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Ethereum layer-2 solutions may focus less on token incentives in the future

Token incentive models may become obsolete as layer-2 networks focus on ease of functionality and low fees, but how will this impact decentralization?

Layer-2 networks continue to gain momentum as the Ethereum ecosystem advances. For example, data from analytics provider Token Terminal found that layer-2 scaling solution Polygon had 313,457 daily active users as of Jan. 17, 2023 — a 30% increase in activity since October 2022. 

Moreover, the Polygon ecosystem recently announced the launch of its beta version Zero-Knowledge Ethereum Virtual Machine. As a result, Polygon’s native token, Polygon (MATIC), maintains a bullish narrative.

While notable, some believe layer-2 networks offering token incentive models may soon become obsolete. For instance, Jesse Pollak — head of protocols and Base core contributor at American crypto exchange Coinbase — told Cointelegraph at ETHDenver 2023 that there are currently no plans to associate a token with Base, the Ethereum layer-2 network recently launched by Coinbase. He said:

“We think about tokens as a powerful incentive tool that can change user and developer behavior. At the same time, we have seen situations unfold over the last few years where tokens have been used as an incentive mechanism with a lack of product fit for the underlying chain. Tokens have also resulted in nefarious or risky situations in the past.”

According to Pollak, Base is a layer-2 solution that allows developers to easily build applications without requiring an incentive mechanism. “Our product will stand on its own. It will be very easy for developers to use to build applications and distribute those to real human beings,” he said.

Shifting focus from token models to user experience

Focusing on ease of use and distribution are important points, as Pollak pointed out that many of today’s decentralized applications have been used solely for trading cryptocurrencies. “Trading is not enough to make cryptocurrency the future of the economy. At Base, we are making it easy for developers to build useful applications that people actually want to use,” he added.

Pollak explained that Base is investing in core infrastructure, such as Ethereum Improvement Proposal 4844, which will make the network secure and low-cost compared with other layer-2 networks. “It costs about 10–15 cents to conduct transactions on layer-2s. We aim to bring that down,” he mentioned.

While Base launched its testnet in February, Pollak shared that the Base mainnet launch will take place in the coming months. Moreover, while no plans exist for Base to offer a native token, several ecosystem participants have already expressed interest in building on Base.

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For example, Konstantin Richter, chief operating officer and founder of Blockdaemon — a blockchain infrastructure provider — told Cointelegraph at ETHDenver 2023 that Blockdaemon will serve as an official infrastructure partner for Base. Richter shared that he thinks Base shouldn’t have a token associated with the network, as he believes proof-of-stake (PoS) is an entirely broken system. “Blockdaemon runs more PoS nodes than anyone else, and I can tell you that proof-of-stake only works when token prices go up,” he said.

Richter further explained that Blockdaemon plans to use the Base network to determine how to allow network participants to run nodes while possibly earning a fixed U.S. dollar fee. “This may result in a different type of PoS mechanism, possibly around commitment of compute rather than a staked percentage of tokens that may not serve the network well,” he said. Richter added that such a model could result in a better user experience. He said:

“This could be the biggest paradigm shift within the cryptocurrency ecosystem since the invention of PoS. We are moving away from incentive models that reward users for using a product. We are now focused on ease of functionality and low fees.”

Yet it remains questionable how exactly Base will attract users and developers to the platform without a token incentive model. Given Coinbase’s vast understanding of institutions and decentralized finance (DeFi), Richter doesn’t think this should be an issue: “I prefer to work with Base given Coinbase’s understanding of institutions and DeFi. It’s remarkable that a public Fortune 500 company is committed to putting transactions transparently on Base.”

While it’s too soon to predict future outcomes, it’s important to note that Arbitrum, another Ethereum layer-2 network, also functions without a native token. This has certainly not stopped users from interacting with the Arbitrum network. According to data from the analytics website L2Beat.com, Arbitrum has about $3.35 billion total value locked, making up about 54% of the market share on Ethereum.

