Blockchains enable Web3. Without blockchains, we wouldn’t have crypto tokens and most of the decentralized applications that are running today. This article will give Web3 product designers an understanding of where blockchains came from, what the current blockchain landscape looks like, and where blockchains are headed in the future. This is an extension of the Web3 Design Course 2022. If you haven’t read that – I recommend starting there.
Bitcoin was created by an anonymous figure, named Satoshi Nakamoto, and released as open source software in 2009. Looking at the Bitcoin Whitepaper, Satoshi intended Bitcoin to be a digital currency that could be exchanged without any intermediaries like banks. Bitcoin is simple compared to later blockchains. It’s essentially a ledger that tracks the transfer of bitcoin cryptocurrency between wallet addresses. This ledger is decentralized in that it is distributed across thousands of nodes worldwide. Now, 13 years later, Bitcoin has a market capitalization hovering around $1 trillion.
Ethereum, initiated in 2015, was the next phase in blockchain development. The fundamental innovation of Ethereum is that it generalized blockchains from a simple currency ledger to a virtual machine that can run decentralized applications. Thousands of third-party developers have built up an ecosystem of dApps on Ethereum ranging from decentralized finance (e.g. Compound & Uniswap) to NFT trading platforms (e.g. OpenSea & SuperRare). These new use-cases onboarded millions of users to Web3, which brings us to the present day.
With this increase in demand, Ethereum is now maxed out in terms of processing user transactions. Thus, network fees have skyrocketed. Some transactions can cost over $100, which has made using Ethereum prohibitively expensive for the average user. Ethereum has plans to scale with its transition to Ethereum 2.0; however, other smart contract blockchains with novel design philosophies and software architectures are currently emerging. Indeed, the blockchain landscape is developing rapidly, and each Layer 1 blockchain has its own Web3 ecosystem growing on top of it. Some honorable mentions include Polkadot, Solana, Cosmos, Algorand, Luna, Avalanche, and more.
Last thing – there’s also a video version of this Blockchain Design Course (see below).
Bitcoin, the World’s First Blockchain
In the introduction, we talked about how Bitcoin was the first blockchain ever, and it powers a peer-to-peer digital currency that can be exchanged without intermediaries like banks, or payment processors. But this is all sort of abstract. What is Bitcoin exactly?
There are several layers to Bitcoin – let’s talk about each. First, Bitcoin is a piece of open-source software that is referred to as the Bitcoin Protocol. Open-source means that anyone can download it, and any developer can suggest improvements to the protocol or build applications on top of it. Satoshi released the first implementation of the Bitcoin Protocol, called Bitcoin Core on Github in 2009.
When someone installs, and runs, Bitcoin Core their computer becomes a node on the Bitcoin network, which brings us to the second layer. Bitcoin is a decentralized, peer-to-peer network of Bitcoin nodes, or computers running the Bitcoin Protocol. The protocol defines the rule set for how these nodes interact with one another in order to keep Bitcoin up and running.
For example, when I first run Bitcoin Core, my computer connects to other Bitcoin nodes and downloads the Bitcoin blockchain from them, which is a file of around 400GB. This brings us to the third, and final, layer of Bitcoin. Bitcoin is a blockchain that tracks the movement of a decentralized digital cryptocurrency called bitcoin (BTC).
Remember the blockchain is simply a ledger that is distributed across all the Bitcoin nodes. In other words, each Bitcoin node stores its own copy of the Bitcoin blockchain – this is what makes blockchains decentralized. But how does the blockchain get updated in a decentralized way? If one Bitcoin node had unilateral rights to update the blockchain with new transactions then this would defeat the purpose of decentralization. Nodes take turns updating the blockchain, and coordinate with each other based on a predefined rule set specified in the Bitcoin Protocol.
When a node creates a new block, and adds it to the blockchain, and the other nodes accept the new block, and add it to their blockchains – this is called “consensus”. Bitcoin uses something called “Proof of Work” as its consensus mechanism. This is a highly technical topic, so just understand that, with Proof of Work, nodes must spend large amounts of electricity and computing resources to win the right to create a block and update the blockchain. This high energy expenditure is by design, and is what prevents the blockchain from attackers; however, it’s also a criticism of Bitcoin. The Bitcoin Network consumes a comparable amount of power to Thailand, which critics argue is bad for the environment.
