From CoinShares Research Blog by Max Shannon

The aim of this article is to delve into the factors underpinning Ethereum’s long standing dominance in the DeFi realm and to examine how Solana has made significant strides in recent times, though whether this can be sustained remains uncertain.

The journey of DeFi, valued at around $180 billion at its peak in November 2021, has predominantly seen Ethereum reigning supreme, commanding over half of the total capital locked in protocols since its inception. However, this dominance faced a brief challenge in April 2022, from events like the Terra Luna collapse and the 3AC blow-up. The bulk of DeFi activities on Ethereum are propelled by Automated Market Makers (AMMs) like Uniswap, benefitting from their first-mover advantage, battle-tested code, and higher decentralisation — all factors favoured by native crypto users. DeFi’s trajectory has often been marked by yield farming frenzies, inflated token valuations and greed, then followed by fear as prices plummeted by around 80%. Solana has occasionally edged past Ethereum in volumes despite its lindy, liquidity and security to attract real-world use cases such as bond tokenisations by banks.

Solana’s rise challenges Ethereum’s dominance

Solana’s seamless trading experience, rapid transaction speeds, and low fees have led to higher trading activity on certain days, despite accounting for less than 5% of the Total Value Locked ($1.47bn versus $31.95bn respectively), as of 29 January 2023. The recent surge from an average of $400m in volume throughout 2023 to averaging $1.4bn in 2024, has been fuelled by users seizing opportunities presented by Solana’s airdrops like JITOs or, more recently, JUPs. While airdrops may seem superficial, they often stress test the protocol, gauging its ability to handle high throughput while maintaining chain stability. Solana performed admirably during the JUPs launch, but there’s room for improvement, particularly in reducing failed transactions which can be largely attributed to code logic issues rather than consensus failures. Enhancements such as multidimensional fees and scheduler improvements are underway to make Solana more performant. Additionally, users are benefiting from arguably superior technology from implementing isolated fee markets, priority fees, new clients (firedancer and JITO) and QUIC to be more performant at scale, resulting in 11 months of uninterrupted uptime, most recently from the Berkley Package Filter outage of over 5 hours, halting block production from an ‘infinite loop’ that was propagated to validators.

The focus on order-books will further provide better user experiences and should continue to demonstrate it’s astronomically better protocol capital efficiency as reflected in a higher Volume/TVL ratio. Per 1 dollar of TVL, Solana records US$0.47 cents of volume versus Ethereum’s US$0.23 cents of volume, approximately 20x higher, as of 29 January 2024. Previously, we published a blog reflecting this effect in longer user retention rates, and higher lifetime value per user and earnings per user for Solana, when looking at the Unit Economics of Decentralised Exchanges.

Arguments that don’t make sense

Some arguments from the Ethereum community attempt to discredit Solana’s recent successes by adding L2 volume to Ethereum volume. However, this approach only holds weight if there is atomic composability, ensuring frictionless interaction for transactions between smart contracts without liquidity fragmentation across rollups. While projects like Polygon and Optimism have proposed solutions (‘Aggregation Layer’ and the ‘Law of Chains’ respectively), achieving a dominant ‘composability layer’ among L2 solutions will likely take years. Therefore, comparing Solana to Ethereum and its L2s doesn’t hold, as these platforms currently operate differently and have different architectures resulting in fragmented liquidity and smart contracts.

Another flawed argument suggests that Solana’s volume isn’t genuine because it’s primarily composed of Miner Extractable Value (MEV), which means how much miners/validators can extract from block production in excess of the block reward and fees by including, excluding, and changing the order of transactions in a block. However, CoinShares dismisses this notion, asserting that Solana’s high throughput at low costs makes it attractive for MEV activity. Despite many transactions being generated by machines like oracles, market makers, and arbitrage bots rather than users, successful MEV transactions still represent real volume since gas is expended. Notably, Solana’s actual volume excludes the 58% of total transactions that are failed arbitrage attempts.

Our predictions on the future of Solana DeFi

Solana could witness a proliferation of on-chain orderbook decentralised exchanges, facilitating normal transactions for all submits and cancels, with the state of the order book fully verifiable in the chain state. This approach enables composability with all other dapps, enhancing transparency for traders and vastly improving user experience compared to the current hybrid or off-chain order books predominantly present. Ethereum and its L2s face challenges with liquidity fragmentation and high fees, limiting extensive on-chain order book capabilities.

It’s worth highlighting that Ethereum has reclaimed its position as the leader in trading volumes, with Solana closely trailing behind. This resurgence in Ethereum volumes can be attributed to a short-term shift back towards ETH following the approval of the spot Bitcoin ETFs by the SEC, especially after being oversold previously. Additionally, upcoming possibilities like the SEC approving an Ethereum ETF during 2024, along with scheduled upgrades such as Dencun and Prague/Electra in 2024, could act as further catalysts for price and volume movements. Past trends indicate a pattern of investor caution leading up to upgrades due to the increasing complexity of the protocol, followed by a spike in price a week after the upgrade, perhaps due to a sign of relief, only to revert back to similar levels within a month thereafter.

In conclusion, the battle for dominance in DEX volumes between Solana and Ethereum is a fascinating aspect of the DeFi landscape, reflecting the dynamic and rapidly evolving nature of this sector. While Ethereum has enjoyed a long-standing position of superiority, Solana’s technological advancements, and recent airdrops, have significantly closed the gap in volumes with significantly less capital locked. First-mover advantage, battle-tested liquidity and decentralisation are reasons not to ignore Ethereum’s dominance going forward, as well as more speculative macro asset rotation could likely hold its dominance strong.