However, rumors have been circulating that Arbitrum may initiate a token airdrop in the future. While this may or not be the case, it demonstrates Arbitrum’s ability to determine product market fit before launching a token. Gil Rosen, president of the Stanford Blockchain Accelerator, told Cointelegraph at ETHDenver 2023 that finding product market fit is about ensuring projects acquire the right customers whose value is accretive to the ecosystem, which often isn’t the case with tokens. “Early projects that launch tokens are often locked into tokenomics models before finding product market fit and then are unable to pivot dynamically,” Rosen said.

“DeFi Dad,” a partner at digital asset investment firm Fourth Revolution Capital, told Cointelegraph that he believes the main driver behind layer-2 tokens is to ensure decentralized control over layer-2 networks.

For example, he explained that the upcoming launch of zkSync’s Zero-Knowledge Ethereum Virtual Machine would use a PoS mechanism to allow zkSync tokenholders to act as stakers. “Layer-2 tokens are necessary for building the decentralized future,” he said.

DeFi Dad thinks a layer-2 network without plans to implement a native token could be successful if users are willing to sacrifice decentralization and censorship resistance in the short term. 

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He said, “Base could be successful as a network for transacting with a user’s crypto. However, make no mistake; Base will be a layer-2 (at least for the foreseeable future) that makes trade-offs. As DeFi users, we tend to deprioritize security and censorship resistance until we really need it.”

With this point in mind, Rosen mentioned that he believes token models will remain for many decentralized projects with large developer and user communities, but these will launch later. “A project may launch a token when the networks themselves are more mature and have found product market fit.”

Decentralized social media a game changer for creator monetization — Web3 exec

Decentralized social media platforms could provide the potential for users to own their content and data, and make decisions about monetization.

The idea of decentralized social media platforms continues to gain significant traction, with users becoming increasingly concerned with the centralized nature of traditional platforms and the potential for censorship. Even former Twitter CEO Jack Dorsey has publicly pushed for a decentralized Twitter alternative. 

Cointelegraph interviewed Rick Porter, CEO of decentralized social media startup DSCVR, about the potential of platforms to change the way users interact and share information online. Porter said that decentralized social media platforms provide “the potential for users to own their content, their data, and make decisions about its monetization.”

Porter also believes that decentralized social media platforms can be profitable for the platforms and users alike. According to him, they can monetize and generate revenue through “tokens and digital assets flowing through them natively.” He explained: 

“Fees on these transactions provide a massive opportunity to flip the traditional ad-driven social media monetization on its head, while also giving users an ad-free experience.” 

The CEO mentioned that decentralized social media platforms provide the possibility for individual creators to enable ads or monetize their content. “This would essentially replicate the advertising revenue model pioneered by traditional social media, while also giving more optionality, power and revenue to the content creators on the platform.” He also noted:

“The crypto component of decentralized social [media] will enable more powerful and personalized adtech that can take into account financial assets and transactions, giving users control of exactly how this data is accessed.”

According to Porter, Web3 social media platforms will take product placement, influencer marketing and social advertising to the next level and further democratize them. Advertisers can use nonfungible tokens, or NFTs, as a form of product placement as well as a way to reward their most loyal customers. These advertisers will want to partner with relevant creators and communities, and Web3 adtech will enable these creators to prove their communities are a great fit for the advertisers.

Cast your vote now!

When it comes to the challenges decentralized social media startups face, Porter shared:  

 “Building on-chain isn’t easy. Web3 social media platforms are building on new technology stacks with significantly smaller teams than the Web2 behemoths. From that perspective, it can be a challenge to scale fast enough to meet user demands and serve every Web2 user with a level of features and refinement they desire.” 

Speaking on the subject of regulation within the decentralized social media ecosystem, Porter said, “It is likely that regulations will exist to protect user data and privacy or to prevent the spread of misinformation. It is healthy to have clear regulations that are generally agreed upon by society.” He claimed, however, that “technology usually advances more quickly than regulations do, which is why it is important to give users the tools and power to help regulate the platform and their communities themselves.” Porter believes that decentralized autonomous organizations can be a way to self-regulate and make decisions as a group, rather than leaving everything up to external parties or powerful individuals.

Related: Facebook and Twitter will soon be obsolete thanks to blockchain technology

Thanks to blockchain technology, the social media landscape as we know it may soon evolve to empower users in novel ways.

