
By Assistant Professor Kohei KAWAGUCHI, Department of Economics, HKUST Business School
With the ever-evolving crypto landscape, Ethereum stands as a leading force in innovation, addressing scalability, decentralization, and monetary policy challenges on its path to mass adoption.
“Crypto chains are ready for mass adoption” and “We are entering the Golden Age of crypto” are sentiments echoed by advocates of the crypto economy following Donald TRUMP’s victory in the U.S. presidential election. Since Satoshi NAKAMOTO introduced the concept of blockchain, this community has diligently pursued innovations to address the challenges that accompany it. Many believe that the new presidency will reshape the leadership of the Securities and Exchange Commission (SEC), which has initiated numerous lawsuits against crypto projects. Advocates are hopeful that this shift will foster a more crypto-friendly regulatory environment, allowing the community’s innovative efforts to flourish.
Crypto chains: Inherently innovative platforms
In this article, I review the past, present, and future of the crypto economy from an economist’s perspective, focusing on Ethereum—one of the most successful and innovative blockchain networks. Ethereum revolutionized the blockchain landscape by introducing smart contracts: self-executing agreements with terms encoded directly into the code. This innovation transformed blockchain technology from a mere store of value into a platform for decentralized applications (dApps). In September 2022, Ethereum’s transition from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) consensus mechanism, known as the Merge,1 dramatically reduced the system’s electricity costs, paving the way for its long-term viability.
Despite the challenges ahead, I believe that crypto chains will ultimately achieve mass adoption and become integral to future transactions and financial systems. This optimism stems from ongoing innovations that arise directly from blockchain’s unique capabilities. Essentially, blockchain technology significantly lowers the fixed costs of entry into the transaction-system market, allowing new transaction systems to be launched without the historical requirement of accumulated trust typical of banks and central banks. We no longer need to be local celebrities like the Medici family, who built their reputation as wool merchants before being a trusted ledger validator. The blockchain’s consensus mechanism will validate and finalize transactions without any trust in the anonymous validators. The mechanism is designed so that the system is secured as long as many validators are onboard. Consequently, many transaction systems with new features enter the market and enhance the competition.
The blockchain trilemma
However, reducing entry barriers is not without its costs. Decentralizing transaction validation to potentially malicious actors necessitates that the system be designed to incentivize honest behavior. This often results in user transaction fees that may be higher than those in centralized systems. Vitalik Buterin, Ethereum’s co-founder, termed this the “trilemma”2 of decentralization, security, and scalability. Following the Merge, which increased demand for the chain, the Ethereum community faced the challenge of achieving scalability without compromising decentralization and security—a pursuit that resulted in lower transaction fees.
The widely adopted solution to this scalability issue has been the implementation of Layer 2 (L2) networks, similar to Bitcoin’s Lightning Network3. In the Ethereum ecosystem, L2 solutions handle a subset of tasks off the main Ethereum chain (Layer 1) executing them on another chain and then returning the results to Layer 1. The most common approach is rollups, where hundreds of transactions are bundled into a single transaction within Layer 2, with Layer 1 executing only this consolidated transaction. This method reduces the demand for Layer 1 validation and, consequently lowers transaction fees. However, L2 solutions may sacrifice some decentralization compared to Ethereum itself.
Maintaining the decentralization of validators presents another challenge. Without preventive measures, economies of scale in block construction and validation could lead to dominance by a few actors. In Bitcoin,4 for instance, over 57% of the hash rate is controlled by just two mining pools. In Ethereum, capital-intensive actors could exploit more lucrative opportunities relating to block construction, such as arbitrage and even sandwich attacks on user transactions. This phenomenon, known as Maximum Extractable Value (MEV), is believed to hinder competition among smaller validators.
