Was Modular a Mistake? A Data-Driven Take on Ethereum’s Grand Strategy
By Alex Pack (Managing Partner) and Alex Botte (Partner)
Executive Summary
- Ethereum has underperformed peers like Bitcoin and Solana. The culprit, at least according to the haters, was Ethereum’s strategic decision to modularize. Is that true?
- In the short term, yes. We found that Ethereum’s shift toward a modular architecture has hurt the ETH price due to reduced fees and less token burn.
- The picture changes if you look at the market cap of Ethereum and its modular ecosystem combined. In 2023, Ethereum’s modular infrastructure tokens generated about the same value as the entirety of Solana, $50B. But in 2024, they collectively underperformed Solana. Plus, the gains from those tokens have gone primarily to the teams and early investors, not ETH token holders.
- From a business strategy perspective, Ethereum’s modular shift makes sense as a way to retain ecosystem dominance. Blockchains are valued by the size of their ecosystem, and while Ethereum’s market share declined from 100% to 75% over nine years, that share is still impressive (we compare it to Amazon Web Services, the leading Web2 cloud compute company, which saw its share fall from nearly 100% to 35% over the same time).
- From a longer-term perspective, the biggest benefit of Ethereum’s modular approach is to future-proof the network against technical advances that could otherwise render it obsolete. With its Layer 2s, Ethereum has successfully navigated the first major extinction event for Layer 1 blockchains, positioning itself well for long-term resilience (although with tradeoffs).
Introduction: What’s Wrong?
Ethereum has underperformed relative to its peers like Bitcoin and Solana this cycle. ETH is up 121% from the start of 2023, while BTC and SOL appreciated 290% and 1,452%, respectively.[1] Why is this happening? We’ve heard many arguments: the market is irrational, the tech roadmap and user experience hasn’t kept up with peers, and the Ethereum ecosystem is losing market share to competitors like Solana. Is Ethereum destined to be the AOL or Yahoo! of crypto?
The main culprit of this underperformance has been a very intentional, strategic decision that Ethereum made almost five years ago: to shift towards a modular architecture, and with it, to decentralize and unbundle its infrastructure roadmap.
In this article, we explore Ethereum’s modular approach, using data-driven analysis to assess how this strategy may be impacting short-term ETH underperformance, Ethereum’s market position, and its long-term prospects.
Ethereum's Strategic Shift to a Modular Architecture: How Crazy Was It?
In 2020, Vitalik and the Ethereum Foundation (EF) made a bold, controversial call to unbundle the various pieces of the Ethereum infrastructure stack. Instead of Ethereum handling all aspects of the platform (execution, settlement, data availability, sequencing, etc.), they intentionally let other projects offer those services in a composable way. This started by encouraging new rollup protocols to handle execution as Ethereum Layer 2s (L2s) (see Vitalik’s 2020 essay A rollup-centric ethereum roadmap), but now there are hundreds of different infrastructure protocols competing to offer technical services that were once considered the exclusive monopolies of a Layer 1 (L1).
To understand how radical an idea this is, imagine a Web2 equivalent. A close Web2 comp to Ethereum is something like Amazon Web Services (AWS), the leading cloud infrastructure platform for building centralized applications. Imagine if 20 years ago when AWS first launched, it decided to focus solely on its flagship products, like storage (S3) and compute (EC2), which had nearly 100% market share, instead of building out the dozens of different services that it now offers today.[2] AWS would have missed out on an incredible revenue-generating opportunity to upsell its customers on its expanding suite of services. Plus, with a full suite of product offerings, AWS could create a “walled garden,” making it difficult for its customers to integrate with other infrastructure providers, and thereby locking its customers in. Of course, that is how it has played out. AWS now offers dozens of services, it’s notoriously difficult for customers to move away from its ecosystem, and revenues have grown a staggering amount (from hundreds of millions in its early days to an estimated $100B in annual revenues today).
