- Ethereum is up 22% in the past year as of September 2023, outperforming most large smart contract blockchains. Layer 2s (L2) have played a substantial part in driving value to Ethereum
- Layer 2s can supercharge Ethereum’s scalability, making the network 100x cheaper for users
- The launch of BASE – a Layer 2 blockchain on Ethereum– by Coinbase in August signals a substantial endorsement of Ethereum ecosystem and opens up distribution of decentralized applications to 100 million Coinbase users
- Meanwhile, the largest Layer 2 blockchains built on Ethereum, Optimism and Arbitrum, have surpassed large Layer 1s like Solana in Total Value Locked (TVL). If Layer 2s continue their trajectory they could potentially solidify Ethereum as the leading Layer 1 blockchain
This piece will (1) explain what Layer 2s are and why they’re important, (2) detail recent significant growth by BASE, Arbitrum, and Optimism, (3) outline the broader Layer 2 competitive landscape, and (4) explain centralization risks posed by Layer 2s.
Layer 2s are pivotal to scaling Ethereum
Critics sometimes claim there’s a lack of utility in crypto, as if blockchains were like empty highways without any cars. However, Ethereum’s need for Layer 2 scaling solutions directly suggests the contrary. When a highway becomes so crowded with traffic that express lanes must be constructed, it signifies high levels of utilization. This is akin to what happened with Ethereum and what necessitated the development of Layer 2s.
As a network attempts to process larger amounts of transactions, heightened demand constricts available blockspace and increases gas fees. By May 2022, increased Ethereum usage raised the average gas price for a single transaction to $196[1], many times larger than the average of about $2 just two years prior[2]. Not only did this make user experience on the Ethereum network expensive, difficult, and increasingly time inefficient, it also paled in comparison (at ~14 transactions per second[3]) to other networks like Solana that are capable of up to eight thousand transactions per second[4].
Enter Layer 2 scaling solutions, which solve the problems that were plaguing Ethereum. Layer 2s process transactions from decentralized applications and then “batch” them together before sending a compressed version back to the main network (Ethereum) for settlement, acting as a side road or even a new bus lane augmenting the main highway.
Figure 1: Ethereum Architecture Illustration
Source: Based on Delphi Digital graphic, For Illustrative Purposes Only
Why do Layer 2s matter?
Since Layer 2s batch and send a compiled version of transactions to Ethereum, they can offer fees up to 100x less[5] than on the main chain. In the event that a Layer 2 network goes down, users can port their assets back to the Layer 1 network, recovering them on Ethereum. As a result, Layer 2s increase usability and the transaction potential of the overall Ethereum ecosystem while still relying on the underlying strength of Ethereum—its network security.
How does this impact the value accrual of ETH?
As the network scales, more activity can move to cheaper Layer 2s. In return, Layer 2s, directly accrue value back to Ethereum. Specifically, for every transaction on a L2, a user pays a transaction fee. The L2 keeps a portion of that fee (currently averaging around a 24% margin) while the Ethereum network receives the remaining ~76%[6]. For every transaction sent by a L2, the Ethereum network also burns a small portion of total ETH supply. As a result, incremental activity on Ethereum Layer 2s directly accrues value to ETH.
In the future, the success of Layer 2 solutions could go a long way in validating the Ethereum model versus other Layer 1s like Solana or Avalanche, further entrenching Ethereum as the leading Layer 1.
Coinbase Foray Underscores Relevance
Figure 2: BASE Daily Transactions Surpass Ethereum & other Layer 2s
In August, possibly one of the more compelling developments in crypto this year occurred: Coinbase’s Layer 2 scaling solution built on Ethereum — BASE — went live. BASE opens up distribution of the dApps built on the BASE Layer 2 to the entire Coinbase ecosystem of over 110mm users[7]. With Coinbase’s institutional support for ease of use and integration with its other products, we believe BASE has the potential to serve as a significant new conduit for onboarding mainstream users into crypto.
BASE has already garnered notable traction. Just over a month after going live, BASE surpassed Layer 2 competitors as well as Ethereum itself in daily transactions, hitting over 1 million on September 14th (Figure 2). Some of this progress can be attributed to viral growth of friend.tech. Launched on the BASE blockchain in August, friend.tech is a decentralized application that enables fans to gain access to exclusive chat rooms with influencers and creators in return for holding their tokens. From August 25th to September 25th, friend.tech has generated $19.9mm in fees, the third most fees out of any decentralized application throughout crypto, trailing only Lido and Uniswap[8] and generating significant activity for the BASE blockchain.
At this point in time, while BASE has no plans to launch a token, Coinbase itself is in charge of the processing and batching of transactions. While it is run in a centralized manner today, BASE has announced a commitment to progressively decentralize[9] over time. In addition to producing revenue for Coinbase, BASE—like any Layer 2—accrues value to Ethereum. BASE also shares a portion of revenue with fellow Layer 2 Optimism as a part of the Optimism Collective (more on this later).
