Top Stories of the Week - 2/24
In the newsletter this week, we write about Coinbase’s announcement of their own ethereum-based rollup, another joint statement from national banking regulators, and Eigenlayer publishing its much-anticipated whitepaper. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.
Coinbase Unveils Base Layer-2 Rollup
Coinbase introduces their L2: Base. Base is a rollup built on Ethereum with Optimism's open-source technology (i.e., the OP stack). Coinbase's stated objectives with the launch of Base is to make "onchain the next online" and “onboard 1B+ users into the cryptoeconomy.” Base will be a platform that enables innovation in a developer-friendly environment and provides users with low-cost access to on-chain applications. Base adds to Coinbase's product offerings including its flagship exchange, Coinbase Wallet, its NFT marketplace, and its on-chain products (e.g., USDC with Circle, cbETH).
While exploring options for where to build and how to build, Coinbase internally committed to Ethereum since EVM is the dominant environment, it’s is the most mature/secure/decentralized EVM chain, it has a robust dapp ecosystem, and now there is a path to scale and cheap fees via rollups and EIP-4844 - hence Optimism. Also helped that Optimism is most closely aligned with Ethereum with decentralization. Coinbase also doesn't want to silo its users on its own platform, and the OP Stack provides a modular solution to enable a Superchain, an interoperable cryptoeconomy where custom rollups can share security, a communication layer, an open-source development stack. Base becomes the 2nd L2 deployed on the OP Stack after Optimism Mainnet. (for more info on Optimism and rollups, see our pastresearch).
Coinbase has committed a portion of the sequencing revenue from network fees towards RetroPGF--an incentive program popularized by Vitalik Buterin that rewards projects and individuals that have made positive contribution to the community (e.g., nonprofit teams that contribute to infrastructure improvements rather than proactive grants). After its work on EIP-4844, Coinbase is also going to continue collaborating with the Optimism Collective, contributing to the development of Ethereum and the OP stack. Coinbase has also shared its plans to progressively decentralize the chain over time with specific targeted objectives for this year including: (i) launching at least one fault prover for the OP Stack, (ii) decentralize upgradeability of contracts to a security council controlled by no single entity, and (iii) launching an initial version of the Superchain that is permissionless and open.
Coinbase stated it does not plan to issue a new network token for Base, which will use ETH as the native gas token. Several existing service providers and projects have committed to supporting/building on Base including Chainlink, Etherscan, Quicknode, Blockdaemon, Dune, Nansen, Aave, Magic Eden, Wormhole, and more. Coinbase also announced a Base Ecosystem Fund that is already open to applications. Base is currently on Testnet and doesn't have a target launch date (but Coinbase's lead for Base Jesse Pollak expects sometime in Q2).
Base is a logical next step for Coinbase to meet users in every facet of their crypto journey: starting from users’ first interaction with purchasing crypto on the exchange to bridging on-chain to access the broader cryptoeconomy via the wallet's mass market interface for dApps. Demand for on-chain products like DeFi have led to users taking their funds off exchanges into self-custody, but now Coinbase’s launch of Base makes the process even easier as they can control the entire tech stack including the on-chain platform for projects that interface with users.
According to Jesse Pollack, the product lead for Base at Coinbase, the companyhas explored launching its own chain since 2018 but refrained from doing so due to infrastructure deficiencies that result in user frictions or security concerns. But with the technological progress in recent years and Ethereum’s visibility to becoming more usable (namely sub-$0.01 fees through proto-danksharding with EIP-4844), the formal announcement of Base attests to the current state of the cryptoeconomy. With Base, crypto's path to onboarding the masses suddenly becomes a lot more clear - Coinbase has over 100m users and has significant reach with the leading crypto service providers and projects.
Coinbase isn't the first exchange to launch its own chain - other competitor exchanges have launched their own chains (e.g., Binance's BNB Chain, Crypto.com's Cronos Chain, OKEx's OKExChain). But Base is unique because it is the first exchange chain that is launching as a rollup powered by the OP Stack. This is not just validating for Optimism's technology, but for rollups and the entire Ethereum ecosystem. Jesse Pollack noted that Coinbase explored several networks but Optimism was chosen due to its alignment with Ethereum and commitment to security / decentralization - who says ideology doesn't sell? Optimism will now undergo an identity transformation from just an L2 to a Superchain - or a platform for chains and apps to build on top of, which will be enabled with its upcoming Bedrock upgrade.