But the upshot is that AWS has steadily lost market share over time to other cloud providers, with competitors like Microsoft Azure and Google Cloud gaining ground steadily every year. What started as basically 100% market share has fallen to around 35%.
What if AWS had taken a different approach? What if it acknowledged that other teams might build some services better, and instead of creating lock-in, it opened up its APIs, prioritized composability, and encouraged interoperability? AWS could have allowed an ecosystem of developers and startups to build complementary infrastructure, resulting in better, more specialized infrastructure that made for a more developer-friendly ecosystem and a better experience overall. It would not lead to AWS having more revenue in the short-term, but it could have led to AWS having greater market share and a more vibrant ecosystem than its competitors.
Still, this is probably not worth it for Amazon. It is a public company that needs to optimize for revenues today, not “a more vibrant ecosystem.” So, maybe it’s not rational for Amazon to unbundle and modularize. But it may still be so for Ethereum, because Ethereum is a decentralized protocol, not a company.
Decentralized protocols, not companies
Like companies, decentralized protocols have usage fees and even, to some extent, “revenues.” But does that mean that protocols should be valued based on just those revenues? No. That’s not how it works today.
Instead, in Web3, protocols are valued by the amount of overall activity on their platform, by having the most active ecosystem of builders and users. See below for our analysis of the relationship between token price and Metcalfe’s Value (a measurement of how many users are in a network) for Bitcoin, Ethereum, and Solana. In all cases, token price is highly correlated with Metcalfe’s Value, with the relationship persisting for years, or, in the case of Bitcoin, over a decade.
Why does the market care so much about ecosystem activity when pricing these tokens? Stocks are priced based on both growth and earnings after all. But today theories of how exactly blockchains accrue value to their tokens are nascent and have little explanatory power in the real world. It makes sense to instead value crypto networks by the strength of their network: the number of users, assets, activity, and so forth.
To be more specific, the token price should actually reflect its network’s future value (just like how stock prices are a reflection of the future value of a company, not the present). This brings us to the second reason why Ethereum may want to modularize: as a way of “future-proofing” its product roadmap, increasing the likelihood that Ethereum stays dominant long-term.
In 2020, when Vitalik wrote his “a rollup-centric roadmap” essay, Ethereum was in its 1.0 stage. Ethereum was the first-ever smart contract blockchain, and it was clear that there would be several order-of-magnitude (OOM) improvements coming in areas like blockchain scalability, costs, and security. The biggest risk for a first mover is that they are slow to adapt to new technological paradigm shifts, and they miss the next OOM leap forward. For Ethereum, that was the shift from PoW to PoS and the shift to 100x more scalable blockchains. The EF needed to foster an ecosystem capable of scaling and making significant technical advancements or risk becoming the Yahoo or AOL! of its era.
In the world of Web3, where decentralized protocols take the place of companies, Ethereum believed that fostering a robust, modular ecosystem was more valuable in the long-term than holding onto all of the infrastructure, even if it meant giving up control of its infrastructure roadmap and revenues from core services.
Let’s look into how this decision to modularize played out with data.
The Ethereum Modular Ecosystem and Its Impact on ETH
We look at how modularization has affected Ethereum in four ways:
- Its short-term price (bad)
- Its market cap (good, for some)
- Its market share (great)
- Its future technology roadmap (up for debate)
1. The Bad: Fees and Price
In the short-term, Ethereum’s decision has had a noticeable effect on the price of ETH. While still up meaningfully from its trough, ETH has underperformed BTC, many of its competitors like SOL, and even the NASDAQ Composite over certain time periods.
Much of this is undoubtedly due to its modular strategy.
The first way that Ethereum’s modular strategy impacted the ETH price is through reduced fees. In August of 2021, Ethereum introduced EIP-1559, whereby excess fees paid to the network results in ETH “burned,” constricting the supply. This is somewhat equivalent to a share buyback in the public stock markets and should have positive pressure on price. And indeed it did for a while.
