Exploring L2 economics and business models, will Ethereum迎来 a "bandwidth" moment?

Original Title: “Layer 2 Economics”

Author: Michael Nadeau, The DeFi Report

Compiled by: DeFi Dao

This week we will revisit Layer 2 scaling solutions in the Ethereum ecosystem.

Topics covered:

• Why do we need L2?
• Features of Layer 2 scaling solutions
• Economics and business models
• Impact on the underlying Ethereum tech stack

Why do we need L2?

Anyone who used Ethereum during 2021 knows that the chain can become very congested. This is a classic problem—too much demand and not enough supply. As a result, gas fees (transaction fees) became quite expensive. At the peak of the bull market, sending a transaction on the Ethereum blockchain cost nearly $200. This is not scalable. But it tells us a few things.

First, Ethereum block space is extremely valuable. Some say Ethereum block space is the "New York City" of today's ecosystem. This is a great point.

The second revelation is that Ethereum's product roadmap is still in a very early stage. It cannot support today's billion users. To support more users, applications, and use cases, Ethereum must scale on Layer 2.

It is worth noting that the demand for block space may always exceed supply. Why? Because historically, all significant computing resources have been like this. CPU, GPU, memory, storage, and wired and wireless bandwidth all provide useful proof.

As Chris Dixon pointed out, the computing movement often has a mutually reinforcing feedback loop between applications and infrastructure. For example, smartphones have seen significant improvements over the past decade. Meanwhile, most of the value we derive from phones comes from the applications on them. As applications improve, more users flock to smartphones, allowing manufacturers to invest more in the underlying infrastructure of phones—driving a reinforcing feedback loop between the phone (infrastructure) and what people use (applications).

We can observe this phenomenon today on Ethereum.

As Ethereum applications improve, more users flock to Ethereum. As more users flock to the blockchain, we encounter scalability issues. This drives the need for reinvestment in infrastructure to support more users, better applications, and improved user experiences.

Ethereum is preparing for its "broadband" moment. Layer 2 can be seen as the broadband for blockchain applications. As infrastructure improves, applications will also improve. This should drive user demand, leading to better applications and further investment in more scalable infrastructure.

Layer 2 Features

We can think of Layer 2 blockchains as "block space dealers." Essentially, what they do is purchase block space on Ethereum, make it more efficient (compress data), and then resell it to users and applications seeking lower transaction fees and higher throughput.

A quick analogy: we can think of it like using zip files when sharing information. Sometimes we want to send a very large file or many files at once. However, our computers often lack the storage space needed to send these files, so we create a "zip file." This compresses the data and allows for more seamless sharing.

Another way to think about it is how credit card transactions relate to our bank accounts. Credit cards are an extension solution for bank transfers. Similar to L2 on the blockchain, credit cards like Visa can batch transactions and then settle with banks on the underlying layer. This reduces fees and increases throughput/scalability.

Similarly, Ethereum's Layer 2 scaling solutions batch transactions from the L1 main chain, compress data, and then anchor it back to Ethereum to ensure the security and proof of transactions. This increases throughput and lowers costs—without sacrificing the functionality and security of Ethereum smart contracts.

Thus, applications initially deployed on the Ethereum base layer are moving to the upper layers of the tech stack to be deployed on Layer 2 solutions like Optimism and Arbitrum. If you're curious, you can check out the various applications on Ethereum and the additional chains they are deployed on here.

Currently, a total of $24 billion in value is locked in the Ethereum ecosystem. Of this, $4.38 billion is locked in applications utilizing Layer 2 scaling solutions. Optimism currently has 79 projects, while Arbitrum has 128 projects.

Source: L2 Beat & DeFillama

Economics and Business Models

Optimism and Arbitrum are the leading Layer 2 solutions on Ethereum today. In fact, over the past 6 months, they ranked 6th and 7th in transaction fees among all cryptocurrency projects. Both have charged $6.4 million in fees. This significantly exceeds alternative Layer 1 blockchains like Avalanche, Polkadot, Cosmos, Cardano, and Near. Over the past 6 months, Solana ($8.4 million) and Binance Smart Chain ($132 million) are the only two alternative L1s with more active economic activity.

Here is the daily fees (green) and daily active users (purple) for Optimism over the past 180 days:

Source: Token Terminal

Here is the percentage of Layer 2 transactions relative to the total ETH gas fees (representing total transactions):

Image Source: @funnyking on Dune Analytics

Optimism generates revenue by charging users (who are interacting with applications using Optimism) while still leveraging Ethereum's functionality and security at the base layer. Like any business, Optimism creates value for others and takes a portion of that created value as revenue. In this case, Optimism's technology improves efficiency by compressing transactions at the execution layer of the tech stack, saving users on transaction fees. In fact, the team claims they have saved users over $1 billion so far.

