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Onchainomics #1: Introduction to Onchainomics: Shaping the Future of Borderless Economy
Keywords: Ethereum Layer 2, Competition, Asymmetric Information, Moral Hazard, Culture, Social Platform, Game Theory;
The Ethereum ecosystem has sometimes been characterised by a culture that embraces libertarian principles, pluralism, and cross-border cooperation globally. Vitalik Buterin (2023) identified the value of Ethereum as open global participation, decentralisation, censorship resistance, audibility, credible neutrality, building tools (not empires), and a cooperative mindset. This ethos appears to be influenced by the global multicultural landscape, which aims to enhance the efficiency of cross-border collaboration. However, with the transition to Ethereum 2.0 and the subsequent discussions surrounding layer-2 (L2) solutions, the discourse has shifted towards exploring how these L2 networks with different cultures, can better collaborate with each other, ideally maximise the interest of the Ethereum ecosystem as a whole.
This essay will mainly discover using an economics perspective of asymmetric information to analyse the cross-L2 collaboration and cooperation in terms of different Ethereum L2 cultures. Specifically, this essay will address the analysis of classical competition dynamics between Ethereum L2s, then link back to the scope of economics - the origination of research of asymmetric information, and how asymmetric information theory could help with the current competition dynamic - challenges of L2s. To better understand the issue, some modern research and real-world cases of asymmetric information in the industry will be assessed, following some cultural impact analysis. In addition, plenty of solutions based on practical cases will be proposed, and suggestions trying to support future onchainomics research, practical culture exploration, and the direction of onchain development will be given.
It is essential to keep a balance between competition and collaboration to ensure the long-term success and sustainability of the Ethereum scaling ecosystem. The competition between L2s could be classified into the following 3 types below.
The most fundamental competition is the competition for users, as data (Dune, jhackworth, 2024) shows below, the overall dynamic is top L2s are dominating the transaction market of Ethereum, and since March 2024, the L2 transactions have been increasing from nearly 60% to over 80% nowadays. Though, it is also believed that transaction is not a precise indicator of real user behaviours, activities such as ‘farming’ for potential incentives (mainly done by airdrops, in this case) may contribute a part not to be underestimated. However, Vitalik (2024) proposed in the article "Layer 2s as cultural extensions of Ethereum", that even though these L2s are potentially competing for users, the ecosystem is trying to align with the pluralism-building culture. As far as the development of L2s is differentiated to various purposes or different niche markets of end consumers, leading product level catering to diverse preferences, the potential fostering innovation of L2s may still be on the right track.
The secondary competition between L2s is the ability to survive, in other words, the ability to generate revenue and fees. The main revenue for L2s currently is transaction fees, regardless of which token is being transferred. Transaction fee, also called ‘gas fee’ in the Ethereum ecosystem, on Optimism, Arbitrum, Base or any other Layer 2 networks must be paid in the L2 version of $ETH token. A portion of the gas fee would become the revenue of L2. This portion of the gas fee has contributed as the main revenue L2s revenue currently. However, as Figure 2 shows below, after the peak in late March 2024, the L2 fees paid by users have dramatically dropped and steadily consistent at a relatively low level, including the major L2 such as Base, Opimism, Scrolls, Arbitrum and other L2s on Ethereum. Most L2s are competing with each other in the race to provide protocol-level seamless, convenient transaction experiences, lower cost and faster seed for transaction. Obviously, these factors are the core concern and needs of the user of L2s, but on the contrary, this competition for lower L2 transaction fees is leading to lower L2 revenue, potentially resulting in a negative sum game if the end-user base hasn’t been increased following the fall of transaction fee. EIP-7702, a proposal included in the first part of Pectra, will effectively end this requirement, allowing users to pay gas fees using other cryptocurrencies with broader utility. After the Pectra update of Ethereum, L2s may use their native tokens for transaction fees. Hopefully, this amendment will change the competition dynamic for a better solution for the L2's revenue.
