The first was Bitcoin, and it’s invention of Nakamoto Consensus. By being able to solve the Byzantine Generals Problem (multiple parties coming to a consensus state without using a centralized authority), Bitcoin made decentralized transacting possible for the first time.

Bitcoin was launched in 2009.

The second was the formulation of Ethereum smart contracts. Being able to program money for more functions than “send” and “receive” opened up a brand new frontier of programmable money, or “smart money”. 

Ethereum was launched in 2015.

The newest revolution is the array of scalability solutions being created to solve problems the base layers haven’t been able to… yet. State channels, sidechains, optimistic rollups, and zk-rollups are all battling for dominance in this space. 

***This revolution is happening right now.  ***

Layer 2 scaling solutions are the next great technological advancement in crypto, and are going to bring trillions of value into the web3 ecosystem as they battle to best solve the scaling problem. 

Current Solutions are Falling Short

Blockchain technology enables data to be stored and managed on different layers. Layer 1, or the base layer, of a blockchain is the base layer where the data is stored, whereas “Layer 2” takes the existing technology and adds new functionality. Solutions built on Layer 2 are allowing networks to surpass previous limitations in ways that aren’t yet possible on Layer 1.

As an example, Bitcoin may be decentralized and secure, but the network can’t process more than 7 transactions per second (TPS). Optimizing for TPS isn’t the answer though. Solana may be able to handle ~2,500 TPS, but is far more centralized with ~1,500 active nodes.

Ethereum is currently the gold standard of mass-adopted smart contract platforms, however base layer scaling solutions have fallen short. Although there are Layer 1 changes being made (POS and sharding) to the Ethereum network, these are not far enough along. 

The chart below of active addresses shows a ceiling where high gas fees prevent users from transacting when the network is overloaded. 

The blockchain trilemma is the observation that blockchains will only ever be able to achieve 2 of the following 3 characteristics at a time: 

1. Scalability (Transaction throughput and speed)

2. Decentralization (# of nodes, distribution of nodes, protocol governance)

3. Security (Vulnerability to fraud)

As a result, protocol builders often must sacrifice decentralization or security in order to scale. This is the trap that many so-called “ETH killers” have fallen into in the last year.

It is easier to add scalability than decentralization. A decentralized network is only as secure as its most centralized point of failure. Decentralization determines the way the protocol is built from Day 1, but scalability can be bolted on later, as it is being done now. With Layer 2 adoption improving, it may finally be possible to solve the scaling problem without compromising on decentralization security. 

Solutions like Lightning Network were greeted with enthusiasm for the promises made about scaling the Bitcoin network, but have fallen short in terms of growth and security.

This is why with the Ethereum network, other Layer 2 solutions are in the spotlight. 

A Buffet of Options… and Tradeoffs

There are 4 classes of scaling solutions that have emerged over the years:

1. State channels

2. Side chains

3. Optimistic rollups

4. Zk-rollups

State channels allow a theoretically unlimited number of transactions to be executed between parties before the initial and final state are then committed to the base layer. In order to do so, users must commit liquidity to the state channel, but after that, all transactions can be executed at near-zero cost, later being updated onto the blockchain. 

Lightning Network is the most well-known state channel. But as discussed above, although fast, scalable, and private, state channels have security concerns to do with being “live” and also require a capital commitment that makes it inefficient. 

Sidechains, as the name would suggest, operate on an independent blockchain in parallel with the base layer. Assets must be “bridged” onto the sidechain which is connected to the base layer using a two-way peg on the bridged assets. The assets are locked on their way in and then unlocked on the way out as the sidechain assets are burned. Some people consider sidechains to not technically be Layer 2 since they can operate their own consensus models. The security of the sidechain will vary depending on the characteristics of that particular chain, which adds a need for trust. Polygon is the most well-known sidechain at this time. 

Next you have rollups, which are basically batches of transactions that are published as a single block. Rollups are designed to minimize Layer 1 data requirements while preventing fraud at the same time. This compression function lowers gas fees and increases throughput. There are 2 major ways this is done: 

1. Optimistic rollups

2. Zero-knowledge (zk) rollups

Each has a differing security model. Optimistic rollups assume the best (optimistic) case and if a batch is disputed, the interactive proving mechanism must be executed. Zk-rollups generate the proof upfront rather than waiting for a challenge to be put forward, as Optimistic rollups do.

The two largest optimistic rollups by TVL are Optimism and Arbitrum, which have TVLs of $367.04M and $2.2B, respectively.  