The Broader Layer 2 Ecosystem
Figure 3: Adoption of Ethereum Layer 2s Gaining Momentum
Beyond the recent developments of BASE over the past few months, Layer 2 scaling solutions have been growing in usage consistently over the past year as aggregate Layer 2 daily active addresses outpace leading Layer 1s. Perhaps just as significant of a signal, however, could be total value locked (TVL), which indicates the extent to which users are perceived to trust a particular chain with their capital. Somewhat remarkably, top performing Layer 2s including Arbitrum and Optimism each surpass Ethereum competitor Layer 1s in Solana and Avalanche in TVL (Figure 4), which speaks to general trust in the Ethereum ecosystem as a whole as well as the traction of scaling solutions.
Figure 4: Arbitrum and Optimism TVL rival and surpass Ethereum Layer 1 Competitors
Spurred by notable developments such as the ARB token launch in March 2023, Arbitrum has established itself as not only one of the leading Layer 2s but also one of the leading smart contract blockchains. Arbitrum currently has the third most TVL of any smart contract blockchain at $1.69bn, trailing only Tron[10] and Ethereum itself. While Arbitrum hosts a number of large decentralized finance (“DeFi”) apps such as Uniswap, Aave, and Balancer, its crown jewel is GMX. A decentralized perpetual exchange, GMX accounts for $420mm TVL (25% of total Arbitrum TVL)[11]. Currently, Arbitrum is the center for a flourishing ecosystem of development, leading all Layer 2s with 331 total decentralized applications on the network.
Optimism (OP), the largest Layer 2 by market cap, has performed the best out of any Layer 2 token since the beginning of 2023 (up 35% YTD[12]), which in part can be attributed to the Optimism Superchain vision and the announcement of BASE to participate. The Superchain is a standard for composability amongst L2s. Chains that decide to participate in the Superchain commit to development standards and contribute a portion of fees to the Optimism Collective that eventually go towards funding future ecosystem development.
Notably, one of the chains participating in this is BASE. BASE pays around 2.5% of the total fees it generates to the Optimism Collective[13] and adheres to Optimism’s “Superchain” standards, leaving a path forward to future interoperability. In exchange, BASE has a governance role as a member of the Optimism Collective. Other Layer 2 chains that have committed to the Superchain include Zora and the Public Goods Network[14].
Among the 31 total active Layer 2 projects listed by L2Beat, five currently stand out above the rest in terms of fundamental metrics. As seen below, Optimism and Arbitrum have market caps near $1bn and are the only projects with launched tokens. However, Starknet stands out today in terms of total developers working on its protocol while zkSync leads in terms of daily addresses and total transactions in the past month.
Figure 5: Leading Layer 2 Fundamentals as of 9/27/2023[15]
Figure 6: Leading Layer 2 Overview as of 9/27/2023
Decentralization score indicates progressive stages of decentralization from 0, not decentralized to 2, fully decentralized
Centralization Risks Posed by Layer 2s
These scaling solutions are all early in the process of decentralization, presenting certain risks. Harkening back to the “blockchain trilemma”, one might ask how a Layer 2 blockchain could be faster than Ethereum but still benefit from its underlying network security. The tradeoff here is that Layer 2s sacrifice decentralization.
At the moment, for the majority of Layer 2 blockchains, only one entity runs a “sequencer” that is responsible for processing and batching transactions on Layer 2s. This can lead to adverse outcomes such as outage risk as well as other potentially extractive actions such as MEV[16]. However, most Layer 2s have stated plans to decentralize this over time through what Vitalik Buterin calls decentralization “stages”. Of each of the leading Layer 2s, Arbitrum is the furthest along in this process with eventual plans for a “distributed committee” of sequencers to mitigate risk of value extraction[17].
Conclusion
Despite mainstream consensus of a crypto market downturn since 2022, the Ethereum ecosystem is growing. Many smart contract chains like Solana, Avalanche, Cosmos, Polkadot, and others have decreased in price since a year ago. In contrast, Ethereum is up 22% over the same time period[18]. Ethereum’s liquidity and network effects have allowed it to not only weather the storm of adverse macroeconomic and market events but also attract builders who are working to address its scaling challenges.
The contributions of Layer 2s not only validate the Ethereum model in theory but also serve as a flywheel, helping to drive value to ETH and attracting users and developers for dApps. At the same time, Coinbase is potentially clearing the path towards mainstream adoption of Ethereum-based decentralized applications with BASE. If certain alternative Layer 1s fail to gain traction and suffer as a result of small security budgets and lack of liquidity, consolidation as an Ethereum Layer 2 may become an attractive option.
While Layer 2s introduce significant scalability potential and reduce cost barriers on Ethereum, they are not without risks. In the end, Grayscale Research believes that the diversity of approaches across dozens of Layer 2 blockchains—along with open-sourced, shared standards—will foster competition and innovation, potentially paving the road for Ethereum to solidify itself as the dominant smart contract blockchain.
[5]L2 Fees and Bitcoin.com. The rollup capabilities as well as upgrades on Ethereum itself could enable fees of 100x cheaper
[7] Coinbase as of February 2023
[13] Cointelegraph. Base will pay either 2.5% of its revenue or 15% of its profits to the Optimism Collective, whichever is greater
[15] This chart depicts Fundamental metrics of top Layer 2s by TVL. Arbitrum and Optimism have launched a token while BASE, Starknet and zkSync have not. The market caps column represents market cap for the token.
[16] Maximal extractable value: the maximum value that can be extracted from a sequencer
[18] Coinmarketcap
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