Domain Money Advisors | Investment Memo | 12/14/2021
Polygon is a project that is building a series of layer-2 scaling solutions for the Ethereum network. Layer-2 scaling solutions are mechanisms that increase the throughput of layer-1 blockchains (e.g. Bitcoin/Ethereum) by taking computational load from layer-1 and executing it in a layer-2 environment. Subsequently, layer-2 solutions commit the results of the computations to the main chain on a specific interval as to preserve security. To date, Polygon POS is the leading Ethereum layer-2 scaling mechanism with a native cryptocurrency named MATIC. While Polygon is creating other scaling solutions other than Polygon POS, we focus our analysis on Polygon POS as it is by far the most widely used of all of their solutions.
Ethereum is a decentralized smart contract platform that supports cryptocurrencies, stablecoins, NFTs, DeFi applications, prediction markets and more. One can think of Ethereum as a permissionless financial cloud that supports these applications.
In our strategy piece Why Blockchains Matter we describe why we are convinced blockchains like Ethereum will transform the basic fabric of our financial system. As such, a system that supports payments, capital coordination and financial applications on a global scale needs to be able to process thousands of transactions per second with very low cost. However, Ethereum has well known issues with scale. As of 12/14/21, it costs about $5 to make a simple transaction on Ethereum, regardless of the size of the transaction. Even worse, the transaction fee is variable and reached more than $50 in 2021 when there was high network congestion on Ethereum. Consequently, sending $60 to a friend (the average size of a Venmo transaction in the US) costs $5, which is about 8.5% of the transaction, an expensive proposition.
Additionally, Ethereum can handle only 14 transactions per second vs. the 65,000 transactions per second that can be processed by Visa. In both cost and scale, Ethereum will need to improve by at least 100x to be a viable economic platform.
While the base layer of Ethereum may never scale to the degree needed for mass adoption, there are a number of layer-2 scaling mechanisms (e.g. side-chains, optimistic rollups, ZK rollups) that have been built to improve Ethereum. Examples include, Arbitrum, Optimism and Polygon.
All approaches follow the basic idea that to scale Ethereum some of the transaction processing will need to occur off of the main chain. Based on this view, our expectation is that use cases that require scale will transition over time to using these mechanisms (e.g. off the Ethereum main-chain), further strengthening the entire Ethereum ecosystem as a system that can support thousands of transactions per second. Among all scaling solutions, the scaling solution with the largest adoption is a side-chain, called Polygon POS (“Proof-of-stake”).
Polygon POS operates as an independent blockchain with its own set of validators (~100) that produce blocks for the Polygon POS chain and additionally commit the state of the chain back to Ethereum every ~30 minutes, in order to enhance security.
The scale of Polygon POS comes from the fact that the 100 validators can process transactions at a very high rate without committing to Ethereum for ~30 minutes. Once it is time for a commit, the Polygon POS validators produce a merkle tree root (a form of cryptographic hash) of the current state of Polygon POS and commit that to the Ethereum main chain. The beauty of this solution is that not all transactions on Polygon POS need to be processed on the main chain and scale can be achieved by condensing 30 minutes of transactions into one small commit to Ethereum.
Optimized for scale, the Polygon POS chain provides substantially higher transaction throughput with substantially lower transaction cost as compared to Ethereum. A simple ETH transfer costs less than $0.01 on Polygon vs. $5 on the Ethereum main chain. Additionally, Polygon POS has the capacity to process up to 65,000 transactions per second (although currently it only processes about 85 transactions per second, based on demand).
Another benefit of Polygon POS is that it is EVM compatible, which means that all smart contract applications that are written for Ethereum can be easily deployed to Polygon. This is a substantial attribute.
So far some of the largest Ethereum DeFi applications including Curve, Aave and Sushi, all facilitating billions of dollars of activity per year, are deployed on Polygon and we believe more will transition over time as Polygon POS proves to be an effective and secure scaling mechanism for Ethereum. Also, Solidity (the Ethereum smart contract scripting language) is the most popular smart contract programming language with tools built over many years to assist developers. By being EVM compatible, Polygon benefits from the robust developer community around Solidity.
From a user perspective, using Polygon POS is almost identical to using Ethereum. The only difference is users connect their wallet to Polygon POS rather than Ethereum – the rest of the user experience is the same. Metamask, the most popular Ethereum browser wallet, is compatible with Polygon POS and can be used to store crypto and sign transactions on the Polygon POS network.
