What is Arbitrum and what does it mean for Chainlink (LINK)?

May 31, 2021 | Reviews

It is no secret that the current state of the Ethereum network is, in the nicest way possible, dogs**t.

The current gas fees are a joke and have marginalised any retail investor who has half a brain cell and can work out they will quickly go broke trying to interact on Ethereum.

The issue is caused by Ethereum’s own success. Increased DeFi, NFT and general crypto interest, has lead to a congested network. Those who can afford and are willing to pay more for gas, get to queue jump. Just like in real life, ehh?

If you are new to this whole layer1/layer 2 talk, let me put it in the most simple terms as physically possible. Ethereum is a layer 1 blockchain (the congested one). Building on top of Ethereum to allow it to scale is layer 2 (eases the congestion).

The way layer 2 scaling solutions ease congestion is typically by handling certain transactions and interactions away from the layer 1 mainnet and then feeding the info back to layer 1 so that all the records on-chain are kept in tip-top condition.

It’s a carpool lane for a busy motorway.

We have seen the recent rise of projects focussing on layer 2. The murmurs of the words Arbitrum have been on the lips of many for a few years now and if you speak to any LINK marine, they will be all over it.

Arbitrum is an optimistic rollup. 

Screenshot 2021-05-31 at 14.44.40.png

And no, it isn’t the last remaining hand-rolled cigarette at a party.

A rollup is a layer 2 scaling solution that handles smart contract transactions off-chain, bundles them up, rolls them back up and then deploys them back on to layer 1, in a single batched transaction as opposed to multiple individual transactions.

Now, that is such a basic premise of the sophistication behind a roll-up but this is a beginners article after all.

This is great because you reduce the transactions on the mainchain and ease up that traffic. A huge benefit is given back to the users too as the transaction fees using Arbitrum are expected to be around 100x less than Ethereum layer 1.

The easiest way to go through this is a hypothetical situation so bear with me whilst I take you through a terrible analogy.

Vitalik sees a high paying interest vault on yearn finance. If he deposits USDT he will yield 8% annually. But Vitalik currently has DAI. First, he needs to Swap DAI for USDT using Uniswap v3 which costs to approve the contract ($20ish) and then pay for the swap in ETH (upwards of $50+). Once he has USDT he now needs to approve the yearn Finance contract ($20) and then deposit his USDT in the vault ($20).

Vitalik, unless he is a huge giga-whale has just eaten into his yield by forking out over $100 to pull off this DeFi play. This is the standard currently on Ethereum Layer 1. Every step of the transaction will be handled on the Etehreum mainnet, which is currently ridiculously congested and hence the high gas fees.

Sergey now tries the same thing using Arbitrum. The same protocols are available (this will be happening soon). In the first step, he would need to bridge his tokens from Layer 1 to Arbitrum Layer 2. I can see this being frustrating at first but as liquidity improves so will the process. Once on Arbitrum, Sergey can approve the swap (<$1), execute the swap (<$1), approve the yearn Finance vault (<$1) and then deposit (<$1).

So, Sergey doesn’t have to be a giga-whale to enjoy the same great protocols as seen on Layer 1.

Make Ethereum Great Again.

M.E.G.A…

I know what you are thinking, I can hear it through the screen… If it is off-chain, how the hell is it decentralised?

Well, it is really quite clever…

As with all decentralised trustless networks, anyone can operate a node. A computer running the Arbitrum code that helps it verify transactions on the network.

Let’s take Uniswap for example, which is set to launch on Arbitrum which I can’t wait for personally.

They already have smart contracts written using the Ethereum programming language, Solidity. They will not need to re-write or re-code any of their existing smart contracts as they are already Arbitrum compatible. Very smart move…

Once they have chosen what smart contracts they want to deploy on to Arbitrum, they can package them together in an Arbitrum Virtual Machine (AVM). 

So when any of the Uniswap contracts is interacted with on Arbitrum it is done so by interacting with the AVM.

Each AVM (bundle of smart contracts) is then managed and watched over by an Arbitrum node.

This trusted node is then responsible to ensure that the transactions that are passing through it are legit.

If the protocol requires, it can assign multiple nodes (which is probably for the best) to watch over the AVMs.

So, how does the network secure itself from potential malicious validators/nodes?