After FTX: Defi can go mainstream if it overcomes its flaws

The collapse of FTX and other centralized platforms in 2022 has pushed investors toward noncustodial platforms.

The collapse of the now-bankrupt cryptocurrency exchange FTX has raised many concerns over unregulated centralized platforms. 

Investors are now coming to question how safe it is to keep one’s funds on these exchanges and have voiced grave concerns about centralized decision-making without any checks.

FTX held one billion in a customer’s fund and was found to be using the customer-deposited crypto assets to mitigate its own business losses.

Furthermore, a recent report suggests that the downfall of numerous crypto exchanges over the last decade has permanently taken 1.2 million Bitcoin (BTC) — almost 6% of all Bitcoin — out of circulation.

The revelation of unethical practices by FTX in its bankruptcy filing has set a panic among investors who are already losing trust in these centralized trading firms. Exchange outflows hit historic highs of 106,000 BTC per month in the wake of the FTX fiasco and the loss of trust in centralized exchanges (CEXs) has pushed investors toward self-custody and decentralized finance (DeFi) platforms.

Users have pulled money from crypto exchanges and turned to noncustodial options to trade funds. Uniswap, one of the largest decentralized exchanges (DEX) in the ecosystem registered a significant spike in trading volume on Nov. 11, the day FTX filed for bankruptcy.

With FTX’s implosion acting as a catalyst, DEX trading has seen a notable increase in volume. Just last week, Uniswap registered over a billion dollars in 24-hour trading volume, much higher than many centralized exchanges in the same time frame.

Aishwary Gupta, DeFi chief of staff at Polygon, told Cointelegraph that the failure of centralized entities like FTX has definitely reminded users about the importance of DeFi:

“DeFi-centric platforms simply cannot fall victim to shady business practices because ‘code is law’ for them. Clearly, users realize it as well. In the wake of the FTX implosion, Uniswap flipped Coinbase to become the second-largest platform for trading Ethereum after Binance. As decentralized platforms are run by auditable and transparent smart contracts instead of people, there is simply no way for corruption or mismanagement to enter the equation.”

According to data from Token Terminal, the daily trading volume of perpetual exchanges reached $5 billion, which is the highest daily trading volume since the Terra meltdown in May 2022.

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Cointelegraph reached out to PalmSwap, a decentralized perpetual exchange, to understand investor behavior in the wake of the FTX crisis and how it has impacted their platform in particular. Bernd Stöckl, chief product officer and co-founder of Palmswap, told Cointelegraph that the exchange has seen a significant bump in trading volumes.

“The usage of DeFi will surely rise thanks to the FTX downfall. It is said that Crypto.com, Gate.io, Gemini and some other centralized exchanges are in hot waters,” he said, adding, “With so many CEXs falling, trust in custodial wallets is very low and the advantages of DeFi will surely be adopted by more users.”

Elie Azzi, co-founder and DeFi infrastructure provider VALK, believes the increase in DEX volumes could be the beginning of a longer-term trend, given a general reluctance from traders to trust CEXs with their assets. He told Cointelegraph:

“DEXs are innovating at a much faster rate than their counterparts, with execution and settlement times becoming almost instantaneous on certain chains. The trend is that DEXs are developing the usability and UI of CEXs, whilst improving on the logic in the back end. Combined with the unique features that DEXs bring, including self-custody, the ability to trade from one’s own wallet and retain control of private keys.”

He added that CEX platforms might see more stringent controls and transparency initiatives, but this “transparency would exist prima facie in full DeFi. Rather, no one would need to trust CEXs with assets, and any activity, be it trading, liquidity provision or else would be recorded in real-time on-chain.”

DeFi’s struggle with targeted hacks

While DeFi protocols have seen a significant bump in the aftermath of centralized exchange failures, the nascent ecosystem itself has been a prime target for hackers in 2022. 

According to data from crypto analytics group Chainalysis, nearly 97% of all cryptocurrency stolen in the first three months of 2022 has been taken from DeFi protocols, up from 72% in 2021 and just 30% in 2020.

