market share of 59% by volume, an increase from 43.2% since the bear market. This pattern of dominance can be seen across other categories as well, with Lido leading in the liquid staking market, dYdX in the derivatives market, and MakerDAO in the lending and borrowing market. As most demand is concentrated among a few applications, these apps have an incentive to build out app-specific blockchains in order to extract as much value as possible from the blockchain and into the application itself.

https://medium.com/1kxnetwork/application-specific-blockchains-9a36511c832

There is a growing trend for these dominant DeFi applications to build themselves as app-specific blockchains. One argument in favor of this approach is that it eliminates maximal extractable value (MEV) leakage. Since the value of layer 1 blockchains is determined by the MEV that can be captured, it makes sense for applications to be built as their own blockchain. Additionally, this gives the application more control over the platform and potentially improves scalability and efficiency, while creating a more resilient moat against smaller competitors.

To counter this trend, new applications are looking to be composable with larger ones in order to gain certain advantages. For instance, Panoptic is leveraging the liquidity and custom price range architecture from Uniswap v3 to create custom options contracts. This allows them to avoid the need to build up their own liquidity in order to have a functional application. This will likely become the preferred way for smaller players to enter the market and potentially compete with dominant firms.

In conclusion, while the trend for DeFi apps is becoming monopolistic for the largest players and composable for the smaller ones, competition must occur among all sectors to prevent dominant firms from using their market power to block potential competitors from entering the market. It is important for DeFi to remain open and competitive in order to drive innovation and adoption. In 2023, the monopolization of DeFi applications in particular sectors of the market, the application-specific blockchain thesis, and the emergence of composable applications will all be highly relevant and will lead to an even more apparent oligopolistic economic structure.

DAOs & Governance: New On-Chain Governance Primitives Will Define Decentralization Efforts in 2023

There is a fundamental oxymoron built into the current state of DeFi, where supposedly decentralized applications are owned by a multisig of "trusted" protocol founders and are able to be modified at will by governance. In theory, DeFi should scale naturally away from trusted parties and towards trustless and censorship-resistant applications, but this hasn't always been the case. So what are the major obstacles to continued decentralization?

Antifragility, as famously defined by Nassim Taleb, is engraved on the heart of DeFi. Stressors, shocks and extreme volatility have become the standard in on-chain systems due to the nasency of the ecosystem. These stressors are further exacerbated if on-chain governance systems are not thoroughly examined and tested, as “code is law” exploits are further wreaking havoc. This looming fear of the inability to “control” governance loopholes via a centralized multisig is the leading reason for the centralized status quo.

It is often impractical to devote large resources to effectively decentralize governance when the protocol is dedicated to focus on product and seek product market fit, but with the introduction of Metropolis (previously Orca) many of these constraints are solved. A robust governing system is an outcome of thorough iterations, which often start with the concept of SubDAO’s, or as coined by Metropolis - Pods. As with traditional corporate division, Pods allow for parsing smart contract ownership or some related aspects of governance to be further delegated to community groups. DAO operators are able to slowly initiate core protocol decentralization without opening the DAO to a vast number of governance attack vectors.

Metropolis further offers very granular assistance in shaping the governance structure to ensure a prudent decentralization roadmap without a complete governance overhaul at inception. With the introduction of pods ownership of each critical smart contract can be siloed and delegated to a particular group of participants. This group can be as decentralized as the protocol sees fit. Pod members can issue proposals that are voted by the other Pods members and are executed on-chain.

Having a robust toolkit and a prudent support team offered by Metropolis unlocks a safe and predictable roadmap for protocol decentralization all while alleviating the primary bottleneck in building permissionless and safe governance systems. We believe that SubDAO structures will become the norm in the following crypto cycle as available tooling is rapidly growing. These structures will solidify the promise of on chain applications as valid improvements to the traditional intermediary based financial structures.

2023 Will See Major Application Level Security Upgrades & The Decentralization of Auditors

2022 saw record-breaking losses due to smart contract and bridge hacks, social engineering, phishing, and targeted advanced persistent threat attacks, and the security challenges facing web3 are more clear than ever.

Staggering public losses will scare many newcomers away from the space. In order to onboard the 99% of people who have never used or held crypto, the overall security experience needs to improve significantly.

We expect 2023 to be an exciting year for security enhancing technologies. These new tools will directly enhance the security experience of all users, regardless of scale or holdings. Some of the technologies we see gaining traction this year include:

Rapid Progress in Account Abstraction

Wallets with built-in Social Recovery will allow, for example, a group selected by the wallet owner to have the ability to move the wallet’s assets under specific circumstances in case of loss of keys by the original owner.
The use of Secure Enclave technology already shipping on many consumer devices makes the storage and usage of cryptographic keys easier for seamless integration with Web3 applications.