But as L2s for execution and even alternative data availability (DA) layers like Celestia have launched and grown over time, Ethereum’s fees have gone down. By giving up core revenue-generating services, Ethereum has seen lower fees and revenues. This has meaningfully impacted the price of ETH.
Over the past three years, the relationship between Ethereum fees (measured in ETH) and ETH price was statistically significant, registering a correlation of +48% on a weekly frequency. If fees generated by the Ethereum blockchain fell by 1,000 ETH in a week, ETH price depreciated by $17 on average.
Ok, so outsourcing execution to L2s led to lower fees on the L1, which led to lower (or no) burn, which led to a worse ETH price. Not so good—in the short-term, at least.
But it’s not like those fees just went nowhere. They went to new blockchain protocols, including L2s and DA layers and more. This leads us to the second reason why a modular strategy may have hurt the price of ETH: most of those new blockchain protocols have tokens. Whereas before, an investor only had to buy one infrastructure token to get exposure to all the exciting growth happening in the Ethereum ecosystem (ETH), they now have to pick from many different tokens (CoinMarketCap lists 15 in its “Modular” category, and there are dozens more being funded by VCs in the private markets).
This new category of modular infrastructure tokens has probably hurt the ETH price in two ways. First, if you think of blockchains as companies, it should be perfectly negatively accretive, where the sum of the market caps of all “modular tokens” would have gone to the ETH market cap instead. This is how it usually works in the world of stocks. When companies split up, the old company’s market cap usually goes down by the amount of the new company’s market cap.
But it may be even worse for ETH than that. Most crypto traders are not particularly sophisticated investors, and when faced with the prospect of having to buy dozens of tokens to get access to “all the cool growth that will happen on Ethereum” instead of one, they may get overwhelmed and just won’t buy any at all. This mental overhead and the transaction costs of having to buy a basket of coins versus just one could be hurting both the price of ETH and modular tokens.
2. The Good (For Some): The Market Cap Story
One other way to estimate the impact of Ethereum’s modular roadmap on its success is to look at how its absolute market cap has changed over time. In 2023, ETH’s market cap increased by $128B. In comparison, Solana grew market cap by $54B. While a higher absolute number, Solana grew from a significantly lower base, which is why its price grew 919% instead of 91% for ETH.[3]
However, this picture changes when you consider the market cap of all the new “modular” tokens whose existence are enabled by Ethereum’s modular strategy.[4] In 2023 that number grew by $51B, basically the same as Solana’s market cap growth.
What does this tell you? One interpretation is that the EF, with its modular strategy shift, generated the same value for the Ethereum-aligned modular infrastructure ecosystem as Solana. Not to mention the $128B in market cap value it generated for itself. That is pretty good! Imagine how impressed Microsoft or Apple, who spend years and billions of dollars trying to build their own developer ecosystems around their products, would be of Ethereum.
However, this did not hold in 2024. SOL and ETH continue to grow (although more modestly) and modular blockchains are losing market cap overall. This may be the market losing faith in the value of Ethereum’s modular strategy in 2024, pressure from token unlocks, or perhaps the market becoming overwhelmed by the mental costs of buying a basket of tokens to long Ethereum-related infrastructure when they could just buy one token to long the Solana technical ecosystem.
Let’s move on from the price action and what the market is telling us to the actual fundamentals themselves. Maybe the market in 2024 is wrong, and the market in 2023 was right. Has Ethereum’s modular strategy actually helped or hindered it to become the leading blockchain ecosystem and the leading crypto money?
3. The Great: The Ethereum Ecosystem and ETH Dominance
In terms of fundamentals and usage, Ethereum-aligned infrastructure is performing exceptionally well. Amongst its peers, Ethereum and its L2s have the most total value locked (TVL) and the most fees by far. TVL on Ethereum and its L2s is 11.5x greater than that of Solana; even the L2s alone still exceed Solana’s by 53%.
And if you think in terms of TVL market share:
When Ethereum launched in 2015, it had 100% market share. Despite hundreds of competing L1s, Ethereum and its modular ecosystem have maintained ~75% market share today.