Some of the biggest DeFi exploits of 2022 include the Ronin network exploit in March that resulted in a loss of $620 million worth of funds. The Wormhole bridge hack lost $320 million and the Nomad bridge was compromised for $190 million. In October alone, $718 million worth of crypto assets were stolen from 11 different DeFi protocols.

A majority of the hacks in the DeFi ecosystem have occurred on cross-chain bridges, which Jordan Kruger, CEO and co-founder at DeFi staking protocol Vesper Finance, believes shouldn’t be considered as DeFi exploits.

“A substantial proportion of those exploits (approx. $3 billion this year) have been bridge attacks. Bridges aren’t ‘DeFi’ so much as infrastructure. CEX losses dwarf this number by an order of magnitude. That said, DeFi will improve and become more secure faster than its centralized counterparts because of its ability to iterate faster. This is similar to the way Linux greatly benefitted from an open-source approach and has achieved a strong reputation for security and phenomenal adoption,” she told Cointelegraph.

DeFi is built on the ethos of true decentralization and the decision-making process is often automated via the use of smart contracts. While DeFi does try to eliminate human intervention, vulnerabilities still crop up via different mediums, be it poor coding of smart contracts or breaches of sensitive data.

Lang Mei, CEO of AirDAO, told Cointelegraph that nascent DeFi tech is prone to some bugs and issues but one must remember that the majority of hacks “have been related to either lending or cross-chain bridging, it can be immensely challenging to prevent vulnerabilities in technology which is both radically new and often has a highly-accelerated development schedule due to competition.”

He suggested additional measures that can be taken by developers to minimize the likelihood of exploitable code in their decentralized apps such as “White hat hacking, bug bounty programs, and testnet incentivization are all valuable tools to help identify and correct mistakes. They can also be used to attract and engage users, so it’s essentially a win-win from a team perspective. Decentralization of governance power is also important through the distribution of token supply and safeguards such as multi-signature wallets.”

Till Wendler, co-founder of community-owned DApp ecosystem Peaq, told Cointelegraph that it’s hard to eliminate human-related flaws in smart contacts and design.

“Most thorough smart contract security audit only gets you so far — some exploits result from the way smart contracts interact between themselves in the wider ecosystem, not just from their intrinsic design flaws,” he said, stating, “That said, the DeFi space is definitely now in a better shape than it used to be, and it’s working out its own best security practices on the go, growing more and more reliable by the hour.”

Mitchell Amador, CEO at bug bounty protocol Immunefi, told Cointelegraph that DeFi can take help from progression in the security department:

“There’s a huge explosion of security tech being quietly built in the background to tackle the security problem from all angles.”

“Over time, given innovations in UX and security as well as DeFi’s inherent features of transparency, DeFi could permanently overtake centralized platforms, but this dynamic also depends on the wild card of regulations,” Amador added.

The collapse of centralized platforms in 2022 and the subsequent rise of noncustodial and DeFi services in its wake is surely a sign of changing times. However, according to many in the crypto space, the most crucial factor in the FTX saga was a lack of understanding and due diligence from the crypto investors.

Myriad crypto pundits have been advocating for self-custody and the use of the decentralized platform for quite some time now. Barney Chambers, the co-founder of the Umbria Network, told Cointelegraph:

“The cryptocurrency space continues to be the wild, wild west of finance. Here are a few pointers to ensure funds are safe: Never connect your wallet to a website you don’t trust, hold your keys in a trusted place such as a hardware wallet, never trust anonymous strangers on the internet when asking for help, and always [do your own research]!”

At present, the only way investors can ensure that their funds are protected is to demand the parties they are investing in to provide transparent and clear information on all accounting and rely on noncustodial solutions in terms of both wallets and trading venues. 

Darren Mayberry, ecosystem head at decentralized operating protocol dappOS, told Cointelegraph that noncustodial services should be the way forward for investors.

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“Accountability and audits should be standard procedures for all investors, due diligence is a natural part of business, as is fact-checking and investigation. As for non-custodial wallets — they are the most reliable form of storage that transfers liability solely onto their owner and thus negates the possibility of counterparty risks,” he explained.

DeFi platforms might have their own set of vulnerabilities and risks, but industry observers believe that proper due diligence and reducing human error could make the nascent ecosystem of DEX platforms a go-to option over CEX platforms.