If a set of nodes are watching over a series of smart contracts (AVMs) and one node says “Erm, guys I am not entirely sure that transaction is correct, I think it should be this”.

This effectively opens a disagreement case.

Now, there would only be a few reasons why a node would open a case.

  1. They truly believe that the transaction is false and want to correct it

  2. They are acting maliciously to gain from the transaction

  3. They have made a mistake and are assuming it is wrong when it isn’t

If the first is correct then the node would be required to stake ETH on their proposed outcome or truth.

If the other nodes agree they also stake on the proposed outcome. If they disagree then they stake on the original transaction.

Think of it as a checkers board you are at a starting square (1).

You can move in the direction of what you believe is the truth or you can continue to move in the other direction with the original transaction.

Once staked on the move left or right, the node cannot change its mind. This prevents any flip-flopping about.

In short, if validators can’t agree on the single point of the transaction in question, the case is then sent to the mainchain (layer 1) to be decided and whichever of the directions is correct, drives the protocol forward in that direction.

It is a lot more complex than that but the TLDR of it is that, if there are issues that cannot be determined, there is always the underlying layer 1 that can be called in for backup. As this will not be a common occurrence, this won’t slow down DApps running on Arbitrum.

For those who staked on the untruthful square (checkers board analogy), they will lose their stake.

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Alice is acting truthful and is rewarded, whilst Bob was an idiot and lost his stake. Be like Alice.

So, it pays to act truthfully and you will end up going broke if you are a serial liar or are dumb.

Nodes reputations are then a great indicator of the strength and reliability of their security. This then incentivises all nodes to act truthfully, as they will be tasked to verify more protocols and AVMs and hence make more ETH.

Even if 100 nodes (for example) are looking after an AVM. If 99 of them collude and try to act maliciously, it only requires 1 truthful node to act well and the other 99 would lose their stake (and rep).

The system is quite philosophical and is rooted in human nature and decency, but relayed in a way that it relies on code to act truthfully. It is amazing.

Oh, and those that lose their stake, lose it to those who are acting well and tell the truth.

The way it is structured is that a node would be set to lose more from staking on an untruthful square than it had to gain from the malicious move in the first place.

The process of taking someone’s stake from them if they place it on a wrong and malicious assumption is called slashing.

So, now we have an idea of how Arbitrum works, why the hell are the Link Marines so excited?

Well, Arbitrum has been talked about in the Link community for quite some time now, so the recent hype has been long overdue.

As Chainlink connects the off-chain to the on-chain (you can see where this is going), it was a natural fit for Arbitrum and Chainlink to buddy up.

As Arbitrum handles all of its transactions off-chain it requires a decentralised oracle network (Chainlink), to provide important information from the on-chain world.

When DApps (a series of smart contracts) like Bancor (BNT) is running, they are constantly fetching price data from multiple different on-chain and off-chain sources and they use Chainlink to verify the data is true.

For more on Chainlink head HERE. 

Now, that DApps that typically run on Ethereum layer 1 can seamlessly now run on Arbitrum (layer 2), the household Ethereum DeFi DApps that we all know and love will require all the regular oracle services that Chainlink offers.

But… and this is a big but, as Chainlink already has a network of reliable and trusted nodes that have great past experience in decentralised off-chain data aggregation, Chainlink nodes can now be used as trusted nodes on the Arbitrum network.

So for example, you have a very reliable and trustworthy set of nodes called nodes: 1, 2 and 3. Their reputation is highly sought after on the Chainlink network as they have always delivered the best data and it has always been reliable/free from any bad acting.

These nodes can now simultaneously run the Arbitrum code and act as a node on both Chainlink and Arbtirum. So, their past work experience and reliable nature acting as a validator on Chainlink will serve them very well as a trusted validator on Arbitrum.

If a critical DApp requires the most reliable and premium nodes to ensure its DApp on Arbitrum runs smoothly without any hiccups, it may opt to choose nodes 1, 2 and 3 to be the validators.

Another super important reason why Arbitrum is the talk of the Link community is the fact that gas fees are cut dramatically.

Why is this important for Chainlink and its validator nodes?

Well, every time a transaction occurs on layer 1 the Chainlink nodes have to (like everyone else) pay the gas fee. At the current time, the majority of nodes that allow the Chainlink network to exist are running at a loss or a very slim profit margin.

