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MEMO W26 JUN 2024

People usually do not get the point outside of their own belief system. - xh3b4sd

I want to talk about how everyone is building a worse Ethereum in the L1 blockchain space and explain what this has to do with the way the internet happened. Back in the 1990s nobody really understood the internet. Nobel Prize-winning economist Paul Krugman wrote this around 1998: "By 2005 or so, it will become clear that the Internet's impact on the economy has been no greater than the fax machine's.". Yeah well, thank's Paul! Ignoring performance levels of the average economist out there, I want to focus on the architecture of the internet as we use it today, and then tie a bow into blockchain networks. In most simple terms, multiple computers connected to one another form a computer network. So far so good. In the real world, networks of computers are also connected to other networks of computers. That is basically what the internet is. The internet is a network of networks. And from that point of view the lines between those networks become very blurry, because we have gotten rather good at providing a unified user experience for people on the internet. Beginning 2020, Ethereum started to pursue what came to be known as the rollup-centric roadmap. That means Ethereum mainnet became the base layer of the Ethereum ecosystem, which is often referred to as L1. As a base layer, Ethereum mainnet provides economic security to rollups, which are often referred to as L2s. Those L2s are what enables the Ethereum ecosystem to scale. And from here we can see what this ecosystem is. Ethereum is a network of networks. Today the user experience across different blockchains is still rather clunky and full of friction. Those UX issues are being heavily researched and worked on. At the end of the day, users won't notice what chain they use or whether the underlying infrastructure is in fact Ethereum or Base or something entirely different. Just as no internet user has to worry about the fact whether their Internet Service Provider is AT&T or Telekom, nobody will have to worry about whether they are consuming block space from Solana or Ethereum. And from that perspective we can see that it comes down to networks of networks, again. Now, pioneered by Ethereum, the idea of leveraging L2s for scalability and adaptability has seemingly caught on in the most weird ways. And this is the part in which we are looking at Bitcoin and Solana, because concessions have been made that would have been scandalous not too long ago. We have seen the rise of Bitcoin L2s for almost a year now. Never mind the Bitcoin community leveraging Ethereum terminology. What's more egregious though is the fact that none of the Bitcoin L2s are real rollups in the first place. All the technical details and implicit trust assumptions aside. Those scaling solutions are outright confessions that the way in which Ethereum is leading the charge ends up being the future proof approach every blockchain network is going to gravitate towards. Bitcoin finally implementing L2s is a "fight or flight" response forward in the face of direct competition with Ethereum. And it does not stop there. Solana just came out with some form of zero knowledge compression framework that allows transactions to be scaled on top of Solana. If the attentive reader squints their eyes real hard, then we can already see where this is leading. Some people ponder for Solana being a base layer, compressing transaction batches in similar ways that rollups do. Networks of networks! Every day we can hear how different and how much better all the ETH Killers are. And at the end of the day it looks like all of them lern their lessons and end up gravitating towards the same conclusions and the same overall system design. You heard it here first. It's networks all the way down. Vance Spencer said it best. If you really just end up being a worse Ethereum, then that is not bullish!

The ETH ETFs are about to launch within the next couple of days, once the SEC gives everyone the final go. By accident I discovered an interesting data point on Reddit that surprised me a bit to be honest. Historically the discourse on Reddit has been mostly bad, hateful and incompetent on topics that I was mostly interested in. In any event, here is what I found in the CryptoCurrency subreddit this past week. Somebody who is apparently new to the crypto ecosystem asked in their post what to invest in and what to pay attention to in the space. The person here has so far been invested in stocks and commodities. The poster wrote that they are thinking to allocate 15% of their portfolio to BTC and 5% to ETH. That is interesting for several reasons. For one, this particular person did already understand that the majors are BTC and ETH, and not something weird like DOT or ADA. Second, they are willing to allocate 20% of their portfolio to crypto. And third, their allocation ratio amongst the majors is apparently market cap weighted. Those points confirm some of our believes that we stated here already several times in past Powerlaw memos. The majors are where it's at. Substantial allocations are being made. And allocations are by default market cap weighted, which is what we should be able to expect for the average long term ETF flows.

And one more thought on flows in general, since the timeline is once again full of cognitive dissonance on the matter. The past couple of weeks can be described by a chop-bleed market. We go sideways with a tendency of lower lows. Bitcoin has received about 15 billion USD in net inflows within the past 6 months. Though the price of BTC has mostly been sideways for the better part of this duration, which begs the question whether flows do even matter without any context. What is happening when a new asset class has massive inflows, but muted price action? There are so many different scenarios and strategies that may or may not cancel out net inflows into the new ETFs. If you for instance sell the tokens from your hardware wallet and buy the ETF products again in equal amounts, then you produced net inflows into the ETFs without affecting the asset price on a net basis. The same is true for various similar delta neutral trading strategies. What might be more important, and what might be way harder to assess, is the amount of new long term holders that can be attributed to more meaningful market participants like Individual Retirement Accounts and institutional pension funds.

The scaling factor for the overall Ethereum ecosystem has now reached over 20x according to L2Beat. That translates to almost 300 transactions per second over the past 7 days across all of Ethereum mainnet and L2 rollups. And another super interesting data point caught my eyes this past week, where we saw operating margins for L2 rollups being reported in more concrete terms. Optimism appears to have a margin of 97%, Arbitrum has a margin of 90%, Base has an operating margin of roughly 80% and Blast has a margin of about 56%. All of that is to say that L2s can be run as highly profitable businesses today, which suggests to me that more competition is likely to enter the field in order to bring those huge operating margins down. And the consequence of lower operating margins would then be even more scalability, even cheaper transaction fees and overall better user experiences.

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