Scaling Ethereum and its Resultant Redefinition of Liquidity
Here I outline the noticeable effects that having additional layers/side chains within the Ethereum ecosystem, and EVM-compatible chains, will have on liquidity, from the liquidity provider, trader, and yield farmer standpoint.
The growth of Ethereum via Layer 2 can be likened to the electronification of the equities market.
Without going into too much detail about the centuries-long history of the stock market (SoFi provides a nice TL;DR), in the United States there was previously a very limited number of exchanges that allowed for the trading of equities. The New York Stock Exchange (NYSE) was the predominant exchange for decades, making stock market trading a boys’ club inundated with capital-rich titans.
With the onset of the digital era, along came more technologically advanced exchanges such as the National Association of Securities Dealers Automated Quotation (better known as NASDAQ), a whole host of dark pools, and small broker shops that themselves had order books to facilitate trades. With each additional exchange, there were massive arbitrage opportunities created, and resultant new financial products that appeared, making use of these opportunities.
Fast forward a few decades, and the digital revolution has enabled trading equities to be anyone’s game now, with derivatives even being offered through Robinhood for convenient in-app sale in small denominations.
A few interesting results were produced from this evolution to an electronically unified, globalized stock market:
-With the creation of new exchanges came new opportunities for arbitrage and money to be made for traders interested in going the extra mile to match orders across exchanges.
-Traders eventually generally didn’t care which exchange they were trading with, obviously still having significant trust in NYSE, but for the most part shifting priority to capital efficiency rather than experience.
-Data became an important resource for traders, as in order to complete this shift of priority, there needed to be requisite information regarding capital efficiency to inform this decision. Data providers like Standard and Poor (S&P) were able to serve as a single source of truth for this data, and still continue to do so today.
-There was a dropoff in having trading being more relationship-focused, with the priority instead shifting to the necessity for synchronicity of orders, and a single source of truth to facilitate trades.
Enter the DTCC.
Another revolution to the global process of exchanging stocks came with the introduction of the Depository Trust and Clearing Corporation (DTCC) in 1999. The DTCC functions to reconcile all trades within the stock market, acting to unify the entire space — an important role, as the economy at that point was quickly becoming globalized, but lacked the infrastructure for cross-exchange cohesion.
The DTCC thus stepped in as a single source of truth for settling stock exchange transactions. Thus, the DTCC provided the single settlement layer needed to make the stock market become rapidly more efficient.
The DTCC contributed additional important developments to the stock exchange space; the ability to be able to route trades through multiple locations with a single source of truth for orders resulted in cohesion of global stock markets in an incredibly efficient and coordinated manner, eliminating previous barriers in the industry.
We can learn from this history to promote the growth and unity of L2 of Ethereum.
Parallels can be drawn between layer 1 and the NYSE, and between layer 2 solutions and individual brokers — both in their limitations and in the ways they address these limitations:
Both layer 1 and the NYSE served as foundations for industries (DeFi and the stock trade), and are still incredibly important today. But, both are no longer the only viable options in the space, and cannot accomplish all aspects for the future of the industry.
Similarly, just like smaller brokers offered new arbitrage opportunities beyond those available in stock exchanges, introduction of different Ethereum L2 solutions provides new value-generating capabilities. Further, these different offerings all have their own advantages for the dApps looking to build on them, as individual brokers also offer unique benefits. A range of viable platforms in the space also prevents the overcrowding and subsequent transaction cost and time increases that plagued Ethereum L1 in the first place. Thus, it is a positive thing that such a range of different L2 solutions and blockchains exist in the decentralized finance space.
However, like the pre-DTCC stock market, the number of different players in DeFi causes the space to be incredibly siloed; there is little interoperability between different L2 offerings (as there was between different stock exchanges/brokers), resulting in a number of limitations:
-Lack of composability (i.e. the ability to merge different tools together to generate higher-order functions) results in limits on utilities that can be crafted with the different “Lego” building blocks in DeFi.
-Complicated asset transferral processes (such as having to transfer back to L1 when transferring between L2s) result in high gas fees and slow transaction times — sometimes even taking weeks.
-Decreased capital efficiency due to missed/delayed value-generating opportunities result from this capital tie-up.
-Fragmented liquidity between different L2 solutions and chains is due to different applications that cannot efficiently transfer assets (and thus liquidity), meaning negative consequences on exchanges.
