By Brett Munster
Core Thesis
The Ethereum blockchain has become the dominant platform underlying smart contracts with use cases in DeFi, NFTs, and others. However, its growth has been limited by the inability of the network to scale fast enough to meet demand. To solve this problem, developers have built a variety of solutions on top of Ethereum, which are called Layer 2 networks. These Layer 2s make settlement faster, allow the network to process more Ethereum transactions per second, and ultimately make transacting on Ethereum less expensive. We believe the combination of the dominance of Ethereum with these Layer 2 solutions that increase Ethereum’s usability and affordability will create opportunities for outsized returns both for ETH and Layer 2 tokens.
Introduction
At Blockforce Capital, we are constantly researching new developments to identify emerging trends within the crypto industry. Back in 2020, the rapid rise in the popularity and usage of DeFi applications highlighted the capacity constraints of the Ethereum network. At the time, we noticed network congestion increasing, transaction delays, and increasing gas fees on the network. As we watched this trend play out, we theorized that despite these challenges, the demand for smart contract functionality would continue to increase and other competing base layer blockchains would capture the excess demand from those unwilling to pay high gas fees on Ethereum. As a result, Blockforce made investments into Binance Smart Chain (BNB) and Solana (SOL). That thesis proved to be correct and by the end of 2021, those investments had grown 3,659% and 455% respectively.
The growth of alternative Layer 1 blockchains over the past two years has been the result of demand growing faster than Ethereum’s scaling capabilities. However, the progress of Layer 2 scaling technology has now reached a point that the Ethereum ecosystem can handle this increased demand. Hence, the next evolution of our thesis that started in 2020 is the rise of Layer 2 solutions on Ethereum.
We have conducted months of research and will step readers through how we reached our conclusions and developed our thesis for Ethereum Layer 2 investments. To do that, we need to start with the current state of Ethereum. Only then can we explore what Layer 2 technology is and where it is in its development, the impact it will have on Ethereum, and how we intend to capitalize on this trend.
The Current State of Ethereum
Operations performed on the Ethereum blockchain are paid in a unit called “gas,” which is priced in ETH. More complex operations cost more “gas,” while relatively simple transactions (such as a token transfer between wallets) cost less. Ultimately, “gas” is how the Ethereum blockchain measures transaction fees.
Over the last few years, usage of Ethereum has skyrocketed. According to data from Coin Metrics, Ethereum settled transactions worth over $7.7 trillion in 2021, which represents an increase of more than 500% over 2020. For context, this settlement value rivals the total purchase volume facilitated by credit card networks such as Visa ($8.9 trillion in 2020) and Mastercard ($4.7 trillion in 2020). It also far exceeds the total payment volume processed by fintech payment facilitators such as PayPal ($1.3 trillion in 2021).
As demand for Ethereum’s blockspace grows, the computational burden increases which causes congestion on the network. Miners, being profit maximizing entities, will prioritize the transactions of those willing to pay a higher fee to ensure their transaction is processed quickly. Transaction fees can therefore be thought of as the clearing price where this constrained supply of computational resources intersects with demand. For those unwilling to pay higher gas fees, transaction clearance on the Ethereum network slows considerably.
The average transaction fee on the Ethereum blockchain soared during the DeFi summer of 2020 and the NFT craze in 2021. As previously mentioned, individual transaction fees can vary substantially depending on the nature of the transactions. For example, the fee for an NFT sale on OpenSea is routinely 10x higher than the fee for sending ETH from one wallet to another. As a result, it was common during these times to have individual fees rise to hundreds of dollars per transaction. According to data obtained from Glassnode, users paid nearly $10 billion in aggregate transaction fees on the Ethereum network in 2021.
As impressive as the growth has been for Ethereum over the last few years, it has likely been suppressed due to high gas fees, which have curtailed mainstream adoption of DeFi and other applications. In addition to making the system less usable due to overcrowding, high transaction fees discourage new users, especially those with less financial means. Though the average gas fee is far lower today than it was in 2020 and 2021, it is still too high for most consumer applications and mainstream use cases.