The fees charged to users by Optimism are slightly higher than what they ultimately pay for block space on Ethereum. This difference is their profit. Additionally, Optimism's "Sequencer" is responsible for ordering, batching, and submitting transactions to L1. Since the "Sequencer" determines the order of transactions, it can also profit by extracting MEV. Today, these fees are used to fund ecosystem development.

When batch transactions are recorded to Ethereum's base layer, Optimism incurs costs. These costs are passed on to their users—who are happy to pay cheaper gas fees compared to Ethereum.

Token Economics

Optimism launched its token in June 2021 (Arbitrum has not yet launched its token).

(As a brief aside, we always prefer to see projects launch their tokens after achieving product/market fit.)

That said, Optimism users do not pay fees in OP tokens. Instead, they pay with ETH. Here is the current fee situation per transaction:

Source: L2fees.info

Because fees are paid in ETH, there is no mechanism for burning OP tokens. Instead, activities occurring on Optimism actually promote the burning of base layer ETH. Furthermore, since Optimism's sequencer (where transactions are sent, verified, and ordered) is currently centralized, there is no distributed validator or standard protocol inflation rate, as we see in Layer 1 blockchains. In other words, Optimism has outsourced its validators (security) to Ethereum's base layer.

This means that the OP token today is merely a "governance" token. Therefore, the value embedded in the token comes from the ability of token holders to vote on key decisions in the future, including whether to return a portion of transaction fees to token holders. This is a token model similar to that of DeFi applications like Uniswap.

The circulating supply of Optimism's token currently represents only 5% of the total supply at launch (4,294,967,296) and will grow at a rate of 2% per year. Here is the unlock schedule:

Source: Optimism Community Documentation

Conclusion: The circulating supply of tokens today is only 5%, and there is no clear or set inflation rate, making it difficult to predict the appropriate value of the OP token. The current market cap is $214 million, with a fully diluted market cap of up to $4.7 billion.

We believe there is significant value here due to product/market fit, usage, transaction volume/revenue, and early ecosystem development—especially collaborations with DeFi applications like Uniswap. However, given the uncertainty around token value accumulation, today's valuation of $4.7 billion seems quite high.

Nonetheless, the development company behind the protocol, Optimism Labs, raised $150 million in a Series B funding round at a $1.5 billion valuation last March. Here’s how we consider its relationship to the protocol (and token) value: investors in Optimism equity receive proportionally allocated tokens upon signing subscription documents. Why? This is where value is expected to be generated.

Optimism Labs and its investors hold 36% of the tokens. Therefore, if we value Optimism Labs at $1.5 billion and divide it by 36%, we arrive at a valuation for the protocol (the fully diluted value of the tokens) of $4.1 billion. In cases where insiders in Silicon Valley invest at similar valuations, how often does retail get such Series B investment opportunities? These are some questions worth pondering.

Impact on Ethereum

We believe scaling solutions are positive-sum for Ethereum. Layer 2s will usher in Ethereum's "broadband" moment. We think this will ultimately unlock many use cases that may not have been thought of yet. When we were using AOL, did anyone think YouTube was possible? Probably not. This was made possible by the throughput created by increased broadband.

As more applications are deployed on L2, this should bring in more users. This creates more demand for block space and generates more transactions, leading to more ETH being burned, thus bringing scarcity and value back to the ETH asset.

According to Ultrasound.money, Optimism is currently the 12th largest contributor to ETH burned in the past 30 days (652 ETH). Arbitrum is just two spots behind.

The key takeaway here is that L2s leverage Ethereum for security and functionality. They pay Ethereum for these services. If these solutions had their own set of validators to secure the network, they might not need to anchor data back to Ethereum—thus being seen as competitors rather than complements.

Conclusion

While mainstream media focuses on Sam Bankman Fried's (SBF) apology tour, the signal of the crypto winter so far has been the growth of Ethereum scaling solutions. L2 is quietly becoming the "execution" layer of the tech stack, while Ethereum serves as the "settlement" layer. The application layer of the Ethereum tech stack will ultimately be built on Layer 2 (and possibly L3). We believe this is Ethereum's "broadband moment," and we expect to see a surge of new use cases and applications in the next cycle—all made possible through new scaling layers.

In the long run, we believe L2s will be the main driver of value accumulation returning to the ETH tech stack's foundational settlement layer asset. Meanwhile, we anticipate that leading L2s will see significant value growth in the next cycle.