*Special thanks to Cookies for the discussion and the review of this article.

1. Intro -DeFi is Heading Towards the Next Infra Phase

FAANG, an acronym for Facebook, Apple, Amazon, Netflix, and Google, has disrupted the IT industry, leading in revenue and technological development.

Similarly, in the DeFi space, there's an equivalent term: "SMELL," which stands for Synthetix, MakerDAO, ETH, Lido, and Chainlink. These projects are the foundations of the DeFi ecosystem, providing a new finance primitives and business model of decentralized finance in blockchain.

In addition to these, projects like Uniswap and AAVE have developed the essential components of the DeFi ecosystem using smart contracts. However, from a technical perspective, these smart contract dapps have reached their limitations.

Source: Top 20 projects daily cumulative revenue of top 20 projects - Token Terminal

1.1 DeFi Dapps Reach Their Limit

However, they hit the limitations in terms of customization, user experience and new trials with their current architecture. They are still showing interesting developments and expansion but are limited.

It's time for new experiments to come, to make DeFi products more customizable and be more user-focused. Major projects have showed this movements.

• MakerDAO: A proposal has been made to launch its own chain.

• Frax Finance: Fraxtal launced its rollup in February to further develop its ecosystem.

• dydx: A StarkEx-based rollup has been built, but now it has a separate appchain.

In 2023, modular blockchain was the focus, offering opportunities for customizable blockchain with significantly reduced developer and operating costs. For instance, the upgrade of OP-Stack to Bedrock led to a substantial reduction in fees. Additionally, each rollup project, including OP-Stack, ZK-Stack, Arbitrum Orbit, and Polygon-CDK, launched its rollup framework. These were significant developments in the field.

In 2024, customizable “DeFi Rollups” will emerge and be utilized by lots of projects.

1.2 It's Time for “DeFi Rollups”

In the past, if the project wanted to have a separate infrastructure for its dapps, they needed to build its appchains, using solutions like Cosmos-SDK, Avalanche Subnet, and Polkadot Parachain.

However, these option were expensive. Due to limitation of execution environments or tools, it was challenging to fully leverage the benefits of appchain. These associated costs stem from the need for separate validator sets and the requirement to construct its sub-infrastructure, including explorers, wallets, and so on.

Now, there are multiple benefits to build its own rollups in Ethereum with much lower cost.

The benefits of building a rollup instead of a dApp in Ethereum include:

1. Improved Scalability: Rollups can achieve better transactions per second (TPS) compared to the base chain, which is vital for developing scalable applications.

2. Lower Fees: By batching transfers off-chain, rollups reduce fees multiple times compared to the main chain, improving user experience and reducing the initial barrier.

3. L1 Security: Rollups inherit the strong security guarantees of chains like Ethereum, ensuring a high level of security for the applications built on them.

4. Familiar Tooling: Ethereum rollups allow using Solidity and EVM, reusing developer skill sets and tools.

In summary, building a rollup in Ethereum offers improved scalability, lower fees, high security, composability within the ecosystem, familiar tooling, and modularity, making it an attractive option for dApp developers.

Before diving into how DeFi projects are leveraging Rollup Frameworks to build its ecosystem, lets firstly dive into the options on the frameworks.

2. Ethereum Rollup Frameworks

Before exploring how DeFi projects utilize Rollup Frameworks to create their rollups, let's first examine the market landscape of these frameworks.

Currently, there are approximately 10 rollup frameworks available for use; however, only 5 are ready for production.

Each framework offers its own unique strengths and ecosystem.

2.1 On Major Frameworks

Currently, 5 rollup frameworks are considered the major framework, and are actively being used by projects.

Building this can be simplified with the help of rollup-as-a-service providers such as Conduit, Caldera, Gelato, Ankr, and others. With these frameworks undergoing active development, and the increasing availability of tools like wallets, explorers, and contract management systems (for example, Thirdweb), launching a rollup becomes much easier. Below are some of the most commonly used rollup frameworks, where the related tools continue to expand.

Source: OP-Stack, Polygon CDK

2.2 Benefits to DeFi, of having its own Rollup

The benefits of using rollups for DeFi are as follows:

• Achieve higher throughput and unmatched speed with lower transaction costs. Rollups can offer up to 10-100x better scalability with lower cost than running its own chain.

• Ensure privacy and anti-censorship through transaction bundling and submitting validity proofs without revealing transaction details. Also custom DA is available

• Prevent exploitation of Maximal Extractable Value (MEV) by providing full control over transaction ordering and the ability to internalize or eliminate MEV risks.

3. Blueprint of DeFi Rollups

Given the numerous DeFi projects being built as a rollup, let's delve into the DeFi components and the rollup architecture of some of these projects.