Despite these challenges, Ethereum is still by far the leading smart contract platform on the market today. Ethereum boasts the largest developer ecosystem in all of crypto and the majority of DeFi and NFT activity still happens on the Ethereum network. One reason for this success, despite the higher fees and lower throughput compared to other competing blockchains, is that Ethereum offers the most decentralized, most secure, and most reliable smart contract platform on the market today.
Other smart contract platforms have sacrificed decentralization and reliability for scalability and lower costs. This isn’t to say that other smart contract platforms won’t continue to be valuable, it’s simply a recognition of the fact that there are tradeoffs that must be made when designing these systems. This is where Layer 2 solutions come in: they offer the best of both worlds – increased scalability & low fees without sacrificing decentralization and security.
What Are Layer 2 Networks?
A Layer 2 is a separate blockchain that runs on top of the Ethereum base layer blockchain. The main goal of a Layer 2 is to increase the transaction speed (faster settlement) and transaction throughput (more transactions per second).
Layer 2s work by bundling (or “rolling up”) hundreds and even thousands of transactions that then settle on the base layer as a single transaction. Layer-2 networks also compress the transactional data before settling on Ethereum thus reducing congestion on the Ethereum network. According to Ethereum Founder Vitalik Buterin, rollups can decrease the data footprint of an individual transaction by ~90%. By offloading the transactional burden to Layer 2s, the base layer becomes solely responsible for security, data availability, and decentralization thereby making the whole ecosystem more efficient.
Layer 2s are also able to drastically reduce transaction fees for the end user. While the gas fee on the Ethereum base layer remains the same, Layer 2s can distribute that fee across all transactions in the batch, making it much cheaper for the end user. For example, as we write this, it typically costs $5 – $25 to perform an operation on the Ethereum base layer. However, transactions on some of the largest Layer 2 networks operating today cost on average 10 cents to one dollar.
Furthermore, by posting transaction data onto the base layer, Layer 2s inherit the security and decentralization of Ethereum in a way that competing base layer technologies can’t match. Many rollups are already capable of handling every type of transaction that can be executed on Ethereum and some can already handle more complex transactions than those possible on the base layer.
Over the past year, Layer 2 networks have started to gain traction: they are improving reliability, decreasing fees, and increasing accessibility. For this reason, we believe that Layer 2 networks are nearing an inflection point in terms of adoption. Although they still have relatively low levels of adoption compared to alternative Layer 1 networks, the on-chain data is beginning to show signs of early product market fit. In the last year, Layer 2 networks have grown from roughly $300 million in Total Value Locked (TVL) to over $4 billion.
Leading Layer 2 Approaches: Optimistic & ZK
Measured by transaction volume, there are two primary competing technological approaches to building Layer 2 networks: Optimistic rollups and Zero Knowledge (ZK) rollups. Though it is outside the scope of this post to dive into the technical specifics of each approach, it is worth highlighting the relative pros and cons of each.
Today, Optimistic rollups are more common and more production ready mainly because this approach is easier to program given it is compatible with existing Ethereum tooling. Optimistic rollups rely on game-theory incentives that assume transactions are valid but can be challenged within a 1-week period before they achieve finality on the base layer. The two most popular examples of Optimistic rollups are Optimism and Arbitrum.
In comparison, ZK rollups are mathematically verified and guaranteed off-chain using validity proofs resulting in instant finality. ZK rollups also have a single, upfront computational gas cost meaning the more transactions that are included in each batch, the more this fee is spread out and the larger the cost savings on a per transaction basis. Thus, in theory, ZK rollups should be more scalable than Optimistic (which has a variable computational gas cost structure). However, ZK rollups are more difficult to program and the proofs can be computationally expensive. ZK rollups are arguably the superior technological solution but, in an industry where network effects play such an important role, the best technology is not a guarantee of success. ZK rollups are beginning to come online but Optimistic rollups were launched first and have more traction to date. Examples of ZK networks are Starknet, zkSync, and Aztec.