Consensus mechanisms are important when it comes to the technical design of blockchains. They have a great impact on the security and performance of blockchains. We’ll see in later sections the innovations that are taking place around consensus mechanisms within emerging blockchains.
Bitcoin Protocol is open-source software that establishes the Bitcoin node network, which maintains the Bitcoin blockchain, which tracks the movement of bitcoin cryptocurrency. I know this is confusing – bitcoin (lower-case “b”) is the native cryptocurrency of the Bitcoin protocol (upper-case “B”). Nodes are rewarded with bitcoin when they create a block – this is what incentivizes them to spend electricity to win the right to do so. This reward is also called “bitcoin issuance”.
You may wonder how a digital currency can be valuable. Most of the digital content we’re used to, like images, can be replicated millions of times for free. This brings us to the concept of “tokenomics”, or token economics, which has to do with the monetary policy of cryptocurrencies. A limit on the total bitcoin that will ever be issued is encoded directly in the Bitcoin protocol. Once 21M bitcoin have been issued, estimated to happen sometime in the year 2140, then no more bitcoin will be issued. This limit of 21M is called a “hard cap”, and is the most important thing to understand about bitcoin’s monetary policy. It’s fundamental to why people believe bitcoin has real value.
Juxtapose this 21M bitcoin hard cap to the US dollar. $3.38 trillion were issued just in the year 2020, largely in response to the COVID outbreak. This increased the supply of US dollars by about 20%. There is no hard cap to the US dollar. The Federal Reserve (FED) has total control over the national currency, and can issue as much currency as they see fit. When you create more of something it becomes less scarce and, assuming constant demand, less valuable. This is why you may have heard people say that the currencies are being devalued.
So how can bitcoin, a digital currency currently trading at ~$40k, demand this real world value? There is a fixed supply of bitcoin, so if demand increases then the price of bitcoin will increase. And there is always demand to own assets that hold value or, better yet, increase in value over time. Bitcoin hasn’t seen a great amount of adoption in terms of a currency – something that people use to pay for goods and services (although this could change with the mainstream rollout of Bitcoin’s lightning network). Instead, bitcoin has seen adoption from retail investors, and increasingly institutions, under the premise of “bitcoin as a store of value”.
Scarce resources have been the backbone of currencies for thousands of years. Gold is a good example. One of the reasons it’s valuable is because it’s naturally scarce and difficult to extract from the Earth. Gold is the original store of value asset; however, there’s still a problem with gold. The global supply of gold is estimated to increase by around 2% per year.
Michael Saylor, a prominent Bitcoin evangelist, talks about how bitcoin is the only solution for transferring your money over 100 years – everything else loses its value entirely due to asset inflation. Let’s follow his line of reasoning. He estimates fiat currency (like the USD) is currently inflating at 15% per year, which means you lose all the purchasing power of your money within years. Going back to the 2% gold inflation – you lose all your purchasing power in 36 years. He reasons through other assets like real-estate, but I’ll leave you the pleasure to hear it from him. Gotta love his delivery.
So now you can start to see why bitcoin is thought of as a store of value by an increasing number of investors. The Bitcoin community seems to be content with this limited use-case as evidenced by slow and conservative upgrades to the Bitcoin protocol. Interestingly, bitcoin has not seen much adoption as a currency to pay for everyday goods and services, but this could change soon with the rollout of Bitcoin’s lightning network in mainstream products like Cash App.
That’s Bitcoin in a nutshell. We talked about how Bitcoin is open-source software, a network of nodes, and a blockchain ledger that tracks the bitcoin cryptocurrency. Also, the 21M hard cap grants bitcoin the never-before-seen property of digital scarcity. An increasing number of investors consider bitcoin a store of value asset, similar to gold. The next section covers the second evolutionary phase of blockchains, which enables the growth of a Web3 ecosystem of dApps.
Ethereum & Smart Contract Blockchains
Ethereum, launched in 2015, marks the second evolutionary phase of blockchains. Vitalik Buterin, the founder of Ethereum, was an early-adopter of Bitcoin, but saw the potential for blockchains to power additional use-cases beyond just decentralized digital currencies. Let’s compare Bitcoin and Ethereum by way of analogy.
If Bitcoin is like the calculator app on a smartphone then Ethereum is like a smartphone in itself. Bitcoin is designed to serve one, specific purpose. Ethereum, on the other hand, can run any number of applications. Third-party developers deploy applications to Ethereum like they do with the Apple App Store on the iPhone.