Source: Ethereum DeFi Rollup Tracker - Four Pillars

3.1: Fraxtal: The First Major DeFi to Launch its Rollup, by Frax Finance

3.1.1 Fraxtal’s DeFi Component

Frax Finance is a multi-chain stablecoin protocol featuring three distinct stablecoins: FRAX, FPI, and frxETH. FRAX is pegged to the US dollar, FPI is linked to a consumer goods basket, and frxETH is tied to Ethereum for smart contract integration. The protocol employs a fractional algorithmic mechanism, with the FRAX stabilization relying on two assets: USDC and FXS. To mint FRAX, users must provide collateral equivalent to the desired amount, with the FXS ratio fluctuating based on market conditions.

Frax Finance has been one of the OGs and a major DeFi protocol in the Ethereum ecosystem, currently boosting over $ 1.8 Billion TVL.

Additionally, Frax Finance includes sub-protocols such as Fraxlend for lending markets, Fraxswap for automated market making, and Fraxferry for token transfers. The ecosystem is sustained by the governance token FXS, which captures yield, revenue, and excess collateral value from the Frax ecosystem.

Frax Finance has also launched its own optimistic rollup, Fraxtal, to further enhance the ecosystem.

3.1.2 Rollup Architecture

Source: About Fraxtal | Fraxtal Docs

Fraxtal is a modular rollup blockchain that uses a "fractal scaling" approach to scalability. As a layer 2 solution, it aims to scale Ethereum by handling transactions and smart contract execution off-chain through the use of fraud proofs. This allows it to process many transactions while maintaining the security of the Ethereum mainchain. Fraxtal is built as an EVM-compatible rollup, utilizing the Ethereum Virtual Machine and op codes as its smart contract platform.

In addition to basic layer 2 scaling, Fraxtal introduces some novel concepts. It is designed as a modular rollup, with components that can be used by other chains, networks, and to build layer 3 solutions. It also implements an incentive mechanism called Flox that rewards users and developers for interacting with smart contracts on the network. Users earn FXTL points for spending gas, while developers earn rewards based on gas used by their dapps. These points can later be converted to FXTL tokens, allowing users and devs to earn more than just the gas costs. The native gas token on Fraxtal is called Frax Ether (frxETH), which is a ETH issued by Frax Finance.

3.2 Parallel: A Single Account for the Ethereum Ecosystem

3.2.1 Parallel Network’s DeFi Component

Parallel Network is a Layer 2 taht aims to be a single wallet for Ethereum users, and consolidates liquidity from all chains into one place. It facilitates transactions across Parallel Labs' range of products and enables efficient exchanges between blockchains integrated into the platform.

The platform hosts dApps including cross-margin NFT lending, staking, trading, buy now pay later, and more.

This design aims to notably improve the DeFi user experience. It simplifies interactions with intricate blockchain networks and eases the learning process for newcomers. It provides zero gas fees, exceptional speed, efficient exchanges, enhanced privacy and security, all contributing to a seamless DeFi user experience.

3.2.2 Rollup Architecture

Parallel Network uses Arbitrum's Nitro stack as a L2 and offers cheaper and faster transactions. It is EVM-compatible and inherits the robust security properties of Ethereum. Nitro comes with an optimistic rollup system, a sequencer, token bridges, and fraud proofs among other features.

Parallel Network is an optimistic rollup that uses 'fraud proofs' to validate withdrawals under the assumption that all transactions are inherently valid. However, transactions that involve communication from Layer 2 to Layer 1 need to endure a 7-day dispute window before they can be finalized, serving as a preventative measure against unscrupulous behavior.

The network employs a dynamic and selective approach to sponsor gas, striking a balance between user-friendliness and robust network security. Gas is used as a safeguard against malicious Sybil attacks, ensuring the integrity and reliability of transactions.

Parallel Network also supports the WASM execution environment through Arbitrum Stylus, facilitating the creation of smart contracts using languages like Rust, C, and C++. Stylus contracts offer significant speed improvements, lower gas fees, and cheaper memory usage.

3.3 Aevo: Making Perpetual Trading Experience Better

3.3.1 Aevo’s DeFi Component

Aevo is a high-performance decentralized derivatives exchange platform, previously known as Ribbon Finance, an option protocol, focused on options and perpetual trading. The exchange runs on a custom EVM roll-up that rolls up to Ethereum. Aevo operates an off-chain orderbook with on-chain settlements. This means that once orders are matched, trades get executed and settled with smart contracts.

3.3.2 Rollup Architecture

Source: Layer 2 Architecture - Aevo Documentation

The Aevo Rollup is an optimistic rollup built on Ethereum and it uses optimistic rollups to batch transactions together before posting them to the Ethereum mainnet. A third party operator called Conduit acts as the sequencer, bundling transactions into batches every 1 hour and submitting them on-chain. This bundling helps improve scalability. After a batch is posted, there is a 2 hour dispute period where users can challenge any invalid or fraudulent transactions before they are finalized. This provides a layer of security while still being much faster than native Ethereum transactions.

The core functionality of trading and settlements happens through smart contracts deployed directly on the Aevo Rollup. Users interact with these contracts to place orders, make trades, and settle positions. Deposits and withdrawals use the Optimism standard bridge contracts to move funds on and off the rollup. Deposits take around 10 minutes to confirm, similar to Ethereum, while withdrawals take 2-3 hours due to needing to wait for the full dispute period. Gas fees for transactions like trades are covered by the Aevo exchange, but deposits and withdrawals require users to pay gas themselves.

