Each major crypto cycle has been preceded by a period of infrastructure innovation and then punctuated by one or more resulting breakout consumer applications.
In 2012, the launch of Coinbase made it easier and safer than ever to buy and sell BTC. In 2015, the launch of Ethereum brought smart contracts to blockchain networks and positioned the space for the ICO boom of 2017. In 2017-2018, Protocols like MakerDAO (2017) and Uniswap (2018) set the stage for a Covid-fueled DeFi Summer of 2020, and NFT standards and marketplaces (2017) gave creators fertile ground for a 2021 NFT frenzy.
So where are we now? In June of last year, we argued that AI would primarily benefit crypto by i) democratizing best-in-class software experiences (web3 apps would soon finally have a chance to be at parity with web2 UI) and ii) AI would force the need for cryptographic authentication, possibly leveraging blockchains to provide a source of verifiability.
In this post, we go deeper on how blockchain scalability (and, importantly, approaches to that scalability) have changed since the last cycle, as well as how usability is improving faster than most realize.
Bitcoin purists will be quick to point out that each cycle has also been preceded by a Bitcoin Halving, so it's worth a quick comment on that. If you're unfamiliar, these are pre-programmed moments in Bitcoin’s monetary policy that reduce its inflation by half (by reducing the reward for mining a new block by half). Note the Price at Halving column below compared to the Price 1-Yr Later. The oft-revered Halvings certainly help drive narrative momentum, and that may continue to be the case.
But as BTC becomes more widely held, so will its value become more subject to exogenous macro factors. As block rewards near their horizontal asymptote, those pre-programmed supply “shocks” will have less and less narrative force. As “crypto” finds more use cases, the global crypto market cap will become (and has already become) increasingly dependent on new narratives – narratives like Coinbase, like DeFi, like NFTs.
So while the upcoming 2024 Halving may help market momentum, we’re even more optimistic that, like past cycles, we’re now emerging into a new phase of breakout consumer applications primed by scalability and usability infrastructure breakthroughs.
Part I: Scalability Breakthroughs
The Blockchain Scalability Trilemma
If a cryptonetwork’s scalability is its ability to handle an increasing number and size of transactions without experiencing decreases in performance, then the two most recent crypto booms both revealed the anti-network effects of blockchains as they attempt to scale.
CryptoKitties “broke Ethereum” in 2017, users burned over $150M on gas fees during a single Bored Ape mint in 2022, Bitcoin Ordinals drove up network fees more than 25x – historically blockchains become their most unusable (congested, slow, and/or expensive) in the same moments when they’d be otherwise most poised to break out and scale.
This isn’t by coincidence or bad luck; this happens because each block has a limited amount of space (block space) and an average speed limit at which new blocks can be added (block time) to the network – together block space and block time create a network’s throughput, usually measured in Transactions per Second (TPS). An emerging and more nuanced measure of speed called Time to Finality goes one step further, measuring the average amount of time it takes for a transaction to become permanent. While finality is a hugely important topic, for simplicity we’ll focus on throughput (TPS) below.
Using the Bitcoin network as example, it has a block size of 1MB and block time of 10 minutes. Since most transactions are less than 1KB, the network averages roughly 2,500 transactions per block, meaning it averages between 4-7 transactions per second. Ethereum block size is governed more dynamically by network demand and gas, but effectively blocks are created every 13 seconds with an average TPS hovering around 11-13 TPS.
Increasing block space or block speed might allow for more transactions but would do so with some compromise, most likely increased resource requirements and/or downstream centralization risk. These design tradeoffs are often referred to as The Blockchain Scalability Trilemma – the phenomenon whereby decentralization, security, and scalability are inevitably at odds in a blockchain’s design.
New Solutions to the Scalability Trilemma
In the last cycle, scaling solutions for consumer applications were limited – changes to base protocols are notoriously few and far between, and the dominant ideology was to maximize what was done on-chain. Encouragingly, though, the 2022-2023 bear market brought new infrastructure and new paradigmatic openness to giving builders more optionality in how they choose to scale. The merits and specifics of each are, of course, subject to more complete and ongoing spirited debate, but are creating a marketplace of infrastructure scaling solutions that are more flexible for builders and more affordable for users:
- Scaling Solution 1: Modular Approach - Modular scaling solutions have become the dominant approach to scaling Ethereum ecosystem over the last 2 years. In brief, Layer 2 blockchains like Arbitrum, Optimism, zkSync, Starknet, Mantle, Base and others create a “modular system” by offloading some amount of Ethereum’s function (execution, settlement, or data availability) to the L2. The result is a rich marketplace of L2s for builders to choose from, each of which is taking a slightly different approach to scaling, but all of which are drafting off Ethereum’s existing developer community, its security, and its decentralization. Already, L2s have been able to scale to past 60 TPS with transaction fees less than $1. In theory, they should be able to scale TPS to 1000+ TPS.