Reversible Transactions

When paired with decentralized arbitration projects such as Kleros.io, these proposed opt-in systems of smart contracts promise to allow transactions to be prevented for even rolled back in extreme cases such as a users’s private keys being exfiltrated (or the user accidentally giving away their seed phrase in Discord).

Cross Chain Technology is Evolving

Next generation protocols like Stargate promise to deliver cross chain liquidity in a manner more secure and scalable than contemporary solutions.

In 2023, cybersecurity services providers (e.g. smart contract audit services) will continue to decentralize and increasingly take on the characteristics of DAOs. This is continuation of a trend that already began with services such as Code4rena and Immunefi.com. Cybersecurity work will increasingly rely on small and agile teams that form in an ad-hoc manner to address the specific needs of the security challenge at hand.

Individual auditors will begin to build on-chain reputation with innovations like soulbound NFTs, which could be used to recognize continuous success over time. Commit-reveal schemes could even enable individual auditors to claim priority on finding exploits on chain without revealing any information about the exploit until the time is appropriate. Overall, we expect the simultaneous proliferation of multiple application layer security upgrades and decentralized auditors (and their reputations) to lead to dramatically better security outcomes for users in 2023 and beyond.

NFTs: 2D Liquidity Turns 3D

While not a major focus for New Order in 2022, NFT liquidity has slowly become an area of focus for the DAO. Despite the current downtrend in the market, NFT communities have shown remarkable staying power. Some factors at play could include the bonds made within the community and the many benefits that collections offer to their members.

While NFT collectors have long been concerned with the possibility of their project fading into valueless images as the floor price dropped to zero, there has not been a way for holders to hedge the downside risks of the JPEGs that they own. After all, we know that NFTs are illiquid, and when it comes to a bank run, most people are guaranteed to flee regardless of the loyalty mentioned. This is to say nothing of the large percentage of NFT flippers that are in it for the gains or marketplaces like OpenSea charging exorbitant fees on every transaction.

For these reasons, we believe the idea of hedging and speculation has created a new untapped market in the NFT space. NFT traders at present can only buy low in hopes of selling high someday. As mentioned above, hedging is also impossible, which causes holders to be fearful during a bear market.

For the average retail buyer, owning a blue chip NFT like BAYC (77 ETH floor) is far out of their reach. This could turn a huge chunk of interested buyers away, which is generally bad for the collection and community.

A number of existing projects are attempting to capitalize on this potential demand for NFT perps. One of them, appropriately, is named nftperp. Nftperp is built on top of a virtual automated market maker (vAMM), which was pioneered by Perpetual Protocol. The vAMM model removes the need for liquidity providers and order books, creating a player versus player (PvP) environment in which traders profit from others losing. The vAMM model applied to NFTs allows the following functionality for NFT traders:

vAMM model
Trade with any amount of collateral
Directional longs and shorts
Lite and Pro interface
Up to 5x leverage trading
Discounted fees with NFTP
Real time NFT price feeds

Let's see how nftperp could be valued when compared to derivative volumes on centralized and decentralized exchanges.

Cryptocurrency derivatives trading on centralized exchanges makes up 69% of total crypto volumes on average. For example, 76.6% of daily trading volume on Binance comes from derivatives ($49.52 billion out of $64.65 billion).

On the decentralized side, let's compare Uniswap and dYdX volumes as they are the largest "spot" and derivatives markets in the space.

Uniswap generates $1.09 Billion in daily trading volume while dYdX averages $1.33 Billion for derivatives. This evens out to 45.2% and 54.8% respectively.

In the world of NFTs, OpenSea is king. The platform generates about $16.36 Million in daily "spot" volume, which we can use to project how nftperp might do if the numbers were to match those of industry leaders.

Nftperp takes a 0.3% fee for all positions on the platform. We can see that if nftperp manages to capture a portion of OpenSea volume, it could be very profitable (assuming the protocol distributes a percentage of its revenue to stakers.) for NFTP stakers, which incentivizes others to buy and stake NFTP and in turn drives the price of NFTP up. We used GMX as a reference, as the platform distributes 30% of revenue to GMX stakers.

Overall, NFT perps offer a great opportunity for retail investors who would like to trade NFTs. Instead of purely flipping where one is required to buy low and sell higher than what their purchase price is to make a profit, nftperp allows one to profit no matter an increase or decrease in the NFT’s floor price as long as you’re on the right side of things.

With NFT liquidity, the innovation has not limited itself to perps (like DeFi). We also explore innovation with oracles and how it can help enable new liquidity venues and volume for more niche sectors of the NFT market.

End of Part Three

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2023Crypto Thesis

In the Belly Of The Bear2022 was primed to be a big year for crypto. The industry seemed to evolve dramatically as institutional capital poured into crypto-focused initiatives, exciting new financial primitives were developed, and its legitimacy as an asse
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