Optimistic and ZK rollups have been under development for several years but are just now at an inflection point in terms of technological readiness and adoption.
Measuring Layer 2 Adoption: Consumption of Blockspace
As previously explained, applications built on Ethereum pay gas fees every time they perform an operation on Ethereum’s network. As application usage increases, so does the total gas fee that application pays, which is usually passed on to the end user. Thus, “network fees paid” is a good measure of demand by various applications for Ethereum blockspace. As we write this, the largest consumer of Ethereum blockspace as measured by gas fees is Opensea, the leading marketplace for NFTs. In fact, the top 14 consumers of Ethereum block space are applications such as Uniswap (decentralized exchange), ENS (domain registrar), Metamask (Ethereum wallet) and more. A Layer 2 network, Arbitrum, finally makes the list at number 15. However, we believe this chart will look very different in the future.
Why Layer 2s Will Continue To Gain Traction
As we previously discussed, Layer 2 networks bundle hundreds, or even thousands of transactions into one transaction that settles on the base layer. Rather than paying a gas fee for a single transaction, Layer 2 solutions pay a similar gas fee for the bundle, which they can spread across all transactions in the bundle. Therefore, transacting on a Layer 2 is orders of magnitude more cost effective for end users. It’s possible that transaction fees could drop to pennies, or possibly even fractions of a penny when performing operations on Layer 2 networks. In fact, Layer 2 solutions could easily afford to pay higher gas fees than standalone applications precisely because they can distribute that cost. Thus, should the base layer become congested, Layer 2 networks would likely be given priority by miners over standalone applications in validating their transactions.
As a result, we believe users and applications will be incentivized to shift to operating on Layer 2 networks rather than operating directly on the base layer. Rather than competing for blockspace and bidding against Layer 2s, applications such as Opensea can switch to operating on a Layer 2 and provide users with lower fees and faster transaction times. In theory, that should help applications retain more users as well as let them market to new users who may have been priced out previously. It also may allow Opensea and other applications to develop new features to improve their products that may not be economically viable when operating on the base layer.
It’s our belief that in time, most applications will migrate to operating on Ethereum Layer 2 networks. Being “fast and cheap” is no longer a moat for Ethereum Layer 1 competitors like Solana, BNB, Avalanche and others as Layer 2 solutions come online and fulfill their promise of faster transactions at lower cost. Furthermore, Layer 2 networks have an additional inherent advantage because in addition to being fast and cheap, they should also be more secure and decentralized than alternative Layer 1s, making them more attractive platforms for developers.
Not only do Layer 2’s inherit the security of Ethereum’s base layer, which is already more decentralized than other Layer 1s, but moving assets between blockchains (aka bridging) is likely to be more secure when done between different Layer 2s than bridging between various Layer 1s (of which we have seen numerous hacks). As the funds involved increase in size, this security feature will become increasingly important, thus creating network effects for Layer 2s. Whereas each Layer 1 must provide the full suite of products on its own, users should be able to simply bridge to any Layer 2 they want if features aren’t available on the Layer 2 solution they are currently using. In this way, Layer 2s could become complementary to each other and will likely feed off each other’s growth whereas Layer 1s are much more competitive with other Layer 1s.
As network effects begin to kick in and more and more applications shift to operating on Layer 2s, the top consumers of Ethereum block space will not be applications, but rather Layer 2 networks.
What Layer 2s Mean For Ethereum
So, are Layer 2 solutions positive or negative for Ethereum? Some have theorized that as more transactions move from Ethereum’s base layer to Layer 2, this will cannibalize from transactions on the Ethereum network. In other words, will these layer 2s compete with Ethereum directly by taking away transactions from the Ethereum base layer and earning fees for themselves that otherwise would have gone to Ethereum? We do not believe this to be the case.
Remember that Layer 2 networks still pay gas fees on Ethereum. Thus, all fees earned by Layer 2 networks essentially translate into demand for the base layer Ethereum chain. In fact, if Layer 2 lives up to its promise, it will drastically increase the number of transactions ultimately settled on the Ethereum blockchain, thus increasing the overall demand for Ethereum blockspace.
