Repost from November 22, 2023 Joel Monegro: “Virtual Blockchains In The Modular Era” The full report and all related findings are available on the official website of Placeholder VC.

The pioneers of new technology must raise a lot of capital to create foundational infrastructure, which can lead to over-investment and speculative bubbles. When these bubbles burst, weak firms fail, and market power consolidates around industry leaders and their paradigms. Through this consolidation process, we can identify the common elements across applications and isolate them into standard, modular components that can be open-sourced or sold as individual services. These abstractions make it easier to build more complex applications and enable a shift from capex-dominant to opex-driven cost structures that allow new products to launch faster and with lower startup costs. This pattern is now unfolding in web3 as new “modular” technologies, such as rollups, accelerate development and unlock an era of lean startup innovation. 

Capex to Opex

Technology infrastructure becomes more powerful and easier to use as it becomes more standardized and broadly available. But until that happens, early entrepreneurs must invest heavily into building their own infrastructure before they can distribute its applications, like Edison inventing the grid to sell the lightbulb or early internet startups deploying data centers to run web pages. As the market matures, open standards and on-demand infrastructure services emerge, enabling more efficient business models for companies who adopt them because they don’t need to spend as much time and money to bring their products to market. 

After the dot-com crash in 2000, for example, the internet industry transitioned from buying servers and setting up data centers (capex) to renting them from the cloud (opex). Many open-source frameworks like the LAMP stack,  Ruby on Rails, Django, and NodeJS emerged to simplify web development, while industry leaders like Microsoft, Amazon, and Google leveraged their scale to establish new standards and low-cost infrastructure services. This co-evolved with the API boom that started in the late 2000s, which further simplified the complexities of the internet by offering specialized backend functionality under pay-as-you-go business models. Within a decade of the crash, these abstractions allowed small teams to build and scale new applications quickly and cheaply, accelerating innovation and fueling the golden age of startups that defined the era. 

Web2 infrastructure became so abstract that modern web applications don’t even run directly on physical servers but in simulations of servers: virtual machines, often wrapped in containers that can be easily moved or replicated across many environments with minimal reconfiguration. This technology helped scale web2 by allowing a single, powerful server to run many applications simultaneously and makes it easy to add or subtract compute resources to applications as needed to match demand and control costs.

The concept of virtualization illustrates how abstract infrastructure can become, but I highlight it here because web3 infrastructure is following a similar path with the invention of rollups, which similarly helps blockchains scale by allowing them to power multiple “virtual blockchains” on top.

Layers of Abstraction

Early blockchain startups had to build all their infrastructure – including custom blockchain protocols, frontends, wallets, SDKs, APIs, and more – just to get started. Smart contract networks like Ethereum reduced the need to build proprietary blockchains for many applications, but they imposed significant constraints on costs, programming conventions, and scalability, limiting the universe of possible applications. The more ambitious ideas required a level of flexibility and throughput typically unavailable on public chains, so many of the most exciting applications were impossible to scale. 

Platforms like Cosmos and Polkadot later provided tools to create custom blockchains with shared security and interoperability features, making it easier to launch secure chains. However, they still demand substantial resources and expertise to use and thus remain out of reach for most developers. But just as more layers of abstraction simplified the cloud, emerging Layer 2 (L2) standards like rollups allow developers to deploy blockchain environments quickly and cheaply. 

Rollups execute transactions and smart contracts off-chain and bundle the results of multiple operations into periodic, cryptographically verifiable transactions on a primary blockchain, thereby inheriting the security of the underlying network. It’s akin to how credit card networks process many payments and settle them in weekly batched wire transfers to merchants. With this technology, a single blockchain can secure many higher-performance virtual blockchains simultaneously, drastically increasing throughput capacity while minimizing transaction fees.

Importantly, rollups are not blockchains, at least not any more than virtual machines are actual machines. Rollups are virtual blockchains, simulated environments where smart contracts run as if on a real chain, oblivious to the abstraction. A rollup can be as centralized as needed for performance, control, or compliance as long as the operator frequently settles the output on a trusted blockchain and is disincentivized from corrupting the data. But it can also be decentralized by using “shared sequencer” technologies. 