Most L2s are competing with each other in the race to provide protocol-level seamless, convenient transaction experiences, lower cost and faster seed for transaction. Obviously, these factors are the core concern and needs of the user of L2s, but on the contrary, this competition for lower L2 transaction fees is leading to lower L2 revenue, potentially resulting in a negative sum game if the end-user base hasn’t been increased following the fall of transaction fee. EIP-7702, a proposal included in the first part of Pectra, will effectively end this requirement, allowing users to pay gas fees using other cryptocurrencies with broader utility. After the Pectra update of Ethereum, L2s may use their native tokens for transaction fees. Hopefully, this amendment will change the competition dynamic for a better solution for the L2's revenue.
The third type of competition is competition for talent. As the ecosystem expands, competition for development resources and talent intensifies, potentially causing skill shortages or increased costs has become more visible in the labour side of the market. According to coinbase, despite the rise of Bitcoin and Ethereum, along with the emergence of new categories like DeFi, NFTs, GameFi and DAOs, web3 developers represent less than 1% of the 31.1M software developers globally. On one side, the total supply of developers may be capped as the development in the blockchain industry has been evolving dramatically, specifying and becoming more narrative as a knowledge set integrating plenty of cross subjects such as requiring mastering cross-field knowledge such as tokenomics, game theory of economics, and token engineering. The requirements and standards for developers have steadily increased in the long term. On the other side, the number of Layer 2 protocols has dramatically increased after 2020, while limiting education has been provided. Moreover, during the bear market, a high number of capital groups of various backgrounds such as Three Arrow Capital, FTX Trading Ltd. etc. failed, resulting in invested projects and developers struggling to survive in the market. This situation may push the issue further into fewer developers remaining - less education - less developer supply circle.
Microeconomics has significantly discovered asymmetric information topics since the 1970s. After 50 years of discovering and exploring, blockchain technology emerged alongside the adoption of Bitcoin and Ethereum. The cryptocurrency market, blockchain technology and the onchain narrative are perfectly met with the microeconomics research area of asymmetric information. Furthermore, the discovery of the topic of asymmetric information in microeconomics would be a fundamental, significant analysis before the game theory.
The concept of asymmetric information was initially introduced in the 1960s by Kenneth J. Arrow (1963). In this seminal paper, the author presented a thought experiment: examining the differential impacts on market participants in symmetric and asymmetric information scenarios within a market of plums (high-quality products) and lemons (low-quality products). Through Arrow's theoretical derivations and subsequent economists' continuous data collection and theoretical refinements in the health insurance industry, this work ultimately led to the development of a crucial research area in microeconomics: asymmetric information. Asymmetric information research findings could be classified into 3 types of problems: moral hazard, adverse selection, and information monopoly:
Moral hazard: A moral hazard is originally defined as one party having the advantage to take risks or behave inappropriately while bearing limited risks.
Adverse selection: One party has better information than the other, leading to an imbalanced situation that can be detrimental to the other.
Information monopoly: A small group has exclusive control over critical information or data, giving them significant power and advantage over the others.
By simplifying these asymmetric information scenarios, it is easier to analyse and identify the current L2 collaboration challenges within the Ethereum ecosystem.
Although most of the L2 proposals and discussions are transparent on the forum, meanwhile DAO toolings such as Snapshot, Tally, Aragon etc. are well-known and widely used for governance, discussions and proposals within DAOs of L2s, but in terms of cross-L2 cooperation and information symmetric, these methodologies may still be limited. Potentially, this lack of symmetry may affect the efficiency of collaboration, and overall ecosystem development. The fragmentation of governance processes across various L2 platforms creates silos of knowledge and decision-making, making it challenging for stakeholders to fully understand and participate in the broader L2 ecosystem. The limited cross-L2 governance collaboration also impacts the ability to address common challenges collectively. Issues such as bridge security, standardisation of protocols, and coordinated responses to potential vulnerabilities could benefit greatly from a more unified governance approach. Furthermore, the absence of resilient inter-L2 governance mechanisms may slow down the adoption of best practices and innovative solutions across different parties.
The moral hazard of builders, in terms of financial gain: In the scenario of the competition of L2s and L1, this may refer to the builders of L2s and L1 - the initial stake that locks the token would sell their tokens right away whenever unlocked.
Lack of market signalling: market signalling refers to signals that would eliminate asymmetric information between parties, resulting in a more rational and balanced result. In this case, the signalling between L2s is common standards and talent recognition systems assessing stacks and developers among L2s. The lack of standardized governance frameworks specific to L2 solutions exacerbates this issue. For instance, not every L2 are EVM compatible and there are tremendously different standards between L2s, without common standards, the resources gathered from L1 to L2s would be in deep concern in terms of overlapped and repeat building, ultimately leading to resource waste of the whole Ethereum ecosystem.
