State of Ethereum Q2 2023

Key Insights

• Q2 2023 was a period of consolidation for the crypto market. Regulation is the dominant theme for the near-term narrative. Larger and more decentralized assets, BTC and ETH, outperformed in this regulatory environment.
• Meme coin mania led by PEPE drove higher usage and burn for Ethereum. Real validator yields were supported by higher deflation.
• Ethereum experienced brief finalization issues in May. Client diversity and decentralization of stake allowed the blockchain to maintain liveness and recover without intervention.
• Layer-2 solutions continued to grow, but growth was stifled by higher gas costs. The upcoming upgrade to Ethereum should vastly improve gas prices on rollups, making them competitive with alternate Layer-1s.
• A smooth Shapella upgrade completed Ethereum’s transition to Proof-of-Stake. Staking saw material inflows, and liquid staking tokens continued to grow to become an integral part of the Ethereum DeFi ecosystem.

Primer on Ethereum

The Ethereum blockchain network is a decentralized computation and transaction validation platform. The breakthrough introduction of smart contracts and a virtual machine on the network creates a decentralized Turing-complete software solution. There are thousands of applications built on top of the Ethereum blockchain. The protocol gained broad recognition after developing a deep decentralized finance ecosystem and interesting Web3 use cases. The protocol is under active development and transitioned to Proof-of-Stake from Proof-of-Work in September 2022 with The Merge upgrade. 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

Quarter’s Highlights

Financial Overview

After a couple of eventful and tumultuous quarters, the second quarter of 2023 was a period of calm consolidation for the crypto market. While there were isolated cases of hype and mania, they were largely localized to niche sectors like meme coins and Ordinals.

The central theme for the near-term narrative is regulation. Over the quarter, the United States Securities and Exchange Commission (SEC) dialed up hostilities against crypto, taking action against top crypto institutions, Coinbase and Binance. The SEC also named multiple crypto assets as securities, including top 10 assets like BNB, Cardano (ADA), Solana (SOL), and Polygon (MATIC). Notably, Bitcoin (BTC) and Ether (ETH) were not named as securities.

However, regulation in Q2 was not all negative. Earlier in the quarter, European regulators voted to pass the Markets in Crypto Act (MiCA), a comprehensive regulatory framework for crypto. Even in the United States, there is a newfound hope for a spot Bitcoin ETF, with applications coming from large traditional finance institutions like ARK Invest, Blackrock, Fidelity, and Invesco. While the SEC has rejected similar applications in the past, the stature of these applicants suggests a higher probability of success.

In this tough environment, ETH built its dominance over the global crypto market cap. ETH dominance grew to 18% by the end of the quarter, up from 17.4% at the start of it. ETH’s sustainable monetary policy and strong tokenomics likely contributed to this outperformance.

ETH, however, did lose ground to BTC for the second quarter in a row. ETH / BTC closed at 0.061, down 6% for the quarter and down 16% for the first half of 2023. Bitcoin’s outperformance likely came from a revival in its technical and regulatory narrative. Inscriptions and BRC-20 tokens have led to a technical resurgence in Bitcoin. On the regulatory front, Bitcoin remains impervious to adverse action, being far and away the most decentralized crypto with no foundation or centralized actors.

ETH’s strong tokenomics are reflected best in its issuance statement. About 230,000 ETH worth $400+ million was burnt over the quarter. The high burn was largely thanks to meme coin mania, which drove usage and boosted gas prices by 50% compared to the previous quarter.

Only a few days of meme coin mania led to a significant surge in gas prices, pricing out smaller users. It seems unlikely that ETH gas prices can return to old highs unless a very strong narrative takes hold. Rather, it is more likely that speculatory activity will move to rollups or chains with lower transaction costs that can support more users.

The higher burn led to a growth in real yield for validators. The real yield for the quarter was 6.1%, marginally higher than Q1. The nominal yield was 5.3%, down 0.3% for the quarter, but its impact was more than offset by the net higher deflation of 0.8% compared to 0.3% in the previous quarter.

In Q2, the Shapella upgrade went live, enabling withdrawals from the Consensus Layer (CL) and reducing the risk of staking. Lucrative real yields and a lower risk of staking resulted in strong flows into the staking contract. May and June recorded the highest and second-highest monthly net inflows into the staking contract, with 3 million and 1.9 million net ETH staked, respectively.

Total value locked (TVL) on Ethereum fell by $2 billion to $30 billion. MakerDAO and Curve DEX were the big losers, dropping $1.5 billion and $920 million in TVL, respectively. With growing adoption, LSTs have become an important part of Ethereum TVL. The liquid staking token (LST) share of TVL has grown from 9% at the beginning of the year to 17% at the close of H1 2023. With the growing adoption of liquid staking tokens across DeFi protocols, the cost of staking continues to reduce. As such, the amount of ETH staked should continue to increase.