Maintaining decentralization: Are custody services a threat to DeFi protocols?

DeFi ecosystems try to live up to crypto’s decentralized ethos, but single-token governance protocols could prove a challenge.

Decentralization is part of the cryptocurrency industry’s core, with various protocols trying over time to achieve the level of decentralization that Bitcoin (BTC) managed to get as it grew organically from a white paper published to a mailing list to a new asset class.

Decentralized finance (DeFi) protocols have brought the idea of decentralization to a new level with the use of governance tokens, which give holders the right to vote on or submit proposals regarding issues that govern the development and operations of a project. Governance tokens often represent investors’ ownership in decentralized autonomous organizations (DAOs), which operate using smart contracts.

Governance tokens and DAOs are native to layer-1 blockchains that support smart contracts. Often these tokens are bought for investment purposes and kept on centralized trading platforms, which inadvertently gives centralized platforms an outsized power over the protocols they govern.

Last month, cryptocurrency exchange Binance accidentally became the second-largest voting entity by voting power in the DAO behind the largest decentralized exchange, Uniswap. According to Binance’s CEO Changpeng Zhao, an internal Uniswap (UNI) transfer automatically delegated tokens.

Binance later clarified it doesn’t vote with user’s tokens, but the incident highlighted a problem affecting how decentralized protocols maintain decentralization with custodial services being as popular as they are.

Can custodians threaten DeFi protocols’ decentralization?

Through its accidental token delegation, Binance could propose governance votes as it had 1.3% of the total supply of UNI, far exceeding the 0.25% threshold. The exchange, however, couldn’t pass votes on its own due to a 4% quorum requirement.

Its influence — if the exchange chose to use it — would have nevertheless been significant.

Sasha Ivanov, founder of blockchain platform Waves, said that potentially centralized control from custody service providers is a “serious issue with decentralized governance,” adding that the “promise of decentralization” is “totally unrealized with a single token governance model.”

To Ivanov, there’s “nothing to stop centralized custody services from exercising their right as token holders,” which means that if Binance wishes, it could “make proposals, vote for them and change the direction of the platform and community.” Ivanov’s solution is a governance model “based on more than just token ownership.”

Speaking to Cointelegraph, Hamzah Khan, head of DeFi at Ethereum scaling solution Polygon, said that it’s important to keep in mind that governance tokens have control over each protocol, with every protocol being different in how control is exercised.

Khan added that UNI tokenholders, for example, cannot make changes to the protocol’s code or control users’ assets but can make other changes, such as deciding fees on an individual liquidity pool basis, for example.

Daniel Oon, head of DeFi at blockchain network Algorand, told Cointelegraph that users usually monitor what centralized platforms are doing with their governance tokens and seek them over a lack of faith in supporting applications, including wallets and poor tokenomic designs.

Per Oon, there are various DeFi governance platforms that “ask their users to read multiple proposals, participate in mandatory voting, do X,Y,Z, and stake their tokens” to receive yield as a reward. He added:

“In face of all of these administrative tasks, the user decides to hand it over to third-party centralized platforms to handle the voting process so that they can obtain some yield ex-fees charged.”

As centralized platforms are known to share generated income with users, the simplified use of governance rewards naturally attracts users to these platforms. This leaves DeFi protocols with the challenge of remaining truly decentralized.

Decentralization as a goal

To Ivanov, the challenge of remaining decentralized isn’t currently achievable with single-token governance systems, as protocols using these can only remain decentralized if their token is also decentralized.

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Ivanov said that the industry is in a phase where “decentralization is very much still a goal and not a reality,” as crypto users must “interact with centralized entities to on-ramp and off-ramp into the decentralized economy.” A change will happen, he said, when “we have real-world payment systems through decentralized services.”

Khan took a different view, saying that DeFi protocol teams need to remain conscious of what specifically can be changed through governance votes, adding:

“As long as the protocol is open-source, permissionless, enables self-custody and has no governance control over user funds or material protocol upgrades that would affect user funds, it remains decentralized.”

