Investing in Three Generations of Blockchain
Currently, three generations of blockchain are racing against each other to solve some of the most fundamental challenges to the decentralized economy.
The first generation is Bitcoin, the second generation Ethereum, and the third generation is represented by a multitude of players such as Cardano and Polkadot. Three fundamental challenges are:
- Scalability: Equipping a blockchain network to handle worldwide adoption like a traditional payment system.
- Interoperability: Making different blockchains communicate with each other and with the established banking system
- Environmental concerns: Running a blockchain with/or almost with a net zero-emission. This concern has not grown smaller following IPCC Sixth Assessment Report (2021).
To deliver on the promise of true DeFi (decentralized finance) solving these three challenges is essential.
Three Generations of Blockchain
The first generation of blockchain came to life when the mysterious Satoshi Nakamoto introduced the world to Bitcoin in his white paper from 2008. Bitcoin is known for its qualities of decentralization, transparency, digital scarcity, and high level of security. Beyond being a financial settlement system, many people consider Bitcoin to be a digital store of value, similar to gold or silver.
The second generation of blockchain led by Ethereum that launched in 2015, widened the scope of application for blockchain. Whereas Bitcoin was solely intended as a secure payment system, Ethereum introduced new functionalities such as smart contracts, DApps, and non-fungible tokens.
With Ethereum came the promise of a new decentralized financial system, fully able to compete with the established one. However, some fundamental challenges to get there still persists.
The third generation of blockchain aims to solve the challenges of its predecessors. Many competitors in the third generation exist, but among the forerunners are Cardano and Polkadot. Some of the major challenges that blockchain technology needs to solve are issues of scalability, interoperability, and energy consumption. The blockchain system to first solve these issues will likely dominate the future market.
Cardano and Polkadot have been dupped as “Ethereum killers”. They have the same smart contract functionality that Ethereum offers but may be able to solve the fundamental challenges before Ethereum does. In the hopes of “going mainstream”, and effectively protecting its market shares from being eaten by younger competitors, the Ethereum network is currently in the process of transitioning to version 2.0. With the new updates, Ethereum 2.0 is essentially becoming a third-generation blockchain. Funnily enough, the founder of Cardano, Charles Hoskinson, and the founder of Polkadot, Gavin Wood, were both among the original co-founders of Ethereum, but they decided to walk out and pursue their own visions instead.
The Race of The Third Generation
All the fundamental challenges stem from the grandfather of blockchain: Bitcoin. Let’s take a look at the above-mentioned challenges, and what blockchain systems from different generations do to overcome them.
Scalability is essentially a problem of bandwidth, data storage, and transactions per second.
For instance, there is a cap on how many transactions the Bitcoin network can process. The cap is not coincidental, since Bitcoin is designed to generate a new block every 10 minutes on average (see more here). Bitcoin can process between 3.3–7 transactions per second. Ethereum performs marginally better, but can only process between 15–30 transactions per second (optimistically). Obviously, that is not enough to handle worldwide adoption. In comparison, a Visa credit card can process between 2.000–56.000 transactions per second.
First and second-generation solutions to the scalability problem could be off-chain scaling or side chains.
To work around the scalability problem, payments could move off-chain (not recorded on the main chain) through private, secure payment channels between two or more parties. One prominent Bitcoin initiative that operates with this solution is the Lightning Network
Another solution is sidechains. Sidechains are separate blockchains that are interoperable with the mainchain. They are designed to offload the blockchain by sending transactions via these connected sidechains and putting the end state of the transaction on the main blockchain. In this way, small amount transactions do not need to be processed on and “bottleneck” the main network.
Sharding is another method for attaining scalability on a blockchain. Sharding means fractioning the network, so that transactions are verified by “teams of nodes”, instead of every single node in the entire network. According to Ethereum 2.0’s roadmap, shard chains should be implemented in 2022, after the network has fully transitioned to proof-of-stake.