Network Overview

Source: Offchain Labs, Beaconcha.in

In May, the network faced two back-to-back incidents when finality was affected because of a bug in the Consensus Layer (CL) client, Prysm. Per the post-mortem by Offchain Labs, there was a temporary delay in the finalization of 4 epochs and 9 epochs during the incidents. However, the blockchain recovered without intervention, and there was no impact on users. Even the impact on validators was limited to a potential loss of 0.00015 ETH per validator as a result of missed rewards and inactivity penalty. The issue arose after the Prysm client sub-optimally processed attestations, leading to resource exhaustion and missed blocks. The team has since released an upgrade to fix the issue.

Importantly for Ethereum, the network maintained liveness even as a major client experienced a bug. Its resilience primarily came from its client diversity and decentralization of stake. Over the quarter, Paradigm released a new Rust-based execution client for Ethereum called Reth. Benchmarks and early testing suggest that the client will have significant performance improvements over current solutions, including syncing speed, storage requirement, and robustness.

On-chain activity was flat for the quarter, with average daily transactions at ~1 million. Layer-2 (L2) transactions saw the highest quarterly growth of 60%, showing promising signs of adoption. DeFi transactions also grew by 40% as meme coin mania gripped users in May. On the other hand, NFT transactions fell by a whopping 60% over the quarter. NFTs continued in their deep bear market, with a vicious cycle of lower prices and lower interest.

The period of high gas costs in May led to a dip in Layer-2 transaction activity. Despite that, L2s share of transactions grew from 45% to 56%. Transactions on Arbitrum and Optimism grew by 56% and 19% QoQ, respectively. Arbitrum now rivals Ethereum with an average of 1 million daily transactions. Optimism had a late surge of transaction activity as it underwent the Bedrock upgrade. Since the upgrade, it has had the lowest fees among optimistic rollups on Ethereum.

Cancun and Deneb Upgrades

Despite all the optimizations in compressing and posting data to Ethereum, rollups are still an order of magnitude more expensive than alt-Layer-1s. The greatest challenge for rollups is competing for block space with Layer-1 applications 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 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 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 can be expected sometime in H2 2023.

Quarterly Chartbook

Network Metrics

Despite retail mania around the PEPE meme coin, there was no growth in active addresses over the quarter. In fact, average daily active addresses fell by 3% QoQ, suggesting that PEPE did not bring new users on-chain. Unique addresses saw faster growth, with 10 million new wallets being added compared to 8 million in the previous quarter.

Annualized validator yield was 5.3% for the quarter, slightly below 5.6% in the previous quarter. The fall in yield was a result of lower issuance per validator, given more ETH being staked. As such, the contribution from new issuance fell by 0.4% to 3.4%. This fall was partially offset by a higher yield from tips and MEV payments.

Sectoral Metrics

Stablecoins on ETH fell by $3 billion over the quarter to $69 billion. USDC led the fall in supply, as it fell by $4.5 billion. At the end of the previous quarter, USDC briefly depegged after Circle announced that a part of its reserves was in the failed Silicon Valley Bank. In Q2, BUSD had outflows of $2.8 billion as the SEC named it as a security. Amidst this chaos, USDT emerged as a winner, growing its supply by $4 billion.

Trading volumes on decentralized exchanges fell by 40% for the quarter to $1 billion. While there was an uptick in early May during the PEPE mania, the interest was not sustained. Additionally, Q2 lacked any outlier days with extreme volatility like the previous couple of quarters that experienced very high volumes around the USDC depegging and the FTX bankruptcy events.

Daily NFT volumes fell by 38% in Q2 2023 to $27 million. In the previous quarter, the volumes were supported by the Blur airdrop. Without any such incentive, it seems the NFTs, especially profile pictures (PFPs), are going through a deep bear phase. Prices have fallen significantly, even for top blue-chip projects, and the extensions to product lines have not gained traction.

Infrastructure Metrics

After many quarters of growth, Arbitrum TVL was stagnant for the first time in Q2 2023. However, considering that the price of ARB fell by 17% for the quarter, a flat TVL is reasonable. Native applications GMX and Radiant contributed the highest TVL for Arbitrum, with $520 million and $390 million in TVL, respectively.

Similar to Arbitrum, Optimism’s TVL was flat for the quarter. However, the price of OP fell by 42%, so a flat TVL is an exceptional performance for the network. Exactly, a new interest rate derivative protocol, grew quickly to capture $55 million TVL and become the fifth-largest protocol by TVL on Optimism.

In Q4 2022, the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) sanctioned the popular fund mixer Tornado Cash. As a response, centralized relays started to censor transactions originating from addresses that had interacted with the mixer. Block censorship reached extremely high levels of 75% but has since fallen significantly through the combined action of the community. For Q2 2023, only 29% of the blocks, on average, were passed through censoring relays, down from 49% in Q1 2023.