Besides scaling, unbundling the “execution” layer from the “data availability,” “settlement,” and consensus layers gives developers the flexibility they need while leveraging the security guarantees of the main chain. You could, for example, deploy an application as a rollup that uses Python as a programming language but settles on Ethereum if you dislike Solidity yet want to leverage Ethereum’s security or ecosystem. Open-source frameworks like the OP Stack, the ZK Stack, Polygon’s CDK, Arbitrum’s Orbit, or Rollkit, to name a few, already make it easy for developers to deploy custom rollups with different levels of trust, while decentralized sequencer projects like Espresso and Astria give the option to decentralize the execution layer if necessary. Meanwhile, a growing number of low-code “Rollup as a Service” (RaaS) products, like Dymension, Conduit, Caldera, and Gelato, allow anyone to launch custom virtual blockchains in minutes. 

The broader “modular movement” further empowers developers with co-evolving standards and services covering other areas of the stack, further reducing the costs of building and scaling blockchain applications. Ethereum’s EVM dominates as an “operating system” for smart contracts, while Solana’s SVM is rising quickly as a high-performance alternative (both can be used in independent rollups). Protocols like POKT standardize the RPC/API layer across networks, while platforms such as Syndicate abstract all the complexities of building sophisticated blockchain applications behind simple APIs any developer can use. Frameworks like Polywrap abstract multiple protocols into a single front-end SDK; bridges like Across enable liquidity to move between networks, and wallet standards like SAFE or Squads plus “Wallet as a Service” (WaaS) companies like Magic make creating custom wallet experiences for users on any chain easy. There’s even a new crop of L1s like Celestia that are purpose-built for virtual blockchain environments.  

Millions of Virtual Blockchains

The current strategy for web3 startups is to first launch on high-performance, low-cost networks (like Ethereum L2s or Solana), with eyes on migrating to custom, application-specific environments if they need more scale. Even existing protocols that had already built their own chains, like Celo or POKT, are transitioning to an L2 architecture to streamline their infrastructure costs, echoing the time when internet companies with data centers had to adopt the cloud as a matter of business. If you don’t embrace the new, you’re vulnerable to competitors who do.

Many believe applications running on high-throughput networks like Solana can reach “web-scale” without L2s, but people vastly underestimate what web-scale means because most of the activity on the internet happens in the background. Every click you make triggers hundreds of hidden HTTP requests; just loading Twitter.com triggers over 300 background requests to different APIs and service providers in under 2 seconds, and that’s for one user’s single action. Achieving web-scale means reaching millions of transactions per second, per application, and even that’s not enough if internet demand multiplies by a million. Virtualization is necessary to reach that level of scale, but we also need ultra-high-performance L1s underneath to achieve it. Besides blockchains optimized for data availability throughput, like Celestia, high-performance networks like Solana and Monad are potentially interesting playgrounds for rollups.

That said, scalability isn’t the only reason virtualization is important. Virtual blockchains are a powerful standard for the web3 generation of online services. The first wave of rollups mainly consists of “faster Ethereum” services. However, the flexibility provided by a modular architecture makes virtual blockchains particularly useful for creating application-specific environments or networks tailored for specific ecosystems, industries, or geographies. You can also create “virtual private blockchains” for use cases with strict access control or compliance requirements. Bigger yet is the idea that virtual blockchains could become the default backend infrastructure for all online applications, as Blockchains and Smart Contract Interfaces replace web2’s “Cloud and API” paradigm.

We will go deeper into these ideas in future essays, but the most important point I want to highlight from a business perspective is that modularity represents web3’s shift from capex to opex, and consequently, we can expect a rapid expansion of next-generation blockchain applications. Opex means costs scale with growth instead of being front-loaded by large capital raises before launch. It means entrepreneurs can iterate faster, applications can scale cheaply, and investors can finance ventures with less risk. Like the web after the dot-com crash, these are prime conditions for a golden age of startup innovation in crypto.