Researchers have deeply discovered how blockchain technology and the cryptocurrency market impact the asymmetric information issue such as the research done by Karlsruhe Institute of Technology, Institute of Economics, “The blockchain, plums, and lemons: Information asymmetries & transparency in decentralized markets”(Notheisen, Benedikt; Weinhardt, Christof, 2019) found that although blockchain technology has dramatically increased the symmetric of information, this creates a new problem of ‘bad actors’ would able to take advantage to secure the ‘plum’(high-quality product) first, and leave the ‘lemon’ (low-quality products) to the rest of the market, resulting generations of new market participants refuse to join the market.
Within the current Ethereum ecosystem, the topic of MEV (Maximal Extractable Value) extraction is similar to the topic of asymmetric information in economics. High transparency and symmetry of information have transformed the domain of extractable value into a highly complex, speculative field. With the careless design of the ETH economics design, the MEV extraction may drain value out from the ecosystem, ultimately resulting in systemic collapse. This mirrors the classic "lemons problem" in economics, where information asymmetries enable certain market participants to exploit others. Fortunately, approaches including MEV isolation and minimising MEV have enabled the Ethereum ecosystem to circumvent this challenge after ETH 2.0 updates, the game theory of MEV has been settled specifically in the gas market.
However, it is easy to observe similar problems are happening on the onchain social and community layer. There is an enormous amount of income generated from farming activities in the L2 onchain activities. It started with the ongoing debate between ‘paid QA services’ and ‘witch attack’ until some of the L2s focused on anti-witch system design. Regarding the huge share of farmers’ interests, there’s an intentional ideology propaganda done by, as called, ‘the KOLs (Key Opinion Leaders)’, in other words, influencers mainly express their opinions and price analysis, whether it is responsible or just attracting potential users.
This type of problem is in the broader context of onchain communities, social platforms, and social ecosystems. Builders of these systems must carefully distinguish between "accessible use" and "accessible value extraction". Just as the transparency of information regarding MEV opportunities in Ethereum has enabled rent-seeking behaviour, the design choices that prioritise open access and usability in social platforms can inadvertently create avenues for asymmetric value capture. The challenge lies in striking the right balance - fostering inclusive participation and engagement without enabling disproportionate value extraction by certain actors.
Vitalik has delved into the realms of Taoism, anarchism, and various ancient and modern cultural traditions across the globe, seeking to identify solutions that can establish a more conducive cultural environment for the entire ecosystem. The notion of pluralism has become increasingly nuanced and virtual, as the Ethereum community grapples with the complexities of balancing decentralization, interoperability, and cultural diversity. This essay will endeavour to uncover the diverse cultures present within the Ethereum ecosystem and analyse how these cultural dynamics influence the production-reproduction process from a political-economic perspective. By doing so, it aims to provide valuable insights for builders and on-chain economists, inspiring them to navigate the cultural landscape and foster a thriving, collaborative, and innovative ecosystem.
The article ‘Crypto’s Broken Moral Compass’ written by Polynya (2024), has broadly discussed the memecoin hyped trend and the sceptical culture problem in the crypto industry, with a strong personal style and emotional expression. However, the article has addressed a significant issue that always happening in the industry - moral hazard. The wide spread of the article can be seen as the most recent relatively popular debates and discussions about moral hazard within the Ethereum ecosystem. Specifically, project owners and insiders may produce and post a great number of false pretences, and promotion of a highly suspicious over-hyped fake "degen" (degenerate) culture, especially on CT (Crypto Twitter), but rather as a facade to sell their own project tokens and initiatives. These intentional propagandas are relatively difficult to identify for newcomers who are new to the onchain economy.