Bitcoin and Ethereum are actually similar in many regards. Both are open-source software, anyone can become a node on the network, and nodes are responsible for accepting transactions and creating blocks; however, Ethereum has an extra layer of complexity built into it, allowing developers to deploy decentralized applications via smart contracts. Smart contracts were discussed in Part 9 of the Web3 Design Course 2022.
Bitcoin is a more conservative blockchain protocol than Ethereum with regards to protocol upgrades. Ethereum has an aggressive road map for improving its protocol as we’ll discuss later on. The development ethos of Ethereum is to move fast and break things – and explore what is possible when it comes to building Web3 ecosystems.
Ethereum was the first smart contract blockchain, and is the most dominant smart contract blockchain to date, coming in as the second most valuable cryptocurrency behind Bitcoin. Just as Bitcoin’s native crypto is bitcoin, Ethereum’s is ether; however, ether has a utility aspect to it that bitcoin does not.
Ethereum is general purpose in that it will run any smart contract code that developers deploy to the blockchain. The problem with general purpose coding is that programs are not guaranteed to reach an end state – they can continue to loop forever. This is a problem because looping programs would tie up Ethereum nodes indefinitely, disallowing them from processing other incoming transactions. Thus, an incompetent, or malicious, developer could write a program that halts Ethereum. This is referred to as denial of service (DDOS) and is one attack vector that blockchains need to defend against.
Ethereum solves this problem by making users pay for the amount of computation their transaction consumes. To send ether from one address to another is a simple transaction, and requires relatively little computation. Still, users pay nodes to process this transaction with a network fee, let’s say around $5. Now, when someone uses a dApp, which might call multiple smart contracts on the backend, this added computation is accounted for with a higher network fee (e.g. $20). Thus, it gets prohibitively expensive to tie up the Ethereum blockchain for any significant amount of time.
Ether is a digital currency as well. You can send ether between wallets, and Ethereum wallets have ether balances, just like Bitcoin wallets have bitcoin balances. But ether has added utility over bitcoin in that it powers decentralized applications. This is why ether has a different investment narrative than bitcoin’s store-of-value narrative. Ethereum is a platform similar to an app store. Ethereum’s value as a platform increases as developers continue to deploy useful dApps to it, and Web3 users access these decentralized services by paying ether. Ether as a cryptocurrency has a totally different tokenomics to that of bitcoin, but that’s out of scope for now.
Let’s return to the idea of network fees. Ethereum nodes create new blocks roughly every 12 to 14 seconds, and only a certain number of transactions can be included in each block. This means there is a limit to the number of transactions per second (TPS) that Ethereum can process. In fact, Ethereum can handle roughly 30 TPS. With demand for dApps increasing, demand for Ethereum’s finite blockspace increases, thus driving up network fees.
This especially became a problem with a recent wave of DeFi and NFT-related traffic to Ethereum. The average network fee was as high as $49 per transaction at one point in 2021. Personally, I saw several hundred dollar network fees when using dApps like Uniswap and Aave. And since I was transacting with relatively small amounts of crypto, these high network fees made the transaction not worth submitting. Layer 1 Ethereum has become prohibitively expensive for the average user. In other words, Ethereum needs to somehow process more transactions per second if it wants to retain current users, and onboard the next 100M users to Web3.
You may wonder what I mean by “Layer 1” (L1). Bitcoin, Ethereum, and the other emerging blockchains are considered L1s, because they are the core/foundational blockchain. Layers 2s (L2s) have helped Ethereum scale recently. These are other blockchains built on top of Ethereum that process a bunch of transactions, and send only one transaction to Ethereum L1 for confirmation. L2s reduce the load on L1s, thus helping blockchains scale to more transactions per second.
Ethereum is also in the middle of a major update to its L1 chain as it transitions to Ethereum 2.0. Its new software architecture will feature 64 sharded chains that connect to a main beacon chain. The sharded chains will process transactions in parallel to one another, thus ramping up the transaction per second that Ethereum 2.0 can handle. Also, Ethereum 2.0 will transition its consensus mechanism from Proof of Work (seen in Bitcoin section) to a new mechanism called Proof of Stake (PoS), which we’ll talk more about in the next section. Developers estimate Ethereum 2.0 will handle 100,000 TPS thanks to its sharded chain architecture plus PoS consensus mechanism.