There are certainly reasons for skepticism/concern - fault proofs aren't operational on Optimism yet and sequencing is still restricted to a single centralized party. Due to Coinbase's influence over the broader industry, there is potential for Coinbase to shape how users interact on-chain especially if it adopts restrictive practices that could be a slippery slope when it comes to gatekeeping. In light of these problems, Coinbase aims to deliver a solution this year in its public commitment towards progressive decentralization and making Base interoperable with other chains. Coinbase's launch of its own chain should be positive sum to Ethereum's development as Coinbase becomes a core contributor to the OP Stack, commits to open-source development, and pledges a portion of sequencer revenue towards public goods. Overall, Base should advance the developer ecosystem and establish new frictionless standards for users on-chain. -CY
Banking Regulators Issue Another Joint Statement
The Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corp (FDIC) and the Office of the Comptroller of the Currency (OCC) released another joint statement cautioning banks about liquidity risks in crypto. The statement follows a Jan. 3, 2023 joint statement from the same regulators, which contained strong language essentially banning regulated banks from principally interacting with crypto (such as holding cryptoassets on their own balance sheets or issuing cryptoassets, such as stablecoins). For more on the Jan. 3 joint statement, read our the Jan. 13 edition of this newsletter.
This second joint statement clarifies that the regulators are merely reminding “banking organizations to apply existing risk management principles; it does not create new risk management principles.” Specifically, the regulators highlight two instances in which crypto-related deposits could lead to volatility and liquidity risks: 1) where deposits are derived from crypto firms who hold money on behalf of their own end-clients (i.e., exchanges), and 2) where deposits are related to stablecoin reserves. Essentially, the regulators remind banks here that market volatility or other risks emanating from crypto markets could lead to runs on those deposits, creating liquidity issues for the banks who hold them.
The new joint statement then offers suggestions for how banks should think about applying existing risk management practices to crypto-related business. Here, the regulators suggest four concepts:
Understand “direct and indirect drivers” of deposit behavior
Assess “potential concentration or interconnectedness across deposits” and how that could affect liquidity risk
Include these liquidity risks and funding volatility calculations in the banks’ own contingency planning and liquidity stress testing
Perform “robust due diligence and ongoing monitoring” of crypto-related entities and their deposit accounts
The agencies also (re)emphasized that banks “are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.”
One read of the follow-up is that it’s positive insofar that the regulators specifically clarify they aren’t banning banks from banking crypto, but instead that banks need to be cognizant of the existing and novel risks posed by crypto business. This could be seen as slightly softening their prior guidance and genuinely providing a bit more clarity on how banks can think about crypto-related banking risks.
Another read is that the regulators are reacting to criticism they have already received and preempting criticism they expect to receive in upcoming congressional hearings. These hearings haven’t yet been scheduled but we expect Federal Reserve Chairman Jerome Powell to appear before House Financial Services and Senate Banking Committees (for the semi-annual report to Congress on the state of affairs in monetary policy, mandated by the Humphrey-Hawkins Full Employment Act) in the coming weeks, as well as other banking officials. Several members of these committees have already publicly criticized these regulators’ actions on crypto banking, such as Senator Bill Hagerty (R-TN), who raised this issue at a recent Senate Banking hearing on Feb. 14, and tweeted on Feb. 17 “under no circumstances should banks be used as partisan tools to kill legal businesses,” and we expect that several members of Congress will grill regulators on this topic in upcoming hearings.
Ultimately, this latest statement takes pains to argue that nothing has actually changed and that banks are merely reminded to use effective risk management practices. Whether that’s true or not – that nothing has changed – really matters on the ground more than in these papers and documents. What matters is whether banks are actually being pressured or not, and there is some evidence they are. Further, it matters whether the sum of the actions the banking regulators have taken has had an impact on bank’s risk tolerance frameworks, i.e., whether both banks that do and banks that do not provide services to the sector have sufficient clarity or are not otherwise dissuaded from providing services to the crypto sector. And the picture could get worse in the future as these policy statements and actions trickle down into examination and enforcement teams as they conduct their regular oversight of banks in their jurisdictions. More to come on this, no doubt, but for now, on balance, we view this follow-up statement as slightly positive. -AT
EigenLayer Releases First Public Whitepaper
EigenLayer releases their highly anticipated whitepaper detailing the protocol’s pooled security innovation via ETH restaking and fee-market governance. EigenLayer is a new smart contract protocol that enables a way for Ethereum validators to secure other protocols outside of Ethereum through the rehypothecation of ETH on the consensus layer. The protocol does this by offering an opt-in middle layer where validator node operators can designate their staked ETH withdrawal credentials to an Eigen Layer smart contract. In doing so, the EigenLayer protocol can enforce additional slashing parameters on the validator. Additional slashing parameters facilitate extensible security that can be introduced to meet the demands of other protocols such as bridges and data availability layers on Ethereum. As a result, EigenLayer validators can use their staked ETH to secure additional applications and earn more staking rewards.
