Why Ethereum 1.0 failed and Bitcoin succeeded

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Introduction

Ethereum 1.0 wouldn’t be undergoing a complete redesign unless it had major flaws. So how did we get here? And why did Bitcoin seem to fare much better? Two important factors are user experience and economics. At at minimum, for a product to succeed it needs to be a compelling alternative to an existing problem, and the transaction fee must not exceed the economic value of the actual transactions. Together these point to an upwards trajectory for Bitcoin and a downwards trajectory for Ethereum 1.0.

Competing on User Experience

There’s a saying that for one product to replace another with network effects, it needs to be ten times better. Specifically it must be good enough to justify the painful switching costs. Here we examine that first competitor and if those improvements could arguably be called a 10x better experience.

Bitcoin was 10x better

Who was Bitcoin’s first competitor? Gold comes to mind, but Bitcoin’s inflation in the early years was very large, far exceeding that of physical gold mining. There was little Bitcoin had to offer gold bugs in terms of longevity, inflation, decentralization, at least for now. It was not yet a competitive product.

Rather, Bitcoin’s first competitor was the wire / ACH transfer. In the developed world it’s hard to think of someone without a bank account, and the base of people with experience using these workflows is about as high as the number of people who have ever filed taxes. Moving money could cost $30 for a wire, and take one business day which could mean three total days given that banks often don’t operate on the weekend. ACH transfers are cheaper but much slower, taking 3–5 business days to process.

Bitcoin was an obvious 10x improvement on the wire / ACH transfer

Bitcoin was an obvious improvement with 10 minute block times and fees that were for a very long time under a penny. Unlike banks, Bitcoin didn’t shut down after 5 PM or on weekends. It was an obvious 10x improvement, so much so that years later many continued to think of Bitcoin as a consumer payments network rather than a settlement layer.

That Bitcoin is today thought of as an alternative to gold rather than the wire transfer is irrelevant. During its most formative years it was able to onboard users by providing a clear alternative to bank transfers.

Ethereum turned out to be 10x worse

Who was Ethereum’s first competitor? Many think it was Bitcoin, but it was hardly better equipped to offer a substantial improvement with respect to payments. Rather, than being engineered for payments, it was a general purpose platform and originally branded a “world computer”.

This world computer where anybody could write their own decentralized applications was often referred to as ushering in Web 3.0, where Ethereum would presumably be the backbone of a secure and decentralized internet. Since the contemporary web is referred to as Web 2.0, I think it’s a fair thing to say it was Ethereum’s first competitor. Both the internet and Ethereum share the common trait of being permissionless platforms that anyone can build on.

Ethereum was unfortunately 10x worse than the web 2.0 it sought to replace

The contemporary web is built out using the client-server model and is extremely scalable thanks to horizontal scaling (analogous to sharding). This ability to scale is its superpower: there are billions of internet connected users, tens of billions of internet connected devices, and room for more. Latency is often so small it’s often not neurologically perceivable. Bandwidth is good enough to stream video and costs are largely free, subsidized by advertising.

Ethereum is not exactly a platform ready in any sense to offer improvements on the contemporary web. Its bandwidth isn’t enough to upload small images (the most data that can be uploaded per block is about 13 KB). At 15 transactions per second only about 1 million daily active users can be supported. Latency is far longer than the 2 second limit that will frustrate users on the web. Every state change is approximately $0.06, which bodes poorly given how much interactivity is part of the normal web browsing experience.

Ethereum is unfortunately not the 10x improvement anyone is looking for. If we’re polite, it’s a 10x worse experience. And if we’re honest, it’s several orders of magnitude worse still. Ethereum was picking a battle that couldn’t be won here. Web 2.0’s superpower was scalability and that was Ethereum’s weakness.

Economics of transactions

It’s an economic reality that the value of the transactions must at a minimum exceed the transaction fees paid. Without this, we can’t realistically expect to onboard users. Nobody is interested in leaving money on the table. Single fee markets behave like you might expect, but multiple competing fee markets can crowd out applications with low economic value.

Bitcoin’s single-application platform was smooth sailing

Transactions on Bitcoin were intended for wealth transfer. Although there were secondary uses of Bitcoin such as gambling and storing data, the primary function had the highest economic value. This meant that using the platform as intended was not impeded by secondary uses.

Ethereum’s multi-application platform had unexpected interactions

Transactions on Ethereum were meant to power dapps. Wealth transfer was meant to be a secondary use that unfortunately could not be designed out of Ethereum. So what happens when a low-value application is on the same platform as a high-value application? Unless they both offer comparable economic value, the low-value application may be entirely priced out. Picture dapp A’s bottom 1st percentile of transactions justifying a fee of above $0.06 and dapp B’s top 99th percentile of transactions justifying a fee of below $0.06.

Wealth transfer out-priced dapps on Ethereum

In Ethereum’s case, despite its intended use case being for decentralized applications, the most popular use of Ethereum is still just transferring wealth without the assistance of dapps. Ironically, what was surely considered to be a secondary use of Ethereum is now setting a transaction fee baseline that’s putting dapps out of business.

Interacting with the web, unlike transferring wealth, is not a high-risk workflow. If you try to authenticate to a website or update your Facebook status and there is some interruption or error, you can try again. There is no real risk of catastrophic loss and consequently little need for security, legal systems, or insurance like with wealth transfer. This is largely the reason that software engineering doesn’t require licenses to work in, in contrast with other fields like medicine or other engineering fields.

Web 3.0 applications have been crowded out by wealth transfer. This has been the fate of most dapps, failing to deliver economic value on a per transaction basis greater than the current median fee of $0.06.

The Ethereum 1.0 dapps that survived lacked traction

With that said, there have been a few categories of dapps which have provided enough economic value to survive. Most notably they are gambling, decentralized exchanges for on-chain tokens, prediction markets, ICOs, and collateral-backed loans. What they share is that people are willing to pay on par with baseline transaction fee for these workflows. (It is not a coincidence that they involve moving potentially large sums of money at once.) The problem, however, is that these are niche applications whose values are way out of line.

0x, one of the most popular dex protocols, has collected only $2000 in lifetime transaction fees despite having a market cap of $160M. The token is also not necessary for the protocol to function and will likely be forked out by major relayers. Augur, the most popular prediction market, has only $40k staked in predictions yet has a $170M market capNo dapp has more than 1000 daily active users on a regular basis and only a couple dozen have more than 100 daily active users. Something is not right with these numbers.

Conclusions

So why did Bitcoin do so well and Ethereum always seemed to struggle?

Bitcoin was a 10x improvement over the wire / ACH transfer. Bitcoin only had one use case which also had high economic value, so the fee market adjusted to what users were willing to pay.

Ethereum 1.0 was 10x worse compared to contemporary web architecture. It was an unherently unscalable system (monolithic blockchain) competing with an extremely scalable system (modern web). The situation is so bad that they need a complete rearchitecture. Wealth transfer on Ethereum (not intended to be the primary use-case) created a baseline transaction fee which drowned out all applications with low economic value (i.e. most dapps). The dApps that did survive were less numerous and successful than what was expected.