To clarify, the hyped “degen” culture in this context does not refer to the degen culture that is spontaneous by the users and traders onchain. Paul J. Dylan-Ennis ****identified and reported in the 'Absolute Essentials of Ethereum' (Dylan-Ennis, P., 2024), that ‘in an ironic, almost detached way’. On the contrary, the over-hyped CT “degen” culture may driven purely by the self-interest of the KOLs (Key Opinion Users, KOL) who may started the “hype” from the beginning. A recent case reported by Andy Boyan (2024) shows how the current business model of crypto KOLs may be trapped in a moral hazard and conflict of interest, resulting “race to the bottom that everybody loses”. A similar case was reported by Bubblemaps (2024), which investigated a case of how KOL launched tokens for celebrities, and most of the tokens were dumped to zero. Comparing these moral hazard cases with the research of the Karlsruhe Institute of Technology (2019) mentioned above shows a similar pattern of worse-off games in the market. Both cases may impact generations of consumers losing interest in these onchain products and services. The result is that the market, which should be characterised by transparency and symmetry, has instead become a "rat race" - a cutthroat competition where the ultimate outcome is losses for all involved.
Given the examples above, combined with the passivism of polynya mentioned, a worse scenario caused by these moral hazards would be the reputation of blockchain technology-related culture would be misunderstood by the mainstream culture, resulting in more future generations of potential builders and consumers becoming anti-crypto industry opponents. The worst scenario that may occur is a bad apple effect - "One bad apple spoils the whole barrel”, that more people might treat all the blockchain-related cultures as a whole, leading to negative impressions on many other types of cultures, including but not limited to cypherpunk, regeneration, degeneration etc., regardless what and how these onchain cultures and activities solve any realistic problem. The final result of the moral hazard problem, if it could not be handled by the crypto culture - spreading the positive value as a collective voice to the mainstream audience, may lead to a worse-off negative sum game for all L2s, even the whole industry.
To address these challenges, the L2 ecosystem could benefit from initiatives that promote cross-chain governance collaboration, standardised frameworks for L2-specific challenges, and improved tools for aggregating and disseminating governance-related information across different L2 solutions. Such efforts would not only enhance transparency and participation but also foster a more cohesive and resilient L2 ecosystem that can better serve the growing demands of decentralised applications and users.
The Farcaster ecosystem presents a unique case study in market efficiency and information symmetry across Layer 2 (L2) blockchain networks. It effectively reduces transaction costs and information asymmetries in cross-L2 communication and cross-chain governance, creating a more transparent and efficient market for onchain governance. This ecosystem facilitates a form of Coasean bargaining across L2 networks, where L2s can negotiate and allocate resources more efficiently, minimising externalities and reducing the deadweight loss associated with siloed governance structures. The increased transparency and broader dissemination of information lead to improved. The limitation of this approach is that social media may integrate information and feed users with a potential bias, leaving a potential risk of a controllable discussion background. Overall, the social media/platform approach of the increasing cross-L2 governance information transpassing is a benefits outweigh the drawbacks method.
The OP Stack exemplifies a positive externality in the L2 ecosystem, demonstrating network effects and economies of scope. It represents a case of complementary goods in the blockchain space, where the success of one platform (OP) generates positive spillover effects for another (Base). The resource allocation from OP to Base during the latter's early development stages can be viewed as a form of strategic investment or even predatory pricing, aimed at capturing market share and establishing a dominant position in the L2 market. This strategy has facilitated the migration of early adopters (projects and teams) from OP to Base, effectively lowering switching costs and increasing market liquidity. Conversely, Base's utilization of OP Stack technology and its subsequent contributions back to the OP ecosystem illustrate a virtuous cycle of innovation and knowledge spillovers. This reciprocal relationship can be analyzed through the lens of game theory, representing a cooperative equilibrium in a repeated game scenario, where both parties benefit from sustained collaboration.
As Vitalik Buterin analysed and proposed (Vitalik Buterin, 2019), building out the infrastructure for making collusion-resistant mechanisms is possible. Based on this idea, combining the modern development of the onchain paradigm of application, an “Onchain Fact-Check System” may address some of the issues, with a Polymarket incentive mechanism aims to archive and retrospectively verify statements made by KOLs and other market insiders in the public would be helpful in solving the moral hazard problems and reducing false pretences. Operating cyclically, akin to months or seasons, this system would assess the accuracy and intent of influential communications. Differentiating between paid promotions and genuine opinions, could illuminate potential conflicts of interest and provide insights into authentic user sentiments onchain. While raising important questions about privacy and free speech, this mechanism could potentially deter misinformation and generate greater accountability in onchain discourse, contributing to a more transparent and trustworthy information environment onchain.
