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Node Notes: What’s next for Ethereum?

Welcome to our new series, Node Notes, where we’re spotlighting topics from our bi-weekly research piece, The Node Ahead. If you want to read the full piece, you can check out our blog or sign up to receive The Node Ahead straight to your inbox. This edition of Node Notes is an excerpt from Node Ahead 41.

Last year Ethereum changed its method for validating transactions from proof of work to proof of stake (aka “The Merge”) and then last month enabled users to withdraw their staked funds for the first time (aka “Shapella”). These were two of the biggest updates to the Ethereum network in its history, but that doesn’t mean Ethereum is done improving. In fact, there are a number of additional upgrades coming as soon as later this year. The last thing we want is for any of our readers to be at a dinner party, and someone makes a funny comment about Proto-Danksharding, everyone laughs, and you have no idea what anyone is talking about (though I fully recognize it’s likely most of you attend much cooler dinner parties than I do…). Regardless, let’s cover two of the most important improvements coming to Ethereum over the next year or two.

The first and possibly most important improvement coming to Ethereum is sharding. If you remember our coverage of The Merge, we highlighted the fact that The Merge didn’t directly improve scalability, it merely created the preconditions necessary for future upgrades to increase the transaction throughput and speed. Well, sharding is that future upgrade.

As we know, Ethereum’s base layer can handle a limited number of transactions before blocks become full, wait times increase, and fees rise. Hence, we have Layer 2 networks such as Arbitrum and Optimism. The idea behind Layer 2 networks is that they take on the computational burden of processing transactions which frees up the underlying Ethereum base chain to handle the security and storage functionalities. While this is a huge improvement, and we have seen Layer 2 networks take off in usage, Layer 2s still can’t quite reach their full potential due to the design architecture of the underlying Ethereum base chain. The fastest Layer 2 networks still have to submit a significant amount of data to build consensus on the Layer 1 chain. Moreover, it places a heavy burden on validators to download this data, given an estimated 95% of the transaction fees on Layer 2s are due to costs associated with posting data to the base layer.

Sharding alleviates this data problem by splitting the Ethereum blockchain network into multiple parallel blockchains, each one responsible for processing transactions of a given type. This greatly increases the space for more data which should make transactions on Layer 2 as cheap as possible for users and should allow Ethereum to scale to more than 100,000 transactions per second. Simply put, sharding is akin to adding additional lanes to a congested highway. Anytime you hear the word “sharding” in crypto, think of greater scalability and more transactions.

The end goal for Ethereum is what is called “Danksharding,” which is a specific method of sharding named after the individual who first proposed sharding on Ethereum, Dankrad Feist. However, the fully realized version of Danksharding is still years away and requires several steps to get there. The first step in that process is EIP-4844, otherwise known as “Proto-Danksharding.” The ‘Proto’ prefix refers to crypto researcher Proto Lambda. Now I know that Proto-Danksharding sounds weird and intimidating, but it’s really quite simple. Proto-Danksharding is just a fancy term that refers to the first step of improving Ethereum’s transaction capabilities by enabling Layer 2s to transfer their data much more cheaply and pass the savings on to end users in the form of cheaper transactions. It’s likely to also decrease the cost of running a node on the Ethereum network, which should lead to a more robust and decentralized network.

EIP-4844 is currently scheduled to be implemented in Q3 or Q4 of this year. However, if history is any indication, it’s very possible that the timeline will get pushed back to early 2024. 

The second major upgrade on Ethereum’s horizon is Proposer-Builder Separation (aka PBS). This is likely further out on the timeline than Proto-Danksharding, but still worth knowing about. When transactions are submitted on the Ethereum blockchain, they initially enter a pool of pending transactions known as the mempool (short for memory pool). Validators (ie, anyone who staked at least 32 ETH) can see every transaction in the mempool and pick which individual transactions to verify and then group them together to form a block. Because validators ultimately decide which transactions are completed and in what sequence, there is an opportunity to front-run certain transactions before the block is built.

The value that a validator can obtain, above the standard block reward and gas fee, from front-running transactions due to the ability to change the order of transactions within a block is called Maximum Extractable Value (often referred to as MEV). MEV is essentially an invisible tax in the form of slippage (deviation from the price a user tried to buy ETH at and the price they actually received) on the Ethereum network. MEV can also cause congestion and increased gas fees as there are additional transactions that get put in blocks which, in theory, could crowd out other transactions from the mempool. Taking advantage of MEV opportunities requires sophisticated technical know-how and custom software making it much more likely that institutional operators benefit from MEV rather than everyday stakers. It potentially could also lead to more centralization because the staking returns for large, centralized operators could be higher, thus disincentivizing smaller or individual stakers.

Proposer-Builder Separation looks to solve these problems. As the name implies, PBS splits the validator function into two separate roles. The first role consists of grouping individual transactions and the order into a block (block builders), and the second role is validating a block of transactions and propagating it to the network for inclusion in the blockchain (block proposers). The key to this is that the block proposers can’t see the contents of the block, they simply choose what they believe will be the most profitable based on which block has transactions that are willing to pay the highest fees. Proposers then pay a small fee to the block builder as a thank-you for doing their job before sending the block to the network and collecting those fees.

This separation greatly limits the opportunity for a builder to benefit from MEV. Block builders still have the ability to pick transactions from the mempool and in which order. However, if builders try to front-run transactions, the rewards from doing so are likely to go to the block proposer, not the builder. Thus, there should be less incentive for sophisticated operations to front-run transactions as builders.

For proposers, PBS levels the playing field. Rather than doing their own MEV searching, block proposers can only pick a pre-built block. Block proposers have no way of directly influencing which transactions or which order the transactions make up a block, so it should be impossible to front-run any transaction as a proposer. Furthermore, a small or solo validator sees the same information as a large validator, so sophisticated operations do not gain any advantage over smaller validators when proposing blocks. This should limit any centralizing force MEV would otherwise exert on the Ethereum network.

By altering the economics, the hope is that PBS will solve most of the problems caused by MEV. But that is not the only thing PBS should solve.

PBS also helps increase the censorship resistance of the network. Under the current system in which one validator plays both roles, there is potential for validators to purposely exclude certain transactions for whatever reason they deem fit. By separating this into two functions, it makes it much harder for block proposers to exclude transactions, as they do not get to see which transactions are included in each block.

PBS is likely 18 -24 months out, so it’s not coming anytime in the immediate future. In the meantime, you can impress all your friends with your knowledge of Proto-Danksharding, MEV, and PBS.

Disclaimer:  This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely that of Brett Munster and do not express the views or opinions of Blockforce Capital or Onramp Invest.