Khan added that veTokenomics models used by protocols like Curve and QiDao “seem to be an interesting solution to combat decentralized exchanges and other custody agents” from gaining too much control over a protocol’s governance. veTokenomics models allow tokens to be locked or frozen for a specific period of time in exchange for non-transferable veTokens that can be used in governance.

Put simply, veTokenomics forces centralized entities not to participate in governance, as locking tokens would reduce the liquidity they need to process user withdrawals. Moreover, the period in which tokens are locked also influences voting power. Khan added:

“veTokenomics does seem to protect against centralized custodian governance attacks, whereby token holders are able to ‘lock’ their token in the protocol to participate in governance. For example, if a user locks up a token for 4 years, they receive 4x the voting power.”

Unlocking tokens earlier than expected, he said, typically results in a 50% penalty, while voting power boosts decay along with lock-in periods.

Oon noted that centralized entities “have been observed to pursue more profitable paths such as lending out those tokens to other organizations” that provide a yield equivalent or higher to that of a DeFi protocol’s voting sessions, which leads to a lower amount of committed votes.

As those holding their tokens on centralized platforms do not participate in governance, the voting power of those who do is boosted. When centralized entities do vote directly, he added, general observations “have shown that the centralized entity will usually vote in favor of higher emissions and the like, which increases fees generated.”

Such a move could have unpredictable consequences. Michael Nonaka, a partner at multinational law firm Covington and Burling, told Cointelegraph that a DeFi protocol can be decentralized even if the voting power is concentrated in a small number of token holders, adding:

“Problems arise if a large token holder is able to wield enough influence to alter the trajectory of the DeFi protocol to reflect the holder’s objectives, rather than the objectives identified by the protocol to spur interest in the token and protocol. “

Nonaka noted that in such a scenario, other holders may sell their tokens over the belief that they no longer represent the value of the protocol’s founder or tokenholders.

As it stands, any action centralized entities take could easily affect decentralized governance. Most centralized entities seemingly do not participate in on-chain governance but simply safeguard users’ tokens on their platforms.

Influencing decentralized governance

If centralized entities do attempt to influence a protocol’s governance — either for their own gain or because they believe it’s the right thing to do — there are several options available to tokenholders.

Khan believes that one option is to no longer participate in that protocol. He said:

“One of the primary principles of Web3 and DeFi is the right to exit and the right to fork — users are not required to continue using a specific DeFi protocol if they don’t agree with its governance.”

Khan elaborated that if centralized actors leverage their custodied voting power for malicious intent, users can “simply withdraw their funds and developers can fork the code to create a governance structure that is more aligned with the values of the users, developers, investors, and other stakeholders.”

Anton Bukov, co-founder of decentralized exchange (DEX) aggregator 1inch Network, seemingly agreed with Khan, stating:

“DeFi users should understand that depositing their digital assets to custodian platforms also gives voting power to these platforms. I want to believe that if those platforms would take any unexpected actions with deposits, this would lead to reducing deposits and user base.”

Speaking to Cointelegraph, David Weisberger, CEO of smart order routing software provider CoinRoutes, said the actions of regulators around the world could also heavily influence decentralized governance. If “regulators demand visibility into the controlling owners of protocols,” concentration on custody service providers could “help the protocol adapt.”

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OKCoin chief operating officer Jason Lau told Cointelegraph that, over time, capital flows increase as more financial institutions get involved in DeFi. He predicted that services will likely adapt to the space rather than influence it to change:

“Custody services shouldn’t be seen as the primary challenge to DeFI. DeFi proponents will likely grapple with user trust failures, as seen with the Tether scandal, and likely government regulation that will change how DeFi operates. Instead, we have seen custody services adapt to include DeFI principles in their services.”

The emergence of decentralized custody solutions also means institutional investors can self-custody their funds while allowing protocols to remain decentralized, Lau added. Nevertheless, using regulated custodians can “enhance the credibility of a Defi protocol,” he said, and could both improve security while ensuring transparency.

There’s still a lot left to be figured out, as decentralized protocols are, just like cryptocurrencies, the cutting edge of financial technology. Engaging in decentralized governance, for now, can be seen as a brave endeavor as tokenholders explore the unknown.