Ethereum launched in 2015 as the first smart contract blockchain and, despite competitive Layer 1s, has remained the second largest cryptocurrency by market cap to this day. Ethereum’s dominance can be measured in more than market cap – tens of billions of dollars worth of crypto is transacted on it every day, and Ethereum attracts over 4000 active monthly developers, which is the most of any layer 1 blockchain.
Having said all that, other competitive layer 1 smart contract blockchains are sprouting up, and building up significant developer and end-user communities. This landscape of emerging layer 1 blockchains brings us to the present moment. If Bitcoin is blockchain 1.0, and Ethereum blockchain 2.0, then we are now in the era of blockchain 3.0. These emerging layer 1s seek to solve problems in blockchain scalability and interoperability, each with unique design philosophies and cultural ethoses.
Emerging Blockchain 3.0 & Blockchain Wars
Right now we are witnessing rapid growth in the emerging layer 1 blockchain landscape. Ethereum is undergoing major reconstruction in its transition to Ethereum 2.0, and competitive layer 1 blockchains intend to steal market dominance from Ethereum, as well as support the next wave of Web3 adoption with scalable and interoperable technologies.
Layer 1 blockchains are like nationstates. They all have their own economies powered by their native cryptocurrency. Each blockchain attracts its own developer community who then build out a Web3 ecosystem on top of the blockchain, thus attracting end-users. These are the “blockchain wars” that you may have heard people talk of. The emerging Layer 1s are sometimes referred to as “Ethereum-killers”.
At the end of the day, blockchains are competing for more end-users. Metcalfe’s law stipulates that the more users in a network, the more valuable the network is. This is also known as “network effect”, and we can look at a familiar example as to why this is. Users sign-up to Facebook because there are already billions of users with Facebook accounts. They want to go where their friends and family already have accounts. In other words, they are attracted to Facebook’s existing network effect. It wouldn’t be hard to copy Facebook’s code, and deploy TravisBook, but it would be extremely difficult to get any user adoption, because Facebook is already the dominant social network.
This relationship appears to be true for blockchain networks. Macro investor Raoul Pal has shown the market cap of a crypto network is proportional to the square of active wallet addresses. This phenomena of winner-take-all exists everywhere in the tech landscape – think of Facebook, Amazon, Google, Apple, and Netflix. How many people do you know use a search engine alternative to Google? This proliferation of layer 1 blockchains, and their Web3 ecosystems, looks a lot like the internet tech boom in the 90’s. The lesson we learned from that is that 99% fail, and 1% take all.
All of this leads to something unfortunate about Web3 culture, “chain maximalism”. People want the blockchain they are invested in to be the winner. This explains why crypto Twitter, and the culture in general, can feel toxic and divisive. It’s just something to understand as a product designer, that blockchain developers and end-users have financial incentives to oppose other blockchains, and Web3 ecosystems.
But, it likely won’t be as cut and dry as one single winning blockchain. As we’ve already seen, Bitcoin and Ethereum both serve two different use-cases. Bitcoin’s design is optimized for decentralized digital currency, and Ethereum is a platform that runs decentralized applications. We will likely live in a multi-chain future as blockchain design does not appear to be a one-size fits all. Maybe people will have their preferences like PC versus Mac, but more likely blockchains will be designed with specific use-cases in mind.
For example, a blockchain built for decentralized social media doesn’t need the greatest security guarantees, but needs to process hundreds of millions of transactions per second. Whereas, another blockchain might be responsible for trillions of dollars locked in decentralized finance protocols, and need to be trusted by large public institutions. This blockchain would presumably need better security guarantees than the social media blockchain.
The Layer 1 blockchain landscape is quite varied in terms of design philosophy and software architecture; however, all Blockchain 3.0 Layer 1s have several things in common.
- Proof of Stake consensus for energy-efficiency
- Increase transaction throughput to scale blockchain to more users
- Improve blockchain interoperability and avoid siloed ecosystems
Let’s pause on Proof of Stake for a minute. Proof of Stake is the consensus mechanism of all emerging Layer 1s, and is an innovation on Bitcoin’s Proof of Work consensus. In PoW, nodes spend electrical energy in order to create blocks; whereas, in PoS, nodes stake the Layer 1s native cryptocurrency in order to create, and vote on, blocks. This is like posting a security deposit in order to participate as a validator node. The more crypto a node stakes, the greater chance that node will have to participate as a validator node, and earn block rewards.
