Layer1 to Layer2 transformation, discussing the business insights behind "Ethereum L2".
Original Author: David, TechFlow Research
Doing L2 seems to have become a trend recently.
From emerging projects to established public chains, everyone is actively exploring and implementing L2 solutions.
On July 17th, Mantle Network, a modular L2 solution using Optimistic Rollup, incubated by BitDAO, went live on the mainnet;
On July 18th, Linea, an L2 solution developed by Consensys, the parent company of Metamask, also released its mainnet Alpha version;
Earlier, Coinbase also announced the testing network of its L2 solution BASE.
Recently, even the established public chain Celo proposed in its internal forum to change its development direction from being an independent Layer 1 public chain to an Ethereum-compatible L2 solution.
I vaguely remember the battle of new public chains two years ago, where various factions appeared with the intention of being an "Ethereum killer," attempting to "kill" Ethereum; but now, the focus is on L2, resembling more of an "Ethereum builder," aiming to "share" Ethereum's performance issues through technical optimization.
These are two completely different approaches: the former is direct competition, while the latter is elegant parasitism.
Now, why is everyone enthusiastically embracing L2 instead of rushing to launch new public chains? Is it because new public chains are no longer appealing, or is L2 truly able to bring new narratives and profits?
L2, a faster and more effective business
We won't dwell on solutions like Mantle and Linea, which were specifically built for L2 from the start. Their external narrative revolves around improving ETH scalability and reducing fees to create better interactive experiences for applications and users.
As for Celo, an L1 public chain choosing to do L2, the initial intuitive reaction is to see it as a "compromise and reversal" – a public chain competing with ETH and solving Ethereum's shortcomings through a "don't break, just improve" approach, claiming "I can do it better myself"; and then, in turn, choosing to become Ethereum's L2, giving a sense of surrender and joining.
In this regard, let's see how Celo portrays it:
The benefits brought by compatibility, security, and liquidity are indisputable, but the author believes that they don't touch upon the core interests: what determines whether a project chooses to independently develop a separate L1 or to parasitically leverage Ethereum and expand through L2?
The answer lies in cost and benefit.
The article "Doing Rollup is a Good Business" from Lightning HSL provides a great perspective on business: whether it's developing L1 or L2, the goal is to solve existing problems and create value. However, from a business point of view, L2 seems to be more profitable.
Business Model: L2 --> Equivalent to ETH main chain --> Lower gas fees, faster speed --> Attract dapps and users --> Increase on-chain transaction volume;
L2 Revenue: Gas fees paid by users on L2;
L2 Expenses: L2 operators regularly batch and upload Rollup transactions to Ethereum L1, incurring gas fees;
The difference between revenue and expenses is the approximate gross profit of operating L2 rollup; therefore, the more applications and TVL on L2, the more user transactions can be generated, allowing L2 operators to increase revenue and improve profits, while expenses remain relatively fixed.
In terms of cost, Rollup does not require the development of complex consensus mechanisms and theoretically does not require tokens (even though current projects have them). It only needs a minimum of one server to start and run. The core technical components can be built using Optimistic or Arbitrum, which means there's a complete open-source solution and the difficulty is certainly lower than building a standalone L1.
In comparison, the cost and difficulty of developing a new public chain (L1) are much higher:
First, you need to develop a consensus mechanism that the market can accept, which requires a lot of R&D resources, time, and accumulation;
Second, you need to attract enough nodes to participate in your network to ensure its security and decentralization;
Finally, you need to construct some differentiated narratives, such as focusing on privacy or security, etc...
At the same time, the data also supports the analysis of cost-benefit.
According to data from Token Terminal, in the past six months, among the top ten projects by revenue, only Ethereum, Tron, and BNB Chain made it to the list based on the public chain layer alone, while Arbitrum made it to this ranking in the L2 category. Considering the difference in construction time between these L1 chains and Arbitrum, it's evident that Arbitrum has a better cost-benefit ratio in terms of pure revenue.
In addition, in a bear market environment, it's more difficult to raise funds from VCs and gain trust from retail investors. Creating a new L1 inevitably involves obstacles from primary to secondary markets, and it becomes significantly more challenging for project teams to monetize tokens through the capital market. Therefore, doing an L2 is clearly more practical and cost-effective.