This isn’t because their services are poor, quite the opposite, whatever they are making as an oracle data provider, they are effectively paying out to transact on Ethereum.

This is obviously not good and there isn’t a real incentive for node operators to join or continue at the minute with the current price of ETH gas.

So once they get to operate on Layer 2 as a regular oracle service provider and a trusted Arbitrum node, you can see how running a successful Chainlink node can begin to look a lot more appealing.

Another thing, now this is purely speculation, so don’t hold me to this but I think it is relatively obvious if you follow the blockchain explorer Etherscan.

I believe a lot of the FUD surrounding “Sergey is dumping on us” is nonsense. But, the reason a lot of LINK changes hands from large wallets is for a few reasons.

The first being, Chainlink have a grant foundation. Similar to the Ethereum, Foundation which supports upcoming projects by granting them some ETH to develop and contribute to the Ethereum ecosystem. Chainlink also does this but they get an angry mob coming after them for some reason, narratives are ridiculously strong in crypto and we live in a post-truth world.

So, it doesn’t matter what is true or not, whoever shouts the loudest wins.

Anyway, back to speculation… The second reason I believe a lot of LINK changes hands is since Chainlink has potentially subsidised the current node operators to keep the network running. As they are being stung with high ETH gas fees, it isn’t crazy to suggest some of the Chainlink grant funds have been allocated to keeping the validators afloat.

So, getting back to Arbitrum. As and when the layer 2 solution expands with all the usual DApps and protocols Chainlink nodes will not have to fork out ridiculously large ETH gas fees each time they submit a transaction as everything is handled off-chain.

Looking deeper into the profitability of Fiews (Highly trusted Chainlink validator node), it doesn’t look all that appetising at the minute to run on Layer 1.

These are taken from the 22nd of May which seemed to be a busy day for the Chainlink validator.

The rewards came in at around 1894 LINK ($45,456 at an average price of $24/LINK) whilst the gas fees paid by Fiews was 16.62ETH or around $44,185. Net profit $1271.


Screenshot 2021-05-31 at 15.21.21.png

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Whilst this may be okay for a select few validator nodes which can run at a profit with lots of requests per day, if Chainlink wants to maintain a truly decentralised oracle network, it can’t allow a handful of nodes to handle the whole network.

To incentivise other smaller nodes to become big players, there needs to request for them to fetch off-chain data and there also needs to be incentives.

Arbitrum and layer 2 can create an environment where smaller and emerging Chainlink nodes can operate at a healthy profit margin and be able to get their foot in the door as a respected validator. It is vital, in my opinion, that newer nodes become a bigger part of the Chainlink network and increase the decentralisation.

This means that nodes operating on Arbitrum will quickly become profitable. Also, those that are running on layer 1 will see the added benefit of congestion easing. As a lot of protocols are running on layer 2, it will reduce the traffic and gas fees of those remaining on layer 1. Win-win.

Now, I have no idea if a large amount of LINK is actually given to subsidise nodes in the oracle network, but if it has been and it is also being sold to pay for maintenance and operations etc, we might also see a reduced selling pressure across the board.

I think this might allow the LINK price to climb as Arbitrum gets off the ground and the network effect will be exponential for Chainlink.

There are a few other areas that Chainlink and Arbitrum are working on together like the Verifiable Randomness Function (VRF) that allows a trusted random number to be written into DApps. This would be 100% necessary for things like NFTs, gaming or DApps that offer lotteries and gambling services etc.

Also, fair sequencing is a hot topic that will benefit from Arbitrum too.

Due to the speed and frictionless transactions on Arbitrum, Chainlink’s fair sequencing service (FSS) prevents front-running bots from participating in the network.

The long and short of front running bots are that they effectively see the transaction you are about to execute and can increase their gas price so they cut ahead of you. If they do this before you, they could increase the price of the coin (if slippage is high) and immediately sell it back to you at a higher price and turn a handsome profit for a few seconds work.

Millions and millions of dollars are made every year by these bots and all at the expense of DeFi users. FSS and Arbitrum will be a great addition to any protocol that plugs it into their DApp.

I have probably missed a lot of stuff off here but I might revisit this one soon once the full rollout begins.

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