State of Ethereum Q4 2023

Key Insights

• Q4 2023 was a growth quarter for ETH, but it underperformed the larger Bitcoin and the younger platform chain challengers.
• However, all of Ethereum’s fundamental metrics returned to growth. The return in crypto market sentiment, reflected onchain as transaction and user activity grew.
• Ethereum’s rollup network now laps the mainnet three times in terms of transactions. Strong growth in rollup activity bodes well for Ethereum’s scaling vision.
• Total value locked (TVL) on Ethereum grew by 35% in Q4, with DEX volumes growing by 26% and NFT volumes by 31%.
• Ethereum's upcoming Cancun-Deneb (Dencun) is finally around the corner. The 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 later in Q1 2024.
• Ethereum promises an exciting 2024 with much-hyped launches of EigenLayer and Blast as well as a potential spot ETF approval.

Primer

Ethereum (ETH) is a distributed blockchain computing platform for smart contracts and decentralized applications. Ethereum’s smart contracts have enabled 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 where 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.

Instead of scaling at the base layer, Ethereum has chosen a scaling strategy through a network of Layer-2 protocols. Through this strategy, Ethereum plans to scale while maintaining a high degree of decentralization. These protocols rely on Ethereum for data availability and security, while they only focus on fast execution. Ethereum is planning a network upgrade in Q1 2024 that will allow it to better serve the needs of these protocols by creating a separate transaction type to store data and reduce the costs for the Layer-2s.

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Key Metrics

Performance Analysis

Financial Overview

A single job-risking (probably job-costing) fake X (formerly Twitter) post was all it took for investor interest and sidelined capital to return to crypto. On October 16, 2023, the Cointelegraph X account published that the Bitcoin spot ETF had been approved. The market reacted instantly, with BTC surging by 7% from $28,000 to $30,000. While the news was later confirmed to be fake, the market had shown its hand. Investors and capital realized that the Bitcoin spot ETF approval would be a big catalyst and piled in. So ended the two-year-long crypto bear market and began the first leg of the current crypto cycle.

ETH performed well, with its price surging by 37% for the quarter, however, it was the second worst-performing non-stable asset above $10 billion. It underperformed both its larger peer Bitcoin, and younger platform chain challengers like Solana and Avalanche. Bitcoin was driven by the ETF narrative, while the younger platform chains saw a sentiment reversion after being sold off more heavily during the bear market.

However, not all was bad for Ethereum. With a broad recovery in sentiment, fundamental ETH metrics improved compared to last quarter. Over the quarter, 216,000 ETH was issued, but 270,000 ETH was burnt through transaction fees. This burn led to a net deflation of 50,000+ ETH at an annualized deflation rate of 0.2%.

In the first half of 2023, certain high volatility periods generated greater real yields for validators, but there were no events of similar magnitude in the second half. In Q4, the annualized real yield for stakers was 4.3%, flat compared to the previous quarter. The growing amount of ETH staked and lower MEV opportunities meant validator rewards were lower by 0.2%. However, their impact on real yield was offset by higher net annualized deflation for the quarter of 0.2%, compared to the previous quarter’s inflation of 0%.

Network Overview

Censorship Resistance and Decentralization

It seems that every quarter, a new attack vector on Ethereum surfaces. Like the Lernaean Hydra, as one head is dealt with, another takes its place.

• In Q4 2022, relays were censoring transactions by addresses sanctioned by the U.S. Office of Foreign Assets Control (OFAC). This threat was mitigated by Flashbots open-sourcing its relay, allowing for more competition. In the subsequent quarters, relay censorship fell below 50%.
• The next attack vector surfaced in Q3 2023, with block builders increasingly censoring transactions. This remains high at 60-70%, with potential solutions under discussion.

In Q4 2023, Ethereum is facing a new threat. Some validators are playing “timing games” where they propose a block slightly later but still in time to meet the network cutoff. Proposing the block later gives them more time to capture greater MEV. However, this is a zero-sum game, as the excess MEV captured in one block lowers the MEV of the next block. Further, if all validators delay their blocks, no one captures excess MEV, and a new equilibrium is reached. However, blocks being built later do have negative implications for the network.

• It encourages validator colocation to reduce latency. A validator that is closely located with other validators can propose a block later and still meet the network cutoff. As such, it penalizes geographically distributed home stakers and rewards professionally managed colocated validators.
• Delays in proposing blocks may lead to more missed blocks, causing greater network instability.

The core developers have suggested some solutions to discourage and mitigate the impact of these timing games. A short-term solution is coordinating the relay layer to enforce block requests at an earlier time. Longer-term solutions include adding explicit penalties for missing blocks, rewarding earlier block production, and introducing variable block times.

Transactions and User Activity

In Q4, average daily transactions grew sequentially by 6% to 1.07 million, the highest for any quarter in 2023. However, the growth was led by simple wallet transfers, stablecoins, and infrastructure transactions. Layer-2, NFT, and DeFi transactions declined over the quarter by 29%, 9%, and 5%, respectively. The fall in Layer-2 transactions may be explained by hype receding from friend.tech, which had peaked in Q3.

As user interest increased, active addresses trended slightly higher for the quarter, growing by 4% to ~400,000. However, there was slower growth in unique addresses, suggesting fewer new users joined. The growth rate in unique addresses fell for the second quarter in a row, down to just 3% in Q4, compared to 4% in Q3 and 5% in Q2 2023.

