This article explores how L2 affects value capture on L1?
Author: Michael Nadeau
Original compilation: 0x 11 , Foresight News
This crypto winter, the growth of Ethereum scaling solutions is one of the few stories that continues to be watched by the market. Transaction fees are falling, applications are migrating to L2, TVL is growing; at the same time, user experience is getting better.
L2 has come to a bright moment, but how does it affect ETH on L1? Should ETH holders and validators consider L2 as a complement to Ethereum? Will value accumulate in the tech stack? What does this mean for other L1 public chains?
This week we have a data-based update covering the economics of the Web3 tech stack as it relates to L2:
L2 business model and near-term growth
How L2 Affects ETH Economics
Investor's Mental Model/Framework
Do we still need L1 contention chains?
L2 business model and near-term growth
L2 attempts to solve the scalability problem of Ethereum L1. They make a profit by compressing data and "reselling" Ethereum's block space. L1 is slow and expensive, with limited block space. Therefore, we should think of Ethereum as the final clearing and settlement layer of the technology stack. The base layer records the final state of everything that happens on the execution and application layers above it—as the single source of truth.
Execution services that enhance the user experience (lower costs, faster transactions) for the application will be handed over to Layer 2. These services are executed on another chain than Ethereum, and the data is then recorded into L1. Below is a simplified view of the technology stack.
Most of the computing resources (Gas) are currently consumed in Ethereum L1, which is where applications are initially built. Remember, the Web3 stack has no centralized party coordinating development activity (nor does the Internet), everything is open source. Builders are scrambling to get in, but not everyone is working on the same schedule or with the same agenda. This is not the well-coordinated agile sprint you see in well-run tech companies. L1 infrastructure and applications are under construction until the scaling solution is available. As L2 breaks out, we expect to see more application migrations, and new projects may start directly on L2 in the future.
The data reveals this trend, so let’s take a quick look at the total computing resource (Gas) usage on Ethereum, and how the top L2 is consuming resources now.
Data source: Arcana Analytics
Arbitrum and Optimism now take up more block space than Polygon. Collectively, these three L2s make up about 4.5% of the current Ethereum block space, up from about 3% by the end of 2022.
Next, look at other data in L2:
Note: Year-to-date in 2023, the average fee per transaction on Ethereum L1 is $4.84.
As mentioned earlier, L2 serves applications by providing a better and cheaper experience for users. They purchase block space on Ethereum L1, then compress data, package transactions, and finally record data proofs on Ethereum.
But are all L2s created equal? Are they all complementary to Ethereum?
L2 and ETH economics
Before L2, when Ethereum became congested, transaction fees would skyrocket. At one point in 2021, fees could even go as high as $200 for a transaction. Using Ethereum during the adoption cycle is a bit like trying to hail an Uber after a delayed flight, too much demand and not enough supply.
L2 is designed to solve this problem. But what exactly happens when a user pays 21 cents on Arbitrum today? How much did Arbitrum reap in fees? How much do validators earn?
How much value does the baker get when you buy a sandwich at a coffee shop? How much should meat producers be paid? How much to the dealer? How much are the toppings and condiments? What's so special about a sandwich? What brings the most value? Is everything else a supplement?
This is something we should be thinking about in terms of L2 and the economics of the Ethereum tech stack.
The answer is that by 2023, about 62% of the fees paid by users in Arbitrum have been paid to Ethereum validators. Since its inception in 2021, 64% of all fees have been paid to Ethereum validators.
Meanwhile, 80% of the fees generated through Optimism are now owned by Ethereum validators. Since its inception in 2021, 74% of all fees have been paid to Ethereum L1. The following is the data provided by Token Terminal:
It's a win-win situation. Application users get superior execution and lower fees, further driving more use cases, more developers and ultimately more users. Ethereum validators will benefit in the form of transaction fees, and passive holders will benefit from increased transaction volume driving demand for Ethereum. Meanwhile, Optimism and Arbitrum benefit from Ethereum’s network effects, essentially outsourcing their consensus and security costs to the base layer.
What about Polygons?
Polygon is a sidechain of Ethereum, which makes it different from Optimism and Arbitrum. As a sidechain, Polygon has its own set of validators. So it has its own consensus and security, unlike Optimism and Arbitrum "consistent" with Ethereum.
CheckCheckThe main source of Ethereum burns to understand this. Arbitrum and Optimism topped the leaderboard, while Polygon came in third from the bottom despite handling a high volume of transactions.
In conclusion, not all L2s are created equal. Sidechains like Polygon operate more like their own L1, while leveraging Ethereum for ultimate security and settlement guarantees. Rollups like Optimism and Arbitrum really rely on Ethereum for consensus, security, and data availability.
When we analyze the economic impact on Ethereum validators and ETH holders, we believe that Rollups such as Optimism and Arbitrum are complementary to Ethereum. They can create net new demand for block space by providing app developers with a superior user experience. At the same time, most of the value processed by their solution ends up going to Ethereum validators in the form of transaction fees, and to passive ETH holders in the form of fee burns.
Polygon seems to have little complementarity to ours. In fact, it looks like Polygon holders and validators benefit more from its tight connection to Ethereum.
Investment perspective: How to understand complementarity?
Every product on the market has substitutes and complements. A substitute is another product you might buy when the first product is too expensive. For example, chicken is an alternative to beef. Complementary goods are products that you usually buy together with other products, think gasoline and cars, or bread and hot dogs. All else being equal, when the price of a product's complement falls, demand for that product increases.
Now, if L2 is complementary, and they keep reducing costs for a superior user experience, what does this mean for ETH?
We think ETH will continue to capture most of the value generated by L2.