To address this issue, the Ethereum community proposed and implemented an innovative solution to separate the capital-intensive task of block construction from the non-capital-intensive tasks of block proposal and validation. This approach5 aims to lower entry barriers for block proposers and validators, thereby maintaining decentralization—crucial for the security of the consensus mechanism. However, the implementation did not prevent market concentration in the builder sector with the capital-intensive task of block construction being subcontracted to “builders,” with block proposers choosing which block to propose based on an off-chain auction. As a result, and perhaps unsurprisingly, 89% of block building is now controlled by only two builders.
Centralization compromises
The aforementioned solutions, such as Layer 2 and Proposer-builder separation, were originally designed to maintain decentralization in block proposal and validation. Ironically, they have led to new forms of centralization within various parts of the ecosystem, albeit in sub- or off-chain organizations. The extent to which this centralization poses challenges for the ecosystem remains an open question. Less decentralized Layer 2 chains might defraud users or impose monopolistic fees. Concentrated builders could coordinate to censor transactions from certain users for non-economic reasons or to increase fees paid to them. Therefore, Layer 2 chains and builders try to signal that they are not malicious and care about their reputation, indicating a resurgence of a trust-based economy.
The PoS consensus mechanism itself faces additional challenges from recent “innovations”. Currently, becoming a validator requires a deposit of 32 ETH (approximately 800,000 HKD). Some entities have introduced staking pool services to enable smaller ETH holders to participate in validation. These services pool ETH from multiple users, stake it, and distribute the staking revenue to the original owners. Additionally, some providers, such as Lido,6 have launched liquid staking services, which issue tokens equivalent in value to the staked ETH. This allows ETH holders to earn staking revenue while maintaining liquidity through these equivalent-value tokens—provided the service remains viable. While these services help redistribute the staking revenue to small validators, they can also effectively centralize the validation process among a few operators, jeopardizing the security of the consensus mechanism.
Monetary policy in crypto chains
The last, and perhaps most critical challenge for any crypto chain on the path to mass adoption is the high volatility of its value. For a crypto chain to be widely accepted as a standard means of transaction, stabilizing its value is even more important than addressing previous issues. This necessitates a reevaluation of the central bank’s role beyond validation, particularly concerning monetary policy. Currently, ETH is issued as a staking fee when a block is proposed and validated and is burned as a transaction fee. The staking fee rate has remained relatively fixed—5 ETH since its launch in 2015, 3 ETH since a fork in 2017, and 2 ETH since 2019. The question arises: can and should monetary policy be adjusted to stabilize value?
For fiat currencies, monetary policy can address either inflation and economic fluctuations or exchange rate volatility—but not both simultaneously with free capital flow across currencies, known as the famous monetary policy trilemma. In crypto chains, however, the effects of monetary policy on the security of the consensus mechanism must also be considered. Changes in staking rewards can influence the number and types of active validators, complicating the already “impossible” trilemma for crypto chains. Finding a solution to this complex problem remains elusive.
Concluding Remarks
In this article, I have reviewed the challenges faced by crypto chains—particularly Ethereum—along with the proposed and implemented solutions, as well as emerging issues. The reduction of fixed costs for entry into the transaction-system market has transformed crypto chains into innovative platforms. The community’s rapid iterations through trial and error lead me to believe that this industry will eventually reap substantial rewards.
Moreover, I am convinced that economic analysis of these issues will significantly benefit the industry’s development. As we stand at the intersection of technological innovation and economic principles, one thing is clear: the future of crypto chains is not just about code; it’s about decoding human behavior in a decentralized world. The race is on, and the finish line may well herald a new economic paradigm.
1. https://ethereum.org/en/roadmap/merge/
2. https://vitalik.eth.limo/general/2017/12/31/sharding_faq.html#this-sounds-like-theres-some-kind-of-scalability-trilemma-at-play-what-is-this-trilemma-and-can-we-break-through-it
3. https://lightning.network/lightning-network-paper.pdf
4. https://coinpaprika.com/news/two-mining-pools-now-control-57-of-bitcoin-s-hashrate/
5. https://eips.ethereum.org/EIPS/eip-7732
6. https://lido.fi/