HKUST Business School Magazine

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-systemmarket, 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 Network. 3 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 approach 5 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. Biz@HKUST 43