The advantage of zk-rollups is in the fact they have stronger security guarantees *and* shorter finality time. This is the benefit of ensuring security upfront, rather than waiting. Optimistic rollups may require up to a week to withdraw their funds from the rollup and the dispute mechanism has difficulty with increased throughput. 

3) zk-Rollups

In a post from Vitalik Buterin, he points out that ETH 2.0 scalability solutions are still a long way away in the roadmap, but usability as a data availability layer for rollups is available much sooner. As such, it seems self-evident that rollups are the future of Ethereum, and built-in scalability solutions will only be necessary if they fail. 

Of all the zk-rollups, the one that stands out to me the most is StarkWare’s StarkEx and StarkNet. 

StarkEx is a non-custodial computer that does the proving. You’re basically buying space on a computer or getting cloud computing and can scale it better than if you were on your own. 

StarkNet is a network with all the building blocks and composability of Ethereum, but with more scalability. It’s already reached a TVL of 1.1B. 

StarkWare secures their protocol using STARKs (Zero-Knowledge Scalable Transparent Arguments of Knowledge), a cryptographic proof they invented. This is not to be confused with the SNARKs used in Zcash, which are non-interactive (and therefore more private than STARKs). 

Computational integrity is the key principle where permissionless blockchains are able to prevent fraud or bad actors in a trustless system. Not only do StarkEx and StarkNet enable this computational integrity, but they validate and prove much more quickly than SNARKs are capable of.

StarkWare’s record of growth and production is strong, and it stands out that StarkNet was released ahead of schedule. More importantly, products like dYdX, DiversiFi, and ImmutableX are all protocols built using StarkEx. 

Picking Winners in a High-Growth Sector

As an entire sector of crypto emerges to solve the scaling problem, some solutions will stand out in their ability to seamlessly help other projects scale. Zk-rollups, and specifically StarkNet, are my favorites in this arena right now. 

From interviews with StarkWare co-founder and co-inventor of STARKs, Eli Ben-Sasson, it’s clear that they’ve done a great job of future-proofing their work, which strengthens my conclusion that this is the most feasible of the Layer 2s. 

Layer 2 projects are the next technological advancement in crypto, and are going to have increasingly more value to the entire ecosystem as they battle to best solve the scaling problem. If we’re going to bring more users onboard, we need more scaling solutions.

That’s why we’re always looking to invest in projects that can bring the next million or billion people into crypto. These layer 2 solutions are that. And if they can take their early promises and actually deliver on them, amazing things will happen.

While the typical narrative surrounding the crypto industry is focused on volatile prices and the opportunity to make mind-blowing returns, I believe not enough attention is paid to the remarkable redistribution of power from institutional and state level down to the individual. 

This power shift hasn’t fully played out yet, but the cracks in the traditional paradigm are clear and growing. As Web3 thesis takes hold, we can expect a new emphasis placed on the individual, and more specifically, the individual within a network. What this will look like, I don’t know for sure, but I’ve observed 3 social trends that are already underway: 

1. Power is being transferred from corporations/institutions to the individual.

2. Decentralization enables individuals to innovate and create change at scale.

3. Open-source technology leads to exponential innovation.

Right now, the projects we are most interested in are those with the potential to change the lives of millions (or billions) of people, and it starts with these shifts. 

The Individual Matters More Than Ever.

Like many other people, I was drawn into the world of crypto by the promise of sound money and all that entailed. However, what’s more recently captured my interest is the idea of sovereign individual identity and the democratization of power that is today captured by institutions and governments.

Decentralization is fuelling the financial revolution and building the products that will provide real utility to people all over the world. The more users on these decentralized platforms, the more unstoppable they become. 

That’s the fundamental promise of Web3. It has the potential to disrupt every industry in which people organize themselves and their information… so pretty much everything.

An old saying goes “Power is never given away freely; it must be taken.” This is the defining principle of Web3. This power shift won’t come from the generosity of our existing elites. Instead, we must build a new system that overshadows the old and rips the reins of power away from those who today wield it as tyrants. 

Individuals always have more power than they give themselves credit for. Only when they start building something do they see how fragile the old system was and how many of their compatriots wanted the same changes they did. Just look at the civil uprisings happening all over the world today. When people coordinate for a common goal, they can amass far more power than their repressive leaders. 

The best way to measure this shift is by asking, “Is network is becoming more or less powerful?” Look at the institutions and corporations we grew up knowing, respecting, and even fearing. Are they gaining or losing power right now? Compare that to the burgeoning technology and talent networks of the last decade, and the change is clear. 