Optimism has once set a positive precedent. In 2023, Optimism RPGF3 ( Retroactive Public Goods Funding, the 3rd Round) proposed to use retroactive public goods funding to compensate contributions to the development of the Ethereum and Optimism ecosystems. Extensively, the Optimism Collective decided to promote OP's culture and values - build an equitable Internet, this retroactive incentive establishing an undeniably significant cultural milestone. This campaign laid the groundwork for subsequent collaborations, developments, builder onboarding, and consumer brand awareness within the OP Stack ecosystem.
In this regard, cross-chain and inter-L2 cultural collaborations could emulate this cultural campaign paradigm, initiating a retroactive cultural promotion campaign. This would serve to clarify origins and undertake initiatives for L2s as a cultural cluster. Simultaneously, it would strive to facilitate cultural exchange and cooperation, and break down information asymmetries and slow information diffusion between L2s, accelerating cultural interchange and circulation among them. Moreover, this approach could aim to more rapidly realise the pluralistic future envisioned by Vitalik Buterin (2024): a landscape where L2s maintain their unique cultural characteristics while fostering greater openness and inclusivity. It would also enable swifter consensus-building and problem-solving on issues of mutual interest. Subsequently, L2s could explore implementing a retroactive incentive mechanism, either based on Ethereum L1 or on a consensus chain following Ethereum's Pectra update. This could be celebrated as the Ethereum ecosystem's grandest "on-chain summer," commemorating the birth of a novel on-chain culture. Specifically from an economic perspective, this strategy leverages network effects, reduces transaction costs in cultural exchange, and promotes positive externalities within the L2 ecosystem. It also addresses the free-rider problem in Ethereum ecosystem marketing as a whole collective and encourages the production of more culture-related public goods and infrastructure used cross L2s, in the form of shared cultural values.
In short, to build greater network effects and extend the interoperability across L2s, further developers may consider the following directions:
Improving transparency and data sharing to align incentives across L2 solutions
Developing more shared standards, similar to the OP stack, to enhance interoperability
Focusing on user needs and pain points to design L2 solutions that prioritise end-user experiences and accessibility
Fostering open communication channels between L2 projects to facilitate knowledge sharing and collaboration
Implementing cross-L2 governance mechanisms to encourage coordinated decision-making
This essay explores the asymmetric information topic within the Ethereum ecosystem. Specifically, the essay has revealed significant asymmetric information challenges between L2s, including moral hazards and adverse selection, which significantly impact the L2 ecosystem's efficiency and fairness. Moreover, this essay has discussed the contrary situation of over symmetric information and its impact on onchain cultures, particularly moral hazards among market insiders, which can lead to detrimental effects on the ecosystem's reputation and long-term viability. To address these challenges, several solutions have been proposed, such as the collective social platform of cross-L2s government discussion, increasing the adoption of common standards, and the implementation of a fact-check system, aiming to enhance transparency and accountability. Additionally, cross-L2 cultural campaigns and retroactive incentive mechanisms inspired by Optimism were raised as a special solution. Overall, this essay has raised the attention of the asymmetric information research within the Ethereum ecosystem and tried to propose various solutions and suggestions for better cross-L2 culture and cooperation. A better understanding of asymmetric information and competition dynamics of L2s could help the ecosystem discover a healthier, more sustainable, and inclusive ethereum ecosystem.
Farcaster | X | Linktree | Zora (For Colletable Edition)
183Aaros.eth is a long-term contributor to the onchain economy, an economist and senior analyst focusing on onchain economic activities and their impact on off-chain economies. He's also the founder of the LeapOnchain, an association of onchain-native Analysts& DAO experts. His recent essays Onchainomics #1 and #2 have received 3500+ mints on Zora and won the 2nd prize in Kiwi News writing contest. You can explore more of his works and information on his personal homepage.
Onchainomics #1: Introduction to Onchainomics: Shaping the Future of Borderless Economy
https://zora.co/collect/base:0x36a16070fe69fe6a8257d9ce77b3ad04b36670a9/2Onchainomics #2: Bridging Onchainomics with Decentralised Social: a Social Platform, or an Emerging Re-globalisation Society
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183Aaros