Ecosystem and Development Overview

Rollup Network

Through all the ups and downs, a trend is emerging clearly that Ethereum is actually scaling through its rollup network. Major rollups have cumulatively increased Ethereum’s throughput by almost three times to 4 million average daily transactions. There was a boost in L2 activity in December as inscriptions mania spread beyond Bitcoin to Ethereum rollups.

zkSync Era had the highest transaction activity in Q4 at 900,000 average daily transactions. Sequential rollup transaction growth came from Linea, Arbitrum, and Scroll. Linea transactions grew 3x to 300,000, Arbitrum transactions increased by 30% to 800,000, and Scroll was a new launch in Q4 with average daily transactions of 120,000.

Sectoral Performance

Ethereum’s total value locked (TVL) grew by 35% to $30 billion, in line with its price performance. Lending protocols Spark and Aave had the highest growth among the top applications, growing by 286% and 33%, respectively. Curve DEX underperformed, with its TVL falling by 13% for its fourth down quarter in a row.

Blast, a rollup by the Blur team, and EigenLayer, a restaking platform, were new entrants among the top applications. While neither product is live, they each attracted TVL of more than $1 billion with points incentives with the promise of a future airdrop. Blast and EigenLayer collect most of their TVL in liquid staked tokens (LST) of ETH and, invariably, further incentivize liquid ETH staking.

With growing incentives to stake ETH, its staking ratio has grown throughout the year. The staking ratio almost doubled in 2023, growing from 13% to 24%. However, the growth rate was somewhat slower in Q4. There was a net inflow of only 2 million ETH into the staking contract in Q4, compared to 3.6 million in Q3. Celsius, the bankrupt crypto lender, in preparation for the distribution of its assets, has been unstaking its ETH.

In Q4, among the large staking entities, Lido, Coinbase, and Rocket Pool grew their ETH staked by 5-6%, while Binance and Figment saw outflows of 9% and 3%, respectively. A large part of the growth in Q4 2023 came from smaller liquid staking protocols like Ether.Fi, Stader, and Swell, whose ETH stake grew by 200%+. EigenLayer has been a key catalyst in promoting the growth of long-tail LST protocols, as it allowed deposits for multiple LSTs.

With higher prices and greater user interest, volumes surged on decentralized exchanges (DEXs). Daily volumes through Q4 2023 averaged $1.3 billion, up 26% from Q3. Uniswap was the primary driver for volume growth, with its average daily volumes growing by $330 million to $930 million. Curve, Dodo, Maverick, and Balancer all had lower volumes in Q4 2023 compared to Q3 2023, with the largest fall in Curve volumes of 35% to $140 million.

Similar to DEXs, NFT marketplace volumes recovered over Q4 2023. Daily average NFT volumes grew by 31% in Q4 to $15 million, reversing the trend of the last two quarters. It was the sector leader again that led the growth, with Blur volumes growing by 38% sequentially to $10 million. Daily average OpenSea volumes grew by 23% to $4 million. Smaller challengers, LooksRare and X2Y2, lost market share as their volumes dropped by 52% and 8%, respectively.

Development Activity

Crypto has lost developers over the 2 years of the bear market. As sentiment turns, we expect this trend to flip. Ethereum has fared somewhat better than its peers for developer retention. Its share of weekly active developers has increased to 31%, marginally better sequentially and 1% higher compared to Q4 2022. As Ethereum’s rollup infrastructure grows and attracts more opportunities, it may retain its developer share even in a bull market.

Qualitative Analysis

Cancun and Deneb Upgrades

Ethereum’s vision of scaling through rollups is materializing. Ethereum rollups now have significantly more transactions than the mainnet, and as they become more battle-tested, they likely benefit from a TVL migration from the mainnet.

However, 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 Ethereum mainnet 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, EIP-4788, and EIP-7514.

• 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.
• EIP-7514 caps the churn rate for Ethereum validators, reducing the rate at which more ETH is staked. This is a stop-gap solution aimed to buy time for researchers to figure out a more long-term solution for controlling the amount of ETH staked.

Dencun is expected to go live on the Goerli testnet on January 17, 2024, with Sepolia and Holesky testnet upgrades in the following weeks. There is no planned date for the mainnet release, but it is expected later in Q1 2024.

Prague and Electra Upgrades

After Dencun, the Prague and Electra (Pectra) fork is next. The upgrades in Pectra are still under discussion, but there seem to be two major camps -

• The Geth client team wants to prioritize upgrading Ethereum’s state organization to Verkle tree proofs instead of the current Merkle Patricia tree proofs. This upgrade will help Ethereum unlock stateless clients, reducing the storage requirement for validators and helping the blockchain scale. However, this would be a more complex upgrade, taking over a year to ship.
• The other camp, which includes Nethermind, Besu, Reth, and other execution client teams, wants a smaller feature upgrade before focusing fully on Verkle. These other upgrades may include the following EIPs -
  • EIP-7002 will let execution layer transactions trigger exits on the consensus layer. This upgrade helps liquid staking protocols kick any offending validators.
  • EIP-7251 allows the maximum effective balance on the consensus layer to exceed 32 ETH, allowing for easier compounding for solo stakers and fewer validators for large node operators.

The client teams will finalize the upgrade plan in the coming months, and the release will vary based on its scope.

Closing Summary

Ethereum had a strong end to the year 2023 as market sentiment improved. All its key fundamental metrics returned to growth after a few quarters of decline, with very strong growth in its rollup ecosystem. However, despite all the positives, ETH was far from central to the crypto narrative as top dog BTC and younger platforms like SOL and AVAX stole the show.

Going into the new year, ETH has a slew of upcoming positive developments. The much-awaited Dencun upgrade promises to bring new life and lower transaction fees to its rollup network. Additionally, EigenLayer and Blast launched could create a wealth effect for the ETH faithfuls. Finally, after the BTC spot ETF approval, all eyes have turned to a potential spot ETH spot ETF approval. As the second largest crypto asset and the only other crypto asset with a futures ETF, the path for the ETF may be clear. 2024 promises to be exciting!

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