Going from 100% to 75% market share in 9 years is pretty good! Compare this to AWS, which went from 100% to about 35% market share in approximately the same time period.
But wait, is ETH actually benefiting from the dominance of the “Ethereum ecosystem”? Or are Ethereum and its modular parts thriving but not using ETH itself as an asset? It turns out yes, ETH is a pervasive part of the broader Ethereum-aligned ecosystem. When Ethereum extends itself to L2s, so does ETH. Most L2s use ETH as gas (the currency of their network) and most have at least 10x more ETH in its TVL than any other token. Check out the below table to see how dominant ETH the asset is on the three biggest DeFi apps in the Ethereum ecosystem, across both their mainnet and L2 instances.
4. The Debatable: The Technology Story
From a technical roadmap standpoint, Ethereum’s decision to modularize the L1 chain into separate components allows projects to specialize and optimize within their specific domains. As long as these components remain composable, decentralized application (dApp) developers can build using the best pieces of infrastructure available, ensuring efficiency and scalability.
The other, even greater benefit of modularization is to future-proof the protocol. Imagine a new technical innovation that is so game changing that only the protocols that adopt it will survive. This happens often in the history of technology: AOL went from a $200B to $4.5B valuation because it missed the shift from dial-up to high-speed broadband internet. Yahoo! went from a $125B to $5B valuation because it was slow to adopt new search algorithms (like Google’s PageRank) and missed the shift to mobile.
But if your technical roadmap is modular, you as the L1 don’t have to catch every new wave of technical innovation – your modular infrastructure partners can catch it for you.
Has this strategy worked? Let’s look at the Ethereum-aligned infrastructure that has actually been built:
- L2s with best-in-class scalability and cost of execution. At least two novel tech approaches have succeeded here: optimistic rollups, as exemplified by Arbitrum and Optimism, and rollups based on zero knowledge (zk) proofs, as exemplified by ZKSync, Scroll, Linea, and StarkNet. And there are many more high-throughput, low-cost L2s.Fostering two types of blockchain technologies that have brought OOM improvements in scalability to Ethereum is no small feat. Dozens if not hundreds of L1s launched after Ethereum that still have not been able to ship version 2.0’s with 100x-level scalability and cost improvements. With these L2s, Ethereum has made it past the “first mass extinction event” for blockchains: successfully scaling to 100x transactions per second (TPS).
- New blockchain security models. Innovating in blockchain security is critical to a protocol’s survival—just look at how every major L1 today uses PoS instead of PoW. The “shared security” model pioneered by EigenLayer is perhaps the next big shift. While there are other shared security protocols launching in other ecosystems, like Babylon for Bitcoin and Solayer for Solana, EigenLayer for Ethereum is the pioneer and largest.[5]
- New virtual machines (VMs) and programming languages. One of the biggest critiques of Ethereum is the Ethereum Virtual Machine (EVM) and its programming language, Solidity. While it's easy to code in, it is a low-abstraction programming language that is prone to bugs and hard to audit, which is one reason why there have been so many hacks in Ethereum-based smart contracts. For non-modular blockchains, it is pretty much impossible to experiment with multiple VMs or swap out the initial VM for another, but not so for Ethereum. A new wave of alternative VMs are being built as L2s that allow developers to code in alternative languages and without the EVM, yet still build in the Ethereum ecosystem. Examples include Movement Labs, which is taking the Move VM that was built by Meta and popularized by leading L1s Sui and Aptos; zk-VMs such as RiscZero, Succinct, and an implementation built by A16Z’s research team; and teams bringing Rust and the Solana VM to Ethereum, such as Eclipse.[6]
- New scalability approaches. Like other pieces of Internet infrastructure or AI, we can expect OOM scalability improvements to happen every couple of years. Even now, Solana has been waiting years for its next big improvement called Firedancer, which is being built by one team (Jump Trading). And there are new hyper scalable technologies being developed, like the parallelized architecture from L1 teams such as Monad, Sei, and Pharos.[7] These might represent existential threats to Solana if it can’t keep up, but not so for Ethereum, which can simply incorporate these technical advances via new L2s. This is the approach that new projects like MegaETH, Rise, and others are trying.