Instead of building a unique public chain from scratch, which requires a large investment and takes time to see results, it might be better to parasitize on Ethereum's Layer 2 (L2) solutions. This requires a smaller investment and allows for relatively faster results.
Furthermore, the "traffic business" is crucial, which refers to where users come from.
As mentioned earlier, Total Value Locked (TVL) and transaction volume are key factors for L2 solutions to generate revenue, and this depends on attracting more users.
If platforms like Coinbase, Metamask, or Binance adopt L2 solutions, they can naturally onboard existing users from their centralized exchange or wallet services by integrating with L2. This gives them an unparalleled advantage in terms of customer acquisition costs.
Even for Layer 1 (L1) solutions like Celo transitioning into L2, they can migrate their existing users from L1 with additional incentives and guidance.
However, regardless of the chosen approach, most projects and capital providers start with their own product ecosystems or the existing user base within the Ethereum ecosystem to initiate L2 adoption. They can then expand into other collaborative scenarios (similar to Polygon's initiatives in the Web2 sector).
Is L1 the Dead Sea while L2 approaches saturation?
The previous analysis focused on internal characteristics of L1 and L2 solutions. However, when considering the external competitive environment, the choice to adopt L2 becomes more understandable.
According to data from DeFiLlama, there are currently nearly 200 public chains in the market. Excluding dozens of L2 solutions, this means we face approximately 190 L1 public chains.
Therefore, the current L1 sector is more like the Dead Sea: oversaturated, with fierce competition.
Only a few public chains occupy user mindshare, especially considering the recent black swan events and capital withdrawal. Many once-prominent public chains are no longer visible in terms of user activity, revenue composition, transaction volume, and other key metrics.
Most L1 solutions still exist in concept, but they lack vitality. Jumping into the Dead Sea for business purposes is not a wise choice.
In contrast, the situation is slightly better for L2 solutions.
Looking at the overall TVL, L2 solutions continue to experience growth over time;
In terms of competition, L 2B eat has recorded 26 L2 solutions, which face around one-seventh of the competitive pressure compared to L1. While Arb and OP currently hold significant market shares, other projects have a relatively scattered and average market share. This provides opportunities for new players to emerge as major competitors.
However, considering the technical architecture, there are already typical representatives of different technology stacks for L2 in the existing market:
Optimism and Arbitrum, which use Optimistic rollup;
Zksync and Starknet, which use Zk-Proof;
Base, which is built on OP Stack;
Linea, an EVM compatible chain launched by Consensys;
Zk-EVM and more, launched by Polygon....
Although it is not a blue ocean, there are still opportunities compared to L1.
With the completion of Ethereum's technical upgrades this year and several subsequent upgrades, the narrative around performance will continue for a long time. L2 still has a considerable development window. At the same time, in the bear market, there are not many narratives and tracks that can maintain popularity. In the environment of attention and scarce funding, L2 also has the advantage of continuous attention.
Therefore, from the perspective of competitive landscape and external environment, it seems profitable to do L2 business.
Who does L2 business serve?
Outside of business, the author feels a sense of "redundancy" in the circle.
We often see projects migrate from one L1 to another, from supporting one L2 to supporting more L2. Projects run across chains, and chains themselves are also increasing.
Switching to a new ecosystem allows for another round of land grabbing, gathering resources and capturing users. L1 and L2 are to some extent like undeveloped colonies. Ignoring the differences in technical details, the same business can be done again in a different place.
Do we really need so many "places"? Who do these many places serve?
Capital needs, speculative needs, scam needs, storytelling needs... The only thing that may not be needed is normal needs.
If all L2s are indiscriminately talking about lower fees and faster speeds, what is their essential difference?
After all, as end users, the technical process is not important. When the results of use are consistent, the increasingly bustling L2s can be used interchangeably.
History has shown that after a round of new public chain movements, Ethereum is still Ethereum and has become stronger in competition.
Is it also the case for the current state of L2? From blue ocean to red ocean to dead sea, after a round of cash scattering, the project density becomes larger and larger, and in the end, only one or two will stay on the surface, while there may not be many users in the pool.
The business experience of L2 can be effective quickly, but hopefully it won't be a case of exploiting the last resource.