That’s the carrot – to earn block rewards – but there’s a stick as well. Staking crypto makes it so that nodes have skin in the game. Nodes can have their stake slashed if they do something that undermines the blockchain. Nodes with the most at stake will be chosen as the validator nodes, and work to maintain the blockchain.
PoW and PoS are not intuitive and the reader still may have confusion about how consensus mechanisms work, but don’t worry about understanding these concepts fully. Consensus mechanisms are highly technical topics that play on multiple fields like game theory and computer science. We discuss Proof of Stake here because it unlocks a brand new investment vehicle for Web3 end-users. Users can delegate their crypto to validator nodes, and share in the block rewards these nodes earn for maintaining the blockchain. Users earn dividend payments proportional to the amount they delegate, and this is similar to traditional passive income assets like bonds. Staking has the potential to disrupt the financial sector as Proof of Stake Layer 1 blockchains grow in prominence.
So now we’ve discussed the brief, 13-year history of blockchains starting with Bitcoin, moving to Ethereum, and ending with the emerging Layer 1s currently vying for position in the Blockchain 3.0 era. Interestingly, the vast majority of end-users will not care which blockchain their dApps are running on. Currently, users don’t care which database technology (MongoDB, MySQL, etc.) their Web 2 application uses, and it won’t be any different for Web 3. That’s assuming that the underlying blockchains don’t impose UX limitations on them like high network fees, slow transactions, low staking yield, or a siloed ecosystem with no cross-chain communication.
Comparing Layer 1 Blockchains
As Web3 product designers it’s important for us to understand the blockchain landscape in order to decide which ecosystems to build products in. Let’s finish by discussing a framework for comparing Layer 1 Smart Contract Blockchains developed by The BLOCK Research. The research compares Layer 1s across 4-dimensions:
- Technical Design & Performance
- On-Chain and Ecosystem Data
- Tokenomics and Monetary Policy
- Team and Fundraising
Technical design and performance can be broken into network architecture, consensus mechanisms (e.g. PoW vs PoS), and performance metrics like transactions per second and time to finality. Blockchain design is still highly experimental. Of course, founding teams are in search of the design that results in the most favorable performance metrics. Many will fail, some will succeed.
On-chain and ecosystem data is good for assessing the health, and/or growth of a Layer 1 blockchain. For example, we can objectively say that Ethereum is still the most dominant smart contract blockchain because it has the greatest daily transacted value, largest developer network, and most value locked in its DeFi protocols. Number of active wallet addresses is another important metric. Remember, wallet addresses can be used to predict the value of a blockchain’s cryptocurrency.
Each Layer 1 has its own native cryptocurrency, controlled by its own tokenomic model. Some are fixed-supply (like Bitcoin), and others are inflationary, although there is more nuance here. For example, Ethereum is implementing a policy where a portion of ether network fees are burned. Some believe this will actually make ether a deflationary asset. Also, native cryptos have utility value as well. Users can delegate their crypto to earn staking rewards, and often token-voting is used to participate in a Layer 1’s governance process.
Finally, Layer 1s are being built out by teams of people who influence the ethos and design philosophy of the blockchain. And these teams need to be funded. This brings up a controversial point. Blockchain projects will often hold fundraising token sales, which VCs are increasingly participating in. This calls into question decentralization and the idea of fair launches when VCs own a significant portion of a blockchain’s native token.
This brings us to the end of the Blockchain module in Web3 Design Course 2022. There was a lot of mention about native Layer 1 tokens in this article; however, you probably know there are tens of thousands of crypto tokens in existence today, and wonder where they all come from. These other Web3 tokens belong to dApps and secondary protocols that build on top of the blockchain. Indeed, smart contract Layer 1 blockchains give developers the ability to deploy their own tokens with application-specific utility. Also, these bleeds into the topic of crypto art and NFTs, which are a specific type of token on the blockchain.
All this is to say that tokens are an entirely new design material available to Web3 product designers. In the next module, we do a deep-dive into these Web3 tokens – a lot of new mental models to come!
I, Travis Kassab, am not a financial advisor, tax professional, broker, or legal advisor. None of my podcasts, videos, or articles constitute financial advice. This content is purely for educational purposes, and is not intended to endorse any cryptocurrency or other investment vehicle. At the time of writing this, my cryptocurrency holdings include: BTC, ETH, CEL, SNX, BANK, SOL, DOT, KSM, USDC.
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