Rather than cannibalizing transactions on the Ethereum network, it’s more likely that there will be many more transactions that occur on Layer 2 that never would have occurred on Ethereum’s base layer blockchain in the first place. Because the fees to transact on Layer 2 networks will be significantly lower than the fees on Ethereum today, it should encourage participation from new users. Today, users may choose to avoid transacting on Ethereum all together if fees are too high. However, if fees were lower, new transactions would be feasible on the network. Thus, Layer 2s aren’t “stealing” transactions from Ethereum’s base layer, but instead Layer 2s will substantially grow the pie.
For illustrative purposes, let us return to OpenSea as an example. We believe many more NFTs would be bought by current users if transaction fees fell from tens or even hundreds of dollars down to pennies. But it’s not just current purchasers. Today, there aren’t any “inexpensive” NFTs because it does not make economic sense. Who would buy a $5 NFT if the transaction fee is $25? However, buying an NFT for $5 when the transaction fee is 10 cents is far more reasonable. Thus, it is also likely that many new users will be willing or able to buy NFTs on OpenSea when transaction fees fall. But it is not just impactful for NFTs, we could walk through similar examples across DeFi, gaming, and most other applications built on Ethereum today.
This logic extends to new applications as well. Today, many applications do not make sense because the transaction fees make them economically unviable. We believe once transaction fees drop and throughput increases, many new applications will be developed that previously didn’t exist. This will spur on innovation that will attract many more users.
Reducing fees will make operating on Ethereum more affordable thus increasing accessibility, improving the user experience, and increasing overall demand for Ethereum blockspace.
Why Gas Fees Will Remain High
As we just showed, Layer 2s are likely to increase the overall demand for Ethereum blockspace. However, the processing power of the base layer Ethereum network is not expected to increase meaningfully in the foreseeable future, meaning the total demand will likely continue to outstrip supply of blockspace on the base layer. Miners will increasingly prioritize Layer 2 transactions, which can afford to pay higher gas fees because they amortize the cost over many users. Standalone applications will be forced to choose between paying higher fees and passing that cost onto end users or migrating to Layer 2 networks. Eventually, blockspace on the Ethereum base layer will become too expensive for end users and applications to use directly, further incentivizing all activity to move to Layer 2s where the fees will be substantially less. Which brings us to a rather counterintuitive, contrarian conclusion.
Gas prices on the base layer Ethereum network are likely to stay relatively high for the foreseeable future, possibly indefinitely.
We want to address one risk related to Ethereum’s coming merge to Proof-of-Stake, which many believe will lower gas fees, which would affect our conclusions about the future of Layer 2 solutions. Lower gas fees are not a projected result of the Proof-of-Stake merge. The merge to Proof-of-Stake changes the consensus mechanism used by Ethereum to validate transactions and improve the energy efficiency of the network. However, it is unlikely to have any material impact on enhancing its scalability nor will the merge affect transaction fees, which are a function of supply and demand. According to Ethereum’s own product roadmap, the way it plans to scale and lower transaction fees is primarily reliant on the integration of Layer 2 networks.
Why Layer 2 Solutions Will Keep Costs Low For End Users
This whole thesis is predicated on Layer 2s driving more demand through lower fees and faster transactions for end users. However, as demand increases, what prevents costs from increasing on Layer 2 networks like they increased on Ethereum? In other words, how will Layer 2 networks continue to keep costs down for end users?
First, the job of a Layer 2 network is to aggregate economic activity across many users and thereby spread the cost of operating on the Ethereum blockchain among all those users. In theory, the more transactions a Layer 2 network can process, the cheaper it becomes, because the costs are split across a larger number of participants. Even if the gas fees on the base layer increase, so long as the number of Layer 2 users grows faster than the growth rate of the fees, the average price per transaction on a Layer 2 will drop. Therefore, unlike Ethereum, as scalability and adoption of a Layer 2 network grows, the transaction fees should decrease.