- Scaling Solution 2: Monolithic Approach – Monolithic scaling approaches believe in a single global state machine that scales through parallel execution. The design is similar to parallel computing – when you hear that a computer has 12 “cores”, it means the single machine is able to run 12 totally separate processes at the same time. Blockchains like Solana and Monad use parallel transaction execution as opposed to sequential execution like Ethereum. Already, Solana boasts regular 3,000+ TPS with transaction fees often costing less than $0.01 and has even shown 65,000 TPS in certain tests. Solana’s Firedancer upgrade, slated for later this year, is projecting 600,000+ TPS. The monolithic approach meaningfully increases complexity and risk of downtime, but markets and builders increasingly seem to be accepting minor outages as a worthwhile tradeoff for fast, cheap, and scalable blockchains.
- Scaling Solution 3: Sufficient Decentralization - The last scaling solution is more of a paradigmatic openness to the idea of “sufficient decentralization”, a term originally coined by Former Director of the SEC’s Division of Corporate Finance Bill Hinman in 2018 to describe when a digital asset was sufficiently decentralized so as to not qualify as a security. The concept is helpful since it encourages builders to consider the appropriate level of decentralization for their use case, rather than ideologically maximizing at the expense of scalability. More broadly, builders now have permission to consider practically what aspects of what they're building should be on-chain at all so we're seeing the rise of "sufficiently on-chain" among builders as well.
Part II: Usability Breakthroughs
On top of the infrastructure breakthroughs specific to cryptonetworks, the last two years have also brought tremendous improvements to the incoming usability of blockchains. To name just a few:
- Passkeys - Passkeys are beginning to replace passwords with cryptographic key pairs. For any given application, your phone uses its secure enclave to generate a public key (replacing the username and given to the application) and private key (replacing the password and never moved off your physical device). Already, crypto developers are exploring replacing the clunky seed phrase onboarding of wallet creation with a passkey-enabled wallet.
- Progressive Web-Apps & Mobile-First Progressive Web-Apps (PWAs) are applications that are delivered through the web rather than through a formalized Application. Though PWA’s were first launched in 2008 with iOS 2.0, it wasn’t really until 2019 that feature-rich web-based apps (fast, reliable, able to be added to the home screen) were supported by Apple. As more brands attempt to circumvent the App Store’s stronghold on fees and distribution, an entire cottage industry of PWA-as-a-Service companies has emerged. For consumer crypto companies, PWAs mean easier onboarding for users, self-updating app experiences, push notifications, and the ability to build mobile-first with lower fees. PWAs also reduce a project’s likelihood of distribution being cut off overnight by Apple. While Friend.Tech was a brief flame, skyrocketing to over 4,000 hourly active users and +$1M in daily fees in the span of a few weeks, it was a powerful early case study for the power of PWAs for crypto apps.
- Frames & Open Source Building- Finally, within crypto we’re seeing a novel application of an old concept: opening a protocol pipe to encourage users to build. Farcaster’s launch of Frames is eerily similar to the days of open Facebook and Twitter APIs, giving Farcaster users the ability to to create native and authenticated experiences within any Farcaster client. Think about X’s Polls feature, but instead of being limited to asking users to vote on something, the post can enable the user to perform any number of functions tied to any users Farcaster ID or wallet. This is the first step in exploring the composability of an open social graph and is, only 1 month since launch, inspiring the most energized wave of consumer builders we’ve seen in years. Within a few weeks Farcaster Daily Active Users had increased 10x to 50,000 users per day. That’s a far cry from Meta’s 2B DAU, but the open social building ground is only getting more fertile. The speed at which developers, both technical and non-technical, are building on Frames is also proving out our thesis from last year (Generative-AI is Democratizing the Creation of At-Parity Software) – that generative AI would accelerate crypto products becoming easier, cheaper, and more rapidly iterative to build.
III. State of Crypto Regulation (Part 2): Binance & Spot BTC ETF
Two of the most meaningful regulatory events of the past 18 months happened since our Partner Letter in November: i) The DOJ announced its $4.3B settlement with Binance, and ii) The SEC approved a spot BTC ETF on January 10, 2024.
i) The Remarkably Gentle Downfall of Binance
Since 2018-2019, Binance has been the single largest exchange by trading volume despite nearly constantly being caught in global regulatory crosshairs. To name just a few examples, Binance ceased operations in China in 2017, was forced out of Japan in 2020, and, in summer of 2023 alone, announced they’d be withdrawing from Canada, Belgium, the Netherlands, Cyprus, Austria, and Germany. All were amidst rustlings of governments cracking down on the exchange giant.
