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Intro

The journey to better blockchain infrastructure brings us to a compelling innovation: modular blockchains. Borrowing from modular design principles, these blockchains differentiate themselves by separating essential functions such as execution, consensus, settlement, and data availability. In contrast to monolithic blockchains, which coordinate all these activities on a single layer, modular blockchains distribute these tasks, handling some internally while outsourcing others to additional blockchains.

The implications of this are significant: Modular blockchains offer increased flexibility and scalability compared to their monolithic counterparts. However, like any disruptive technology, they're not without their drawbacks.

Modular

Borrowing from modular design principles, these blockchains differentiate themselves by separating essential functions such as execution, consensus, settlement, and data availability. 

• Execution Layer: This is the initial stage where transactions and changes in the blockchain's state are processed. It is the layer with which users commonly interact and transaction computation occurs.
• Settlement Layer: The settlement layer verifies the execution of transactions and adjudicates disputes. Notably, this layer is absent in monolithic chains and represents an optional component within the modular structure of the blockchain.
• Consensus Layer: The consensus layer is pivotal in maintaining the order and finality of transactions within the blockchain. It involves a network of full nodes that download and execute block contents, subsequently reaching a consensus on the legitimacy of state transitions.
• Data Availability Layer: This layer is responsible for publishing and storing the data needed to validate state transitions. In cases of attacks where malicious block producers might withhold transaction data, the availability of this data for verification is crucial. 

Source: Binance Research

The implications are significant: Modular blockchains offer increased flexibility and scalability compared to their monolithic counterparts while retaining the security and censorship resistance expected in a blockchain. By separating the critical layers of a protocol, the modular chain divides the total work done among the different specialized layers/nodes so that, on net, more total throughput is produced compared to what any individual node could have processed, e.g., a divide-and-conquer approach. 

Source

Many leading L1 blockchains implement a modular approach to their chains and the scalability problem. Ethereum and rollups, Polkadot, Cosmos, Avalanche, Celestia, Polygon, NEAR, etc., are all working on different approaches to scaling that involve splitting the blockchain’s total work among different layers and nodes so that greater throughput can be achieved than a single node.

The Pros of Modular Blockchains

Modular blockchains hold particular appeal for developers looking to increase the throughput (transactions per second) of their applications without building resource-intensive application-specific blockchains from scratch. The modular blockchain structure allows developers to construct scalable execution layers for decentralized applications (dapps) while utilizing the robust security of an established blockchain. 

By dedicating blockspace and increasing transaction per second capacity, modular blockchains permit high-throughput, low-cost computation. Such capacity is key for applications such as high-frequency trading, gaming, and social networks, which demand high throughput. App chains or rollups anchored in an entirely modular blockchain protocol eliminate redundant constraints often seen in their monolithic counterparts. Their design capitalizes on specialized blockchain layers, each fine-tuned for a unique role. Within a monolithic chain, all transactions compete for the same blockspace independent of the rest of the chain’s activity. However, a modular approach can optimize for different applications and thus more efficiently price resources.

Source

It's worthy of note that a multitude of EVM-aligned L2 systems are charting the course to craft customizable L3s on their respective L2 platforms. This trajectory points to more modular blockchains emerging. The essential takeaway is the prediction that app chain innovations will predominantly manifest as L2s and L3s on modular blockchain architectures, sidelining the monolithic models. By synergizing the EVM's decentralization and security frameworks with the scalability of L2s/L3s, the modular environment hopes to trump the monolithic app chain ecosystem. 

Modular Limitations

Yet, as we migrate to this new model, we must be mindful of challenges that could potentially undermine the advantages of modular design. It's important to note that blockchains have often been likened to “islands” due to their inability to share value (assets) natively and information (state). Adopting a modular blockchain architecture exacerbates this interoperability problem by dividing state and liquidity across multiple execution and settlement layers.

Two primary issues arise from this:

1. State Fragmentation: In a modular blockchain architecture where the state of an application is dispersed across different execution layers, data retrieval and verification become more challenging. This issue is not as significant for applications running on monolithic blockchains, as all contract states, both current and historical, reside on the same network. In a cross-chain future where a single application exists on numerous Layer 1, Layer 2, and Layer 3 blockchains, state fragmentation could have far-reaching implications.
2. Liquidity Fragmentation: Liquidity refers to the efficiency with which an asset can be converted to fiat or another asset without significantly affecting its price. Liquidity is critical for DeFi applications as it impacts slippage users encounter, especially on large trades. DeFi protocols on a single, monolithic chain generally face fewer liquidity issues as all users transact on the same network. Conversely, a DeFi application spread across multiple chains will have varying liquidity levels, limiting users to the liquidity available on a particular chain.

Overcoming these challenges is crucial not only to the overall user experience but also to the future growth of DeFi projects. Users might avoid low-liquidity blockchains due to fears of high slippage or difficulties exiting a large position. This calls for a more robust approach to developing modular blockchain architectures that address these interoperability challenges head-on, ensuring the potential of this innovative technology is fully realized.