A Good Connection Can Change Everything.

My biggest mistake in my first few years in crypto was trying to do it on my own. It was only after founding Contango that I really started to grow my network and reputation in the space. When I made it my mission to build my network in crypto, opportunities started pouring in. I was finally able to see my value through the investors and builders who trusted me with their capital and their attention.

In these newfound connections, I realized this industry is not built to compete from within, it is built to compete with the corruption of legacy systems. Our goal is to increase the pie, not to steal more of the pie for ourselves. This became part of our core thesis at Contango. We may not be able to support our portfolio companies with all their capital, marketing and development needs, but we can definitely connect them with partners who can help them with every facet of their business.

We are now somewhat of a matchmaker for our portfolio companies, with ample connections at arm’s reach, we are far more powerful than if we came in alone. 

I shifted my paradigm from “I can do this better,” to “we can do this together.” To me, this demonstrates a shift from a Web2 mindset to a Web3 mindset. 

In Web2, innovation is siloed. Many companies work towards the same goals, with slightly different proprietary software, and in some cases, the same problem can be solved 100 times by 100 different businesses… such a waste of our global human resources. Web3 thrives on collaboration, on openness and sharing of information and ideas. 

Imagine a world where a problem could be solved once, and that solution could be tweaked, replicated, and used freely by billions of people. How much more productive would we be as a global society? 

Open-Source Solves More Problems, Faster.

All over the world, employees are working on the same problem, but not doing so collaboratively. 

A problem needs to be solved once for the human race. Duplicating effort is setting us back. Yet, all these big FAANG companies are working on the same proprietary solution, as they compete to create benefits for their company. Their innovative effort won’t be shared with the world, so someone else will have to solve that problem at another company. 

Sounds inefficient, doesn’t it? 

The open-source nature of Web3 means that one person now has the power to solve a problem for the entire human race. Once they find a solution, no one else has to, it is available to everyone.

“Compossibility is to code, what compound interest is to finance.” - Chris Dixon

Composability allows for that same code to be freely iterated on, tweaked, and built into new and more complex infrastructure. 

When the U.S.A. put a man on the Moon or created the nuclear bomb, everyone was working collaboratively and combining their best efforts to get a higher-level outcome. Open-source does the same thing, but for every scale and type of project. 

Tesla open sources their patents for the same reason. The more people who buy into open-source and add to it, the more all companies can benefit by providing more value to customers. With Hyperloop, Elon Musk created the plans and released them publicly for someone else to pull up. Now, you can get from San Francisco to Los Angeles in 35 minutes. Similarly, Bancor solved the AMM problem once and now that code has been copied hundreds if not thousands of times. 

When the world starts working in this open-source manner, everyone benefits. Rather than 1,000 people all working on the same problem, you have 1,000 people working on 1,000 problems. That’s a win for the world. 

When you realise this power, it’s easy to see that centralized competition is NGMI.

Ideas Will Continue to Attract Other Ideas

There will be no shortage of problems to solve in the future, but there will be a shortage of people willing to give away their intellectual property to centralized companies trying to solve them. Open-source ideology is catching on.

Ideas form in the same way the universe was formed. 

A small amount of space dust starts to coalesce. Gravity pulls more space dust together. As more dust that attracts, density increases and the mass heats up, until eventually a star is born. Eventually that star explodes and shoots elements and space dust everywhere in the universe, eventually leading to the formation of new stars and planets like the one we call home. 

The same is true for an idea. A kernel of insight can coalesce into a revolutionary idea when enough human consciousness is dedicated to it. Eventually that idea can explode into a burning revolution spurring millions of others in the process. 

This is exactly what is happening in Web3 right now. 

Ideas are like basic gravitational force, and their impact can be massively accelerated when millions of people can simultaneously dedicate their consciousness to that same idea. This is the open-source way of working.

We now live in this open universe where anyone can share their ideas. There’s no immaculate conception of ideas. Just one group inspiring another group ad infinitum. 

Web2 was built by a small group of genius CEOs. Web3 will be stronger because it is build by the collective consciousness of all developers and innovators within it. 

The shift from closed-source to open-source is speeding up the power shift from corporations to the individual. As a result, we’re going to end up with more problems being solved, individuals gaining more power, and the world at large benefitting. 

At Contango, we fund projects that accelerate the adoption of Web3 and this financial revolution. This is the intersection of social benefit and outsized returns. 

This is how we invest.