The EigenLayer whitepaper also states that the protocol will not only support restaking ETH natively, but also restaking through a liquid staked derivative token like stETH and rETH, and liquidity provider tokens like UNI/USDC or stETH/WETH receipts. Generally, restaking on EigenLayer requires validator node operators to also run the necessary software for staking on other protocols. However, the EigenLayer whitepaper details the possibility of stakers who do not wish to operate any equipment to other stakers who will on their behalf. “These operators receive fees from both the Ethereum Beacon Chain and the modules they are participating in via EigenLayers. They keep a fraction of those fees and send through the remainder to the delegators,” the whitepaper states.
Ultimately, EigenLayer’s design is a novel way for staked ETH to provide shared security to services beyond just Ethereum itself. It is also a novel way for users to design their own risk/reward frameworks for restaking on other protocols. EigenLayer was founded in 2021. The company is currently in the process of raising $50mn in a Series A funding round. The round is set to give the startup a $250mn valuation and $500mn token valuation.
Many of the ideas presented in EigenLayer’s first public whitepaper are not new. In fact, the details for implementing a restaking protocol on Ethereum that would enable shared security between Ethereum and other protocols have been heavily discussed on severalpublicforums since EigenLayer’s founding in 2021. Rather than present new ideas, the release of EigenLayer’s whitepaper in 2023 is a consolidation of disparate ideas discussed about EigenLayer over the past few years into one cohesive document that outlines the guiding principles and vision for the protocol. This is especially timely given that the EigenLayer team is preparing to launch the first version of its protocol on mainnet Ethereum sometime this year.
As the EigenLayer team prepares the final touches for the first implementation of their restaking protocol, there are three key things to note about the project which are highlighted in their whitepaper.
Risk Management: The first is the protocol’s approach to risk management. The whitepaper outlines two main categories of risk. The first being a coordinated attack by EigenLayer stakers that compromises the stake under management by the protocol and the second being unintended bugs and issues that unfairly penalizes EigenLayer stakers. To manage the first risk, the EigenLayer protocol can restrict the value flow to stakers participating in a specific module. Modules refer to the protocol that staker restakes to such as a consensus protocol, data availability layer, virtual machine, keeper network, or oracle network. Under normal conditions, each of these modules impose additional slashing penalties on validators for misbehavior but in an edge case scenario, the EigenLayer protocol may also impose restrictions of value flow to these modules if a slashing event is underway. Alternatively, the EigenLayer protocol may progressively increase the cost of attack for misbehaving validators under extreme conditions. A large part of risk management depends on the designer of a module and the parameters they set for restaking security. An open question from the EigenLayer whitepaper is how the protocol will allow the permissionless creation of modules such that no module is designed with inadequate and easily exploitable security parameters. To address the second risk of unintentional bugs and issues in EigenLayer smart contracts, the EigenLayer whitepaper outlines two lines of defense: security audits and a multisig. Due to the novelty of a restaking protocol, there is the possibility that a security audit may not catch all loopholes in the protocol’s code. In the event of a bug, prominent members of the Ethereum and EigenLayer community will have the ability to veto all slashing decisions via a multisig. The use of a multisig to govern a smart contract protocol is common among crypto projects. However, it has also proven to be a fallible and exploitable form of governance timeandagain. Therefore, the use of a multisig as a risk management tool for the protocol is not surprising but certainly additive to other unintended risks for users staking funds into the protocol.
Experimentation: One of the unique functions of EigenLayer once the protocol reaches its full potential for enabling permissionless module creation is that of unlimited experimentation. There are several protocol designs that can be tested through EigenLayer smart contracts before being implemented on Ethereum mainnet. Ideas like danksharding, single slot finality, and partial block auctions are innovations that could be more rapidly developed and staged through EigenLayer smart contracts which allows consensus layer validators on Ethereum to restake to other modules and thereby provide similar security guarantees to these modules as the base layer of Ethereum.
Broadness of scope: Finally, one of the important takeaways from the EigenLayer whitepaper as the sheer broadness of protocol scope. Not only will EigenLayer be designed to support native restaking, that is validators restaking their staked ETH natively by pointing their withdrawal credentials to the EigenLayer smart contracts, but also restaking of liquid staked derivative tokens and liquidity provider tokens. Again, each of these modalities of restaking with different types of assets bears different risks and the management of those risks ultimately rests on the shoulders of module designers. The full vision for EigenLayer as presented in its first public whitepaper is ambitious because of its flexibility to encompass many types of module design and assets. Therefore, the first launch of the protocol this year is likely to be a small milestone among several forthcoming milestones that will work towards the protocol’s vision piecemeal for many years to come. -CK/GP
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