State of Ethereum Q3 2023

Key Insights

• In Q3, Ethereum's price and market cap fell by 10%, but it outperformed Bitcoin by 2%. Major narratives from the first half, like meme coins and LST-Fi, receded, but the launch of the viral social app friend.tech on Ethereum's new rollup, Base, captured attention.
• Activity on the Ethereum mainnet was quieter, with ETH burnt decreasing by 48%. This resulted in the first full quarter since The Merge with net supply inflation.
• Ethereum's Layer-2 (L2) transactions boomed, accounting for two times as many transactions as Ethereum mainnet by the quarter's end. Base, aided by friend.tech's popularity, experienced explosive growth, at times surpassing Ethereum mainnet in transaction count.
• Total value locked (TVL) on Ethereum decreased by 19% in Q3, with DEX volumes dropping by 24% and NFT volumes by 49%.
• Ethereum's upcoming Cancun-Deneb (Dencun) upgrade aims to make rollup transactions more cost-effective, potentially rivaling alt-Layer-1s. The upgrade is being tested and is expected to be released in Q4 2023.

Primer on Ethereum

Ethereum (ETH) is a distributed blockchain computing platform for smart contracts and decentralized applications. Building on Ethereum has led to the creation of various new assets and industries, such as Decentralized Finance (DeFi), Non-Fungible Tokens (NFTs), Decentralized Autonomous Organizations (DAOs), and more. It features an execution engine optimized for smart contract processing, the Ethereum Virtual Machine (EVM).

Ethereum utilizes a Proof-of-Stake (PoS) consensus mechanism. As such, users can run validators to secure the network and participate in block production. Users that meet the hardware requirements, run the latest execution and consensus clients, and deposit 32 ETH into the Beacon Deposit Contract can permissionlessly operate an Ethereum validator.

Following the Shapella (Shanghai + Capella) hard fork that went live on April 13, 2023, validators can withdraw ETH rewards earned by running a validator, as well as fully exiting the validation protocol and withdrawing the 32 ETH collateral. The next step for Ethereum is to meet the growing demand for block space by creating a network of Layer-2 solutions that enable it to scale throughput while maintaining decentralization. Today, Ethereum is the world’s second-largest cryptocurrency by market capitalization.

Key Metrics

Performance Analysis

Financial Overview

It was a quiet quarter in the cryptosphere, but overall, the second-largest crypto asset did not do too poorly. While ETH’s price and market cap fell by 10%, it outperformed BTC by 2% and maintained its market cap dominance.

Over Q3 2023, hype receded from major narratives of the first half, namely, meme coins and liquid staking finance (LST-Fi). But even as the tourists left, crypto’s most faithful were enamored by the launch of the viral social app friend.tech (FT). Friend.tech launched on Base, Ethereum’s shiniest new rollup incubated by Coinbase.

In Q4, there is potential for positive developments, including a reluctant approval from the U.S. Securities and Exchange Commission (SEC) for spot Bitcoin ETFs, the listing of ETH Futures ETFs, and Ethereum’s Dencun upgrade.

Activity on the Ethereum mainnet was subdued through the quarter. The amount of ETH burnt fell by 48%, meaning Q3 2023 was the first full quarter with net supply inflation since The Merge. While the inflation may seem surprising, the large drivers for burn over the past few quarters were anomalous events, namely, USDC depegging in Q1 and PEPE mania in Q2.

Annualized real returns for stakers fell sharply to 4.3%, compared to the previous quarter’s 6%. The growing amount of ETH staked and minimal MEV opportunities meant validator rewards were lower by 1%. Additionally, net annualized inflation for the quarter was 0%, compared to the previous quarter’s deflation of 0.7%.

Despite lower yields, the amount of ETH staked continues to grow. Over the past quarter, 3.5 million ETH was staked, with the highest contribution coming from Lido and Figment. Growth in ETH stake presents some challenges to the health of the network. To address this concern, the Ethereum core developers have planned the EIP-7514 upgrade, which will limit the rate of staking growth.

Network Overview

After the U.S. Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash addresses, major Ethereum relays had to censor transactions. The problem abated after Flashbots open-sourced its dominant relay, allowing non-compliant relays like Ultra Sound, Agnostic, and bloXroute to become more competitive. Now, block builders have increasingly started to censor transactions. Potential solutions are being worked on, which include encrypting the mempool. Doing so would shield transactions from censoring parties before they are included in a block.

These problems are not unique to Ethereum. It faces greater regulatory scrutiny because of its size, antiquity, and importance in the crypto-verse. Even though mixers and privacy tools exist on other chains, OFAC has only sanctioned addresses on older chains such as Bitcoin, Ethereum, and Bitcoin Cash. If addresses on other chains are similarly sanctioned, their validators and infrastructure providers may also have to choose between compliance or censorship.

Average daily transactions on Ethereum trended slightly lower for the quarter to ~1 million. Because of EIP-1559, the variance in block demand is reflected more in gas prices than in transactions. Gas prices have trended lower as activity on mainnet has fallen.

Among transaction types, Layer-2 transactions grew by 20% as activity on Base boomed with friend.tech’s virality. On the other hand, NFT transactions fell by 40%, declining sharply for the second quarter in a row. The spike in wallet transfers in mid-September was due to Binance consolidating its hot wallets.