These modular infrastructure partners have helped Ethereum incorporate crypto’s biggest technical innovations into its own ecosystem, staving off extinction and innovating alongside its competitors.
But there are tradeoffs. As we noted above, a modular technical architecture works well as long as the components remain composable. As our friend “Composability Kyle” likes to say, Ethereum added a lot of complexity to its user experience when it went modular. An average user will have an easier time onboarding to a monolithic chain like Solana, where they don’t have to deal with things like bridges and interoperability.
In The Long-Run
So where does all of this leave us?
1. The modular ecosystem generates strong opinions. The market assigned the same growth to Ethereum-aligned modular infrastructure tokens as it did to Solana in 2023, but that was not the case in 2024.
2. In the short-term at least, the modular strategy has absolutely hurt the price of ETH, if only because it led to less fees and less burn.
3. But if you consider the modular approach from a business strategy perspective, things start to make more sense. Ethereum went from 100% to 75% market share over its 9 years of existence, whereas the Web2 comp, Amazon Web Services, went down to about 35% market share during the same period. In the world of decentralized protocols, where the size of your ecosystem and dominance of your token is more important than your fees, this is great.
4. And if you consider the modular strategy from a long-term perspective and Ethereum’s need to future-proof itself against OOM technical improvements that could lead it to become the AOL or Yahoo! of crypto, it has also performed pretty well. Via its L2s, Ethereum has made it past the first “great extinction event” for L1 blockchains.
Still, there are tradeoffs. Ethereum modularized is less composable than if it were still bundled together as a monolithic chain, which hurts the user experience.
It’s also not clear when, if ever, the benefits of modularity will counteract the loss of fees and the competition from modular Ethereum-aligned infrastructure tokens when it comes to the actual ETH price. Sure, it’s great for the early investors and teams behind these new modular tokens who get to take chunks out of ETH’s market cap, but the fact that in a number of instances modular tokens have launched at unicorn valuations means that those economic gains are unevenly distributed.*
But in the long term, Ethereum may emerge as a stronger player due to its investment in fostering a broader ecosystem. Rather than losing ground like AWS did in the cloud computing market, or losing basically everything like Yahoo! and AOL did in the Internet platform wars, Ethereum is laying the foundation to adapt, scale, and thrive in the next wave of blockchain innovation. In an industry where success is driven by network effects, Ethereum’s modular strategy could be the key to maintaining dominance among smart contract platforms.
Acknowledgements
A very special thanks to Kyle Samani (Multicoin), Steven Goldfeder (Arbitrum), Smokey (Berachain), Rushi Manche (Movement Labs), Vijay Chetty (Eclipse), Sean Brown (Hack VC), and Chris Maree (Hack VC) for reviewing drafts, arguments, and data.
Endnote
*We should probably state here that we are a little biased, because our venture firm, Hack VC, is an early-stage investor in many Ethereum-aligned modular infrastructure tokens, as noted in some of the footnotes above. So, in some cases, we are the ones taking chunks out of Ethereum’s market cap, to the possible short-term detriment of ETH token holders.
Footnotes
[1] Returns were calculated through September 26, 2024.
[2] Market share figures are approximate. Given limited available data from the early years of AWS, our reference to “nearly 100%” market share reflects AWS’s dominant position in cloud storage and compute services in its early days.
[3] Source: CoinMarketCap as of October 7, 2024.
[4] Ethereum modular infrastructure tokens include L2s, such as Arbitrum and Optimisum, data availability layers, such as Celestia, and rollup infrastructure, such as AltLayer.
[5] EigenLayer, Babylon, and Solayer are portfolio companies of funds managed by Hack VC.
[6] Movement Labs and Eclipse are portfolio companies of funds managed by Hack VC.
[7] Pharos is a portfolio company of a fund managed by Hack VC.
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