In our last letter, we flagged Binance’s ongoing tensions with the U.S. DOJ as the last dark cloud yet to clear in the bear market. We got that clearing only a few weeks later.
In summary, Binance’s November settlement with the DOJ resolves Binance’s outstanding cases with FinCEN, OFAC, and the CFTC. Binance pled guilty to unlicensed money transmitting, sanctions violations, and failure to maintain an effective AML (anti-money laundering) program. In addition to the $4.3B penalty, Binance will have an external monitor for 5 years. CEO Changpeng Zhao (CZ) has already stepped down and will pay a $50M fine personally.
While the $4.3B settlement was the largest ever announced by the U.S. Department of the Treasury, the news has had surprisingly little effect on the crypto markets. Binance is not being forced to shut down, they appear fully capable of paying the fine off their balance sheet, and then plan to continue doing business globally.
Snapshot of Binance’s Balance Sheet. Courtesy Coinbase Director @jconorgrogan
So instead of roiling, total crypto market cap was actually up +1% in the 7 days following the settlement. One analyst from JPMorgan observed a settlement eliminated “potential systemic risk emanating from a hypothetical Binance collapse”. The settlement punished bad behavior, but there were no allegations of customer funds misappropriation, no inability to withdraw from either exchange, and both CZ and the company seem to have cooperated with authorities throughout the settlement. This was not another FTX.
From here, we expect Binance to struggle to maintain its 40% market share, especially as concerns about its internal monitorship grow and as the SEC continues to pursue its allegations that Binance has been operating as an unlicensed securities exchange in the U.S. The SEC has levied similar allegations against Coinbase and Kraken, so we will continue to keep partners abreast as those cases develop. Overall, though, the Binance settlement was in our view a top decile outcome and clears the way for better markets ahead.
ii) BTC Spot ETF Approval
The SEC has rejected Bitcoin Spot ETFs every year since the Winklevoss twins first applied for approval in 2013. In October 2023, the tide finally shifted when a Federal Appeals Court ruled that the SEC’s prior rejection of Grayscale’s spot ETF had been “arbitrary and capricious”, signaling that the SEC would be under pressure to approve the ETF early in 2024.
After a fake approval tweet from the SEC caused BTC to spike from $46,746 to $47,863 (then back down to $45,633), at long last the spot ETF was approved on January 10th, 2024.
On its first day of trading, BTC ETFs saw over $4.6B in volume, led by BlackRock’s iShares Bitcoin Trust accounting for over 20% of that volume. For context, as of this writing, Bitcoin ETFs have a combined $40B assets under management, more than silver ETFs (a combined $11B), but still trailing gold ETFs (~$95B AUM).
Almost immediately, traditional finance has started to squeeze out inefficiencies, creating a welcomed race to the bottom on ETF fees. This is a good thing for access (albeit synthetic access) to BTC.
Plenty has been written about how the launch of spot Bitcoin ETFs legitimizes the industry, why a tidal wave of institutional capital might be incoming (or not), and of course plenty of speculation on how all of this will affect the price of BTC.
But we wanted to highlight three more underappreciated aspects of the ETF, articulated by Grayscale’s CEO Michael Sonnenshein in the week following the approval:
- Spot ETFs are much easier than futures ETFs for the everyday investor to understand - It’s one step closer to holding the real thing. The Overton window on the approachability of holding Bitcoin directly has shifted.
- Undoing the BTC ETF will be nearly impossible - As more institutions, IRAs, and other tax-advantaged accounts begin adding exposure to BTC ETF products, it’s less and less likely that this decision will be reversed.. While ETF closures (liquidating the underlying holdings) aren’t entirely uncommon, the reversal of an approval for a spot ETF to exist altogether has never happened to our knowledge. For the first time, Bitcoin has been irreversibly embedded into the global financial system.
- BTC ETFs are just the beginning - For many new investors, BTC ETF will be the onramp to realizing that crypto is an investable asset class beyond Bitcoin. Indeed, already there’s speculation that an ETH ETF could be approved as early as May.
At this time last year, the crypto industry was cleaning up the reputational damage of FTX. Now, we have an SEC-approved crypto product being marketed in NYC subways, animated on Wall Street buildings, even allowed back into Google and X paid ads.