Driven by all of these features, Polygon POS has had substantial adoption over the last year.
Since the beginning of 2021, daily active addresses on the Polygon POS chain increased from ~0 to about 375k. To put that in perspective, it is ⅔ of Ethereum’s 560k daily active addresses. This is notable for a protocol that had almost no users at the beginning of 2021. Additionally, this metric has been consistently rising over the course of the last year.
Looking at transactions, we can see that Polygon POS currently processes about 3.5 million transactions per day, having reached a peak of about 9 million per day in June 2021. To put this into perspective, Ethereum processes about 1.25 million transactions per day – approximately a third of Polygon’s current transactions volume. This is the behavior we expect given the cost of a single transaction on Polygon POS is about 500x cheaper than on Ethereum.
One measure Polygon skeptics may highlight is what is known as Total Value Locked (TVL). TVL is a measure of how much capital is committed to DeFi applications, and currently, the DeFi applications on Polygon amount to $4.7B, which is 3% of the $158B of TVL on the Ethereum main chain. We do not see this as a problem. It is evident that Polygon caters to a broad user base and it is intuitive that even though Polygon has ⅔ the number of users as compared to Ethereum, the amount of TVL is substantially less.
The data shows that Polygon POS has grown from 0 to a sizable crypto ecosystem in less than a year and that additionally, it is the largest Ethereum scaling mechanism by a factor of 2x (measured by DeFi TVL). Also, as compared to Ethereum, the data shows that users generally transact more frequently and have fewer assets on average, which shows that Polygon POS is performing. While Ethereum caters to larger crypto investors and institutions, Polygon POS is driving growth by creating a platform that can be used by everyone and for purposes that require more frequent transactions.
We believe that Polygon POS will build on its success from 2021 and draw more users to its platform by providing low cost transactions, as well as by being the home to an increasing number of smart contract applications, particularly those that require scale. Derivative trading, gaming and micropayments are all concepts that can be built on blockchain rails but require scale and low cost transactions. For this reason these applications have not flourished on the Ethereum main chain and Polygon POS is well suited to meet this demand.
MATIC is the native cryptocurrency of the Polygon POS blockchain, equivalent to Ether on Ethereum, and its use cases are to pay for transaction fees and staking. Each Polygon POS validator stakes MATIC and as they process transactions they receive MATIC tokens in proportion to their stake as compensation.
Currently, the market capitalization of MATIC is $14.3B and the fully diluted market capitalization of MATIC is $20B. Given the current market capitalization of MATIC, there is a lot of room for growth as developers deploy applications on Polygon POS that require secure low cost transactions. By comparison, Ether has a market capitalization of $450B, Avalanche has a market capitalization of $22B and Binance Chain has a market capitalization of $87B.
Avalanche and Binance Chain, which have a combined market capitalization in excess of $100B, are both independent EVM compatible blockchains that compete with Ethereum and Polygon POS. Both chains have high throughput but are relatively centralized (Binance Chain has 21 validators and 51% control of Avalanche is in the hands of 50 validators) and therefore, have less security than Ethereum. The benefit of Polygon POS is that it is a scaling mechanism and not an independent blockchain. Polygon POS commits back to Ethereum on a 30 minute interval and is able to leverage the immense security of Ethereum in its design.
Polygon has done a great job attracting developers and users and over time we expect Polygon to thrive as the primary scalable execution environment for Ethereum applications.
Polygon (MATIC) is held in accounts managed by Domain Money Advisors, LLC in the Domain Edge, Domain Access and Domain Balanced strategies. Domain Money Advisors, LLC is providing this information for informational purposes only. While Domain Money Advisors, LLC believes that the information contained herein is reliable and derived from reliable sources, it makes no representation, warranty or undertaking, stated or implied, as to the accuracy or completeness of the information. Domain Money Advisors, LLC, and its parent company, Domain Money, Inc., expressly disclaims any liability or loss incurred by any person who acts on the information, ideas or strategies discussed. The information contained herein is not, and shall not constitute an offer to sell, a solicitation of an offer to buy or an offer to purchase any securities or cryptocurrency, nor should it be deemed to be an offer, or a solicitation of an offer, to purchase or sell any investment product or service. Investing comes with inherent risks and you should always invest within your means and risk tolerance. Past performance is not an indication of future returns and you should always consult a financial advisor prior to making investment decisions. Please see important disclosures at https://domainmoney.com/legal