-Governance issues are created by different instances of the same dApp that cannot interact with each other but aim to share a DAO.
In order to resolve the disparities between L2 solutions and unlock further value in DeFi, an infrastructure like the DTCC must be created to break down barriers preventing complete flexibility and interoperability.
This requires linkages between the different L2 solutions in existence, as the DTCC linked different exchanges and brokers. This also requires solid user experiences (UX) in order to draw and facilitate usage. Specifically, this infrastructure should work with different wallet providers and dApp developers to ensure that it is user friendly; this could be modeled after Robinhood, which “plugged into” the DTCC. As a result, Robinhood provides a maximally user-friendly interface for trading stocks, as an infrastructure uniting L2 should provide for cross-layer 2 asset transfers.
Composable Finance’s cross-layer 2 infrastructure intends to grow the Ethereum ecosystem as a whole.
Composable Finance’s offering serves as an order routing layer for the entirety of the layer 2 space, emulating the unifying, streamlining force that is the DTCC. This infrastructure is in the process of uniting all L2 scaling solutions and linking them in a manner that enables seamless asset transfers between any of these tools. Just as the DTCC provided a massive improvement in the efficiency of the entire global stock exchange space by uniting all systems with a single source of truth, Composable Finance seeks to similarly link all L2 tools and make cross-layer 2 asset transfers far more time- and cost-effective. The end result is an incredibly user-friendly space that unlocks new functionalities and delivers the ultimate level of capital efficiency.
In order to make these tools accessible to developers, and thus facilitate optimal dApp building, Composable has created its own SDK. With this toolkit, Composable provides its cross-L2 capable infrastructure to other developers and projects.
There are obvious liquidity unification projects that can be built using the Composable SDK, but I’m personally more interested in seeing what other cross-layer applications that users can think of.
Due to the fact that Composable’s SDK will also enable cross-layer function calls, users will be able to architect products that are deployed on multiple layers, and have the smart contracts be able to interact with each other. Our team is currently understanding how to make this as universal and accessible for the developer community at large.
Delivering this impactful infrastructure is just the first step for Composable Finance, which seeks to solve additional pressing issues and persistent questions in DeFi and Ethereum’s L2.
For instance, in addition to a comprehensive L2 infrastructure, the DeFi industry also needs to understand how to draw new value to L2, not just that which was already on L1.
The growth of the layer 2 space is clear — consider popular L2 solution Polygon’s 1,105% growth in May 2021, despite the large losses seen by many other dApps that month. However, what is less apparent is whether this growth is attributable to funds being moved over from layer 1, or if L2 has been able to attract additional value into the space on its own. Thus, the industry requires an analysis of how to get new total value locked (TVL) into layer 2 solutions, not just that from L1, if it wants to truly grow and not just shift locations.
This sort of analysis will require ecosystem-wide collaboration; the entirety of the DeFi ecosystem should come together to analyze this TVL movement over time on the high-throughput network that is being created on L2. A better understanding of where the value is coming from will help shape the L2 space’s approach to continued growth, and determine new tactics for attracting new funds and new users.
Thus, our focus, with this infrastructure, is to determine ways in which we can not only draw liquidity from L1 and encourage utilization of Ethereum scalability solutions at large, but also understanding what type of products utilizing this technology would result in the generation of further TVL into the Ethereum space as whole.
Further, we are exploring other pain points that are impending problems for L2 scalability, such as that of maximal or “miner” extractable value (MEV). I honestly expect MEV to be a problem that many cross-layer applications still haven’t entirely thought through.
We are exploring the implications of MEV, which will be as present in L2 as it is in L1. We want to work through this with the community, striving to alleviate this prominent issue
Composable Finance’s ultimate vision is the barrier-free DeFi space of the future.
Ultimately, Composable Finance takes its inspiration from attempting to unify, rather than segregate, scaling solutions to optimize for the future of Ethereum. The end result is not only an infrastructure positioned to unify and thus vastly improve the L2 space, but also an organization that would like to leverage this mindset and technology to build for the future.
I hope that you are as excited as we are at Composable Finance about unlocking the next level of decentralized innovation and utility.
If any developers want to reach out regarding what we are building at Composable, or have ideas about what they could build using the composable SDK, or want to explore these important research questions, please reach out to me on Telegram at @brainjar.