The layer 2 infrastructure maintains a balance between improved transaction speeds and ongoing security from the dispute mechanism. This enables it to deliver a robust decentralized exchange experience.

4. Critiques to Current DeFi Rollups

4.1 Closed-Source Rollups, the New Norm?

Most of the projects are not open-source, and the customization points are not clear. Although this can be justified by the fact that these projects are in their early stages of development, it raises certain concerns.

Primarily, these projects assert that their rollup inherits the security of Ethereum. However, without offering more information or clarifying how this security inheritance works, it might create a barrier for users to fully understand the risks associated with these projects. For a thriving and transparent ecosystem, it is critical for these projects to provide in-depth information, and if possible, open-source their codes.

4.2 Too Much L2, no Distinct Strategy

As I looked into the related projects, I noticed numerous similarities and unclear strategies. Particularly as a general Layer 2 and a perpetual trading Layer 2, there were many similar architecture and strategies.

In the previous DeFi summer, many projects were similar, and those that failed to offer clear advantages did not survive. This pattern is likely to repeat with DeFi rollups. Attracting users to Layer 2 is more challenging than integrating a dapp into the ecosystem, so better customization is needed. Providing a seamless experience for users on other Layer 2s and Ethereum is also essential.

4.3 CEX L2 Needs to Push Boundaries: OKX X1 and Cronos zkEVM

Still, a Centralized Exchange (CEX) serves as the main hub for trading crypto assets. It offers one of the best experiences in crypto asset trading due to its secure infrastructure and regulation by authorities in each country. They also are generating tone of revenue.

As CEXs develop rollups, these should not merely replicate the functionalities and ecosystems of other Layer 2 solutions. Instead, they should enhance the onboarding of CEX users to Decentralized Finance (DeFi). For instance, CEX users could more seamlessly contribute their tokens to lending protocols or Automated Market Maker (AMM) pools.

While regulatory issues may pose a challenge, CEXs need to push boundaries to expand the overall DeFi ecosystem and increase their influence.

5. Thoughts on “DeFi Rollups”

5.1 In 2024, Lots of experiments in the Customizations will be observed

Rollups are being developed extensively, yet their testing has been limited due to the framework's recent launch. These tests can be seen in various aspects, including:

• Unsupported precompiles by Ethereum: This can enhance the range of verifiable signatures and optimize recurring executions in L2.

• New ecosystem incentive system: Projects like Blast and Fraxtal plan to have an incentive scheme for L2 dapps, where the L2 operator shares some revenue with the most used dapps. This could further incentivize the ecosystem.

• Dapp-focused infrastructure: Having a separate L2 can allow for a customized environment. For instance, projects like Kinto have an account system that requires KYC to create an account. This can enhance compliance and support better institution onboarding.

5.2 Rollup vs. Appchain?

Rolllups will not be the ultimate solution to build the best infrastructure, when related costs and development timeframe are not regarded. That is the reason why dydx built its own chain, and currently provides a seamless experience using a Ethereum wallet account. This onboarding experience is similar to getting users onboard rollups. As the adoption of specific rollups increase, there will be projects looking for some other ways to build its infrastructure, but this will depend on whether L1 frameworks improve in significatn way. These frameworks and their ecosystem are not mature as the rollup frameworks and ecosystem.

Refer to the journey of dydx’s infrastructure decision written by our researcher Steve.

5.3 RaaS Vendors Will Become Important

RaaS vendors such as Conduit, Caldera, and Gelato are strengthening the overall ecosystem. They enhance it with better integrations and experiences, such as providing custom sequencers, custom DAs, integration with bridges.

They are currently positioned as the AWS for blockchain, with easy integrations for explorers, wallets, bridges, oracles, and more. They offer more than just infrastructure like a typical SaaS; they also provide consulting to implement and operate the rollup. This strategy has helped them gain more market share and expertise in the field.

The question remains whether they will follow the path of decentralization like major web3 projects, or become a centralized provider and act as the entry point for Web3. I believe there will be a varied approach to this. For instance, Conduit and Caldera may initially be more centralized, while Altlayer, Argus, and Saga may be more decentralized.

5.4 DeFi Rollups In Bitcoin?

this is something out of the Ethereum rollups, but it is worth to note that the defi ecosystem is developing at a fast pace in the bitcoin ecosystem, and lots of infrastructure to support building on top of Bitcoin is being launched, like Citrea, Merlin Chain, B^2 Network and Rollux. They are curently more of a sovereign rollup, so it would be also interesting to see how they will try to inherit Bitcoin security better.

While these projects are still immature and the user experience isn't as good as Ethereum rollups, Bitcoin is undeniably the most "crypto" asset in this industry. The enthusiasm to utilize this cryptocurrency won't just go away. Indeed, this year is likely to witness some interesting developments within this ecosystem.

Refer to this article by 100y’s analysis on Bitcoin L2 ecosystem.

Thanks to Kate for designing the graphics for this article.