An analogy might help highlight our thinking: let's compare Ethereum, Google, and the Internet. We think owning Ethereum might be like owning a piece of the internet, or an important protocol that runs the internet. Now, Google sits on top of the Internet Protocol. Google is great, it solves the search problem on the internet. In this way, Google has enhanced the usefulness of the Internet and brought more users. Now, let's say that every time someone uses Google to search, 6 cents goes to Google and 14 cents goes to the Internet Protocol. Which would you choose as an investor? What if Google was just one of thousands of applications running on the Internet (Ethereum)?
Likewise, Arbitrum and Optimism are addressing important questions. We think they will drive more users to Ethereum. But we cannot ignore the fact that about 70% of the value today belongs to ETH validators and holders. The market seems to be valuing the security, decentralization and settlement guarantees of the execution services provided by L2.
Does this mean investors should avoid L2? There are definitely some nuances here. We think Ethereum could reach a trillion dollar market cap in the next bull run. If L2 continues to charge 30% of user transaction fees, and all transactions (or the vast majority) go through L2 in the future, then one could argue that they could get 30% of Ethereum's valuation, which would be 300 billion The expected market value of the dollar.
In this line of thinking, L2 still has a lot of upside. Keep in mind that only about 4.5% of the gas used on Ethereum today runs through L2. Having said that, the top three L2s combined generate 6% of Ethereum’s transaction fees, yet have a fully circulated market cap of 14% of Ethereum’s.
investment method
Our current thinking is that a few L2s are likely to capture most of the value in the second layer of the technology stack. This is what we have observed so far and is consistent with the power law dynamics we observe across the Web3 technology stack. We'll also be looking at Coinbase's release of L2, Base, later this quarter.
Another way to think about it is to compare owning ETH to owning an index fund. Just as new companies rotate in the S&P 500, L2s & Apps will rotate in and out of the Ethereum ecosystem. Ethereum validators and ETH holders will benefit from it. Just as SPY holders benefit from strong new business being added to index funds.
We think investing in L2 and Apps is more like picking stocks than picking ETFs or indices. Of course, in this case, the (ETH) index still represents a bullish option on the future of Web3.
Do we still need L1 contention chains?
If L2 is solving Ethereum's scaling problem, what is the value proposition of alternatives like Solana, Avalanche, and Cosmos?
First, let's quickly run through some numbers to compare Solana's performance.
Solana is still more than 10x more efficient than Polygon, the most scalable L2 (sidechain) on Ethereum today. Solana also dominates in terms of developers and has a strong user base of more than 380,000 per day by 2023. Having said that, TVL reveals the benefits L2 has gained from its “alliance” with Ethereum. L2 doesn't have to channel its own TVL like Solana does. I guess this is why SOL validators can keep 50% of transaction fees (of which 50% is burned), while Arbitrum and Optimism only keep about 30% in total.
But how does Solana's monolithic approach to scaling compare to Ethereum's modular approach via L2?
Solana bundles settlement and execution services into the same solution, which is unique compared to Ethereum and alternative L1s like Cosmos and Avalanche.
The modular approach taken by Ethereum, Cosmos, and Avalanche creates many additional complexities related to interoperability, security, centralization, data availability, etc., which Solana does not have to deal with.
We believe Solana is distinctly different from Ethereum and other competitors due to its unique overall architecture. In fact, Ethereum's approach to scaling via L2 is starting to look very similar to that of Avalanche and Cosmos. So why would a developer choose an Avalanche subnet or a Cosmos AppChain if they could deploy on an Ethereum Rollup and have instant access to Ethereum's liquidity and network effects?
In summary, we see Solana as an alternative to Ethereum, not a complement to Ethereum. In our opinion, this makes Solana the most interesting alternative. The L1 opportunity in the Web3 technology stack - this is why we took a position in the web during the market dislocation earlier this year. We reported on the project in early January. We also recommend using the network, wallets, apps, staking services, and more. We believe Solana currently offers the best crypto user experience.
in conclusion
in conclusion
Ethereum L2 is growing and becoming more efficient. It’s still early days, but there are indications that Rollups are very complementary to ETH, as validators and holders earn 70% of fees through them. This is not the case for sidechains like Polygon that run their own validators.
L2 margins for Optimisim and Arbitrum need to be monitored. As more and more competitors enter the space, we expect margins to decline significantly, but we will continue to focus on the numbers. Zero competition could eventually commoditize the execution layer of the technology stack.
Since L2 is complementary to Ethereum, we believe that as L2 costs decrease, demand for Ethereum-based applications will increase, bringing more value to validators and ETH holders. Note that transaction volume flowing through L2 eventually needs to grow faster than fees fall.
As solutions like Arbitrum and Optimism mature, the scaling approach of the Ethereum ecosystem appears to be converging with those of Cosmos, Polkadot, and Avalanche. For example, Optimism's "hyperchain" looks similar to the Cosmos Hub or Avalanche's C-Chain.
Investors have a range of options when configuring their portfolio in the Ethereum ecosystem (ETH, L2, oracles, cross-chain bridges, applications/protocols). Having said that, ETH appears to have more attractive returns due to L2 Rollup complementarity. Additionally, investors should consider that sidechains like Polygon are less "consistent" with Ethereum and act more as an alternative L1 while leveraging Ethereum's network effects and EVM standards. We believe Polygon has stronger value-add potential than Rollup. In some respects, Polygon should be compared more to Solana than to Optimism and Arbitrum.
We believe that Ethereum's L2 growth and scalability will destabilize the value proposition of L1 competing chains with similar scalability approaches - such as Cosmos, Avalanche, and Polkadot. But Solana is significantly different because it takes a single approach to scaling (settlement and execution are bundled).