Active addresses trended slightly lower for the quarter, falling by 4% to ~400,000. This fall was despite the spike in September with Binance consolidating its wallets. Unique addresses grew slowly as well, up just 4%, compared to 5% last quarter.

Ecosystem and Development Overview

Layer-2 Network

While activity on mainnet was subdued, L2 transactions boomed. By the end of the quarter, the top three L2s accounted for two times as many transactions as Ethereum mainnet. The growth has come largely because of Base’s explosive launch aided by friend.tech’s virality. Over a brief period near the end of the quarter, Base alone did more transactions than Ethereum mainnet.

However, growth was not the same across L2s. While transactions on Optimism grew by 40%, it would seem Optimism and Base cannibalized some activity on Arbitrum, where transactions fell by 36%. Despite that, Arbitrum still remains the largest L2 with 600,000 average daily transactions, compared to ~400,000 for Optimism and Base each.

Sectoral Performance

Total value locked on Ethereum fell by 19% over Q3. While part of it is explained by the ETH price falling by 10%, the remaining difference indicates some outflows. Curve had a rough quarter with an exploit and ongoing issues with its founder’s loan, as such, its TVL fell by ~50%. On the other hand, Maker’s subDAO Spark was a new entrant that quickly grew its TVL to $400+ million over the quarter. Among the incumbents, Compound and Aave showed resilience, growing by 1% and falling by 13%, respectively.

Stablecoin supply fell for the sixth consecutive quarter. At the end of the quarter, the stablecoin supply on Ethereum was $66 billion, down 5% compared to the end of the previous quarter. BUSD had the highest relative decline with a 52% fall, while USDC supply fell the most in absolute terms with a $2.2 billion decline. Maker’s DAI bucked the trend with a 32% growth over the quarter to a supply of $5 billion. The major catalyst for this growth was the Enhanced Dai Savings Rate introduced in early August.

With no anomalous events creating volatility, DEX volumes fell sharply. Average daily volumes fell to $900 million over Q3, lower by 24% compared to the previous quarter. Uniswap led the fall with 33% lower volumes to $600 million. Surprisingly, Curve’s DEX had relatively stable volumes of $130 million even though it had significant TVL outflow. Maverick bucked the industry trend for the second consecutive quarter, growing its average daily volume by 150% to $55 million.

NFTs remain in deep bear territory. While there were offshoots of positive developments like Pudgy Penguins plushies launching in Walmart, the overall PFP market continues to suffer. There was a sharp drop across marketplaces, with Blur, OpenSea, and OpenSea Pro’s volumes falling by 49%, 49%, and 63%, respectively. CryptoPunks, perhaps the only “blue-chip” NFT, were more resilient, with volumes only falling by 8%.

Development Activity

As the bear market has settled in, the number of weekly active developers across crypto has continued to fall. Over the last year, weekly active developers on Ethereum Core and sub-ecosystems fell by ~40% compared to ~50% for other networks. Ethereum benefits from a long-established history of overcoming adverse market conditions, and its Layer-2s have large treasuries that can continue to incentivize developers to build.

Qualitative Analysis

Upcoming Cancun and Deneb Upgrade

Ethereum’s Layer-2 vision is clearly being realized. Layer-2s now consistently have more transactions than the mainnet, and as they become more battle-tested, there will likely be a TVL migration from mainnet to L2s.

Despite all the optimizations in compressing and posting data to Ethereum, rollups are still an order of magnitude more expensive than alt-Layer-1s in terms of transaction costs. The greatest challenge for rollups is competing with Layer-1 applications for block space and paying higher gas prices when Layer-1 trends drive up usage. The next upgrade to Ethereum, Cancun-Deneb (Dencun), seeks to address this issue through EIP-4844 or proto-danksharding.

EIP-4844 will introduce a new transaction type to Ethereum where rollups may post data to be stored in blobs by Ethereum validators for a short period of time. This data is stored on the consensus layer (CL) clients and does not interact with the execution layer (EL). As such, blobs will not only significantly reduce the costs of rollup transactions, but they will also make their costs independent of any Layer-1 transactions. Rollup transactions will likely become as cheap, if not cheaper, than alt-L1s after the upgrade.

Dencun is also expected to include other ecosystem upgrades, such as EIP-1153 and EIP-4788. EIP-1153 is the foundation for Uniswap’s upcoming V4 implementation, as it relies on the transient storage opcodes in the upgrade. EIP-4788 will expose CL data to the EL, increasing the scope for innovation in staking pools like Rocket Pool.

Dencun is currently being tested on devnets. There is no planned date for the mainnet release, but it is expected sometime in Q4 2023.

Closing Summary

Q3 was a quiet and forgettable quarter for the cryptoverse. While this means there wasn’t a historic bull run, it also means there were no large blowups, no elaborate schemes uncovered, and no adverse regulation. As such, activity on Ethereum mainnet remained muted, with low transactions, low fees, and low volumes. Even in this bear, the crypto faithful found excitement in friend.tech, the viral social app on Base.

Q4 promises to be exciting. Positive regulatory developments are on the horizon, like the approval of BTC spot ETFs and the listing of Ethereum’s future ETFs. Ethereum’s much-awaited Dencun upgrade is also expected later in the quarter which will make its Layer-2s more competitive against alt-Layer-1s. The growing share of L2 transactions shows that ETH’s L2 vision is being realized. Ethereum has always had the cultural fit for viral apps, but now with L2s, it has the tech, too.

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