Cardano has introduced a method of sharding/applying sidechains called Ouroboros Hydra. Hydra is a second-layer solution that can sit on top of Cardano’s protocol. The security of transactions of the first layer is ensured by the distributed consensus on the blockchain, while the second layer processes transactions off-chain. The first layer does thus not verify transaction that takes place in the second layer, but the end state of multiple transactions between parties on the second-layer are recorded on the first layer. See the illustration below from an article by Cardanians.io (CRDNS pool).
After the end state has been recorded on the blockchain, the individual transactions in the payment channels in the second layer (the transactions in the “Hydra’s head) are deleted to minimize data storage.
Finally, Polkadot’s solution to the scalability problem is to spread transactions across multiple parallel blockchains. These parallel chains are referred to as Parachains and they are coordinated by the main chain called the Relay Chain. The Relay Chain provides consensus to the entire platform, while the Parachains are independent blockchains.
In effect, Polkadot is a system of many different blockchains that are connected and work together. With “the parachain model”, Polkadot allows blockchains to achieve scalability at layer-1 rather than relying on layer-2 solutions like Cardano.
Bitcoin’s off-chain scaling solutions, Ethereum 2.0’s method of sharding, Cardano’s Ouroboros Hydra mechanism, and Polkadot’s parachain-model, have all theoretically proven to solve blockchain’s scalability problem. The scalability solutions will potentially far outperform any traditional global payment system with processing powers of anywhere between 1.000–1.000.000 transactions per second.
With the scalability issue comes a closely related issue: interoperability.
As it is today, blockchain systems are unconnected and siloed from each other.  For instance, there is no way for everyday users to convert bitcoins to ether or ether to bitcoins without relying on a crypto exchange, or in other words, a trusted intermediary. That is the very thing that Bitcoin was designed to avoid with its foundational principles of decentralization and trustlessness.
“Interoperability” refers to blockchain system’s ability to seamlessly exchange information with each other. Interoperability is a prerequisite for mass adoption of a cryptocurrency. Not only is interoperability with other blockchain systems required, but also with the established financial system.
It is unlikely that there will ever be one cryptocurrency to “rule them all”. Cryptocurrencies such as Bitcoin, Ethereum, Cardano, and Polkadot, will most likely have to co-exist also together with the traditional banking system. No corporation would want to process its payments with a blockchain if the overall infrastructure is not interoperable and secure.
Numerous projects are working to improve blockchain interoperability. Third-generation blockchains such as Polkadot and Cardano have been built with this concept in mind. Polkadot’s Parachains can interact with each other within the ecosystem, but several “bridges” are also being developed to connect Polkadot with external networks like Bitcoin or Ethereum. Cardano has developed a ERC20 converter that will allow Ethereum tokens to run on Cardano’s Ouroboros protocol.
Bitcoin mining is known to use more energy than countries like the Netherlands or Pakistan. On this background, Tesla decided to suspend payments in bitcoins, and experts, as well as laymen, question Bitcoin’s potential as a future global payment system. Ethereum uses less than half of Bitcoin’s energy, but that is still an enormous level of consumption.
The vast energy use is a necessary evil to keep the proof of work-based blockchains secure. But ETH 2.0 (slow) coming move to a proof of stake consensus mechanism is estimated to cut its energy usage by more than 99% (see my post on proof of work vs. proof of stake).
Polkadot and Cardano were born as proof-of-stake blockchains. However, as I have pointed out in my PoW vs. PoS-post, it can be argued that the money spent on validating blocks in a PoS-network could be better spent on “saving the environment”, while the energy spent on mining bitcoins is in large part, and increasingly will be, coming from renewable energy sources. However, with the current focus on global climate change, it seems unlikely that a cryptocurrency would ever be accepted for mass adoption without almost net-zero carbon emission.
 https://www.youtube.com/watch?v=Ja9D0kpksxw&t=2452s (14–08–2021).
 K. Cromann et. al (2016), On Scaling Decentralized Blockchains (A position paper).
 Carlo R.W. De Meijer (2021),. Blockchain Technology Challenges: new third-generation solutions -> https://www.finextra.com/blogposting/19949/blockchain-technology-challenges-new-third-generation-solutions (29–06–2021).