Second, there are some pending upgrades to the Ethereum base layer that should help improve the performance of Layer 2 networks. In the past, the development roadmap for the Ethereum base layer was focused on scaling the computational power of the network (meaning increasing the transactional throughput), but now, that job has been offloaded to Layer 2 networks and the Ethereum roadmap is much more focused on increasing data availability on the network. This in turn will make using Layer 2 networks much more efficient. The most notable example is EIP 4484 which reduces the cost of call data on base layer Ethereum blockchain which should reduce Layer 2 fees by a factor of 5x. There is also EIP 4844 which will introduce a new transaction format that is expected to further reduce fees for rollups.
Through improvements in the emerging rollup technologies and optimization on the base layer, we are likely to get to sub 5 cent transaction fees and potentially even sub 1 cent transaction fees.
Why Layer 2s Are Good For The Price of ETH
Layer 2s will likely increase the demand for Ethereum’s blockspace without substantially reducing the gas fees on the base layer. This is akin to a company selling more products without lowering the price. A combination of Ethereum activity increasing while the fees of the base layer remaining relatively high should result in Ethereum’s “fee revenue” increasing. In other words, the total dollar amount of gas fees paid on the network should increase even though individual users are paying substantially less.
In theory, this should increase the value accrued to the Ethereum network, resulting in an increase in the price of ETH over time.
But Layer 2’s impact on the price of ETH goes beyond that. Since the implementation of EIP 1559, the Ethereum network now burns (aka destroys) a variable amount of ETH per day based on the usage. Increasing the usage of the Ethereum network, which Layer 2 networks will play a substantial role in, will increase the amount of ETH burned per day. It is likely that this increase will surpass the amount of new ETH issued on most days making ETH a deflationary asset in the coming years.
The demand increase from Layer 2 networks should drive more value to Ethereum’s native token while at the same time decreasing its circulating supply, resulting in significant price appreciation of ETH over the long term.
Layer 2 networks will not cannibalize Ethereum but rather, work in a symbiotic fashion and greatly enhance its value. Layer 2 protocols are likely to be an incredibly positive development for the fundamental economics of ETH.
Layer 2 Tokens
How can we at Blockforce capitalize on our conviction about the rise of Layer 2 solutions? By holding ETH and possibly investing in Layer 2 tokens.
It’s likely that most Layer 2 networks will issue native tokens. Two of the four largest Layer 2 networks, Polygon (MATIC) and Optimism (OP), have already done so while the third, Arbitrum, is rumored to have one coming in the second half of 2022 and the fourth, Starkware, confirmed they will be issuing a token in the future. By next year, all four of the largest Layer 2 networks are likely to have publicly tradable tokens.
However, there are far more than four layer 2 networks. As of today, there are at least 22 different layer 2 protocols in various stages of development. As we alluded to earlier, we expect that number to grow considerably over the next few years. While many of these projects are lesser known, they do bring unique design choices and functionality to the table including specialization for certain use cases. There are numerous L2s outside of the “Big Four” that seem poised for growth over the coming years and it is very likely that many of these smaller layer 2 networks will issue their own tokens as well.
While we have established our view on the value Layer 2 networks will provide, the role of Layer 2 tokens is still unclear. While it’s likely that most, if not all, will have a token, we do not know how the tokens will be issued, the rights and privileges associated with each token, or how (if at all) value will accrue to Layer 2 tokens. It’s too early to know for certain what will emerge as the best model but there will likely be lots of experimentation with token issuance by Layer 2 networks.
The reason we are likely to see a fair amount of experimentation has to do with the simple fact that Layer 2s leverage an existing blockchain. This has two key implications.
First, it is easier to launch a Layer 2 network than a new Layer 1. Teams trying to launch a new base layer platform not only need to build the technology, but they need to also attract users, developers, funding, etc… In contrast, because Ethereum already has established network effects, Layer 2 networks can launch with all those components in place from the start. Thus, we anticipate a large proliferation of new Layer 2 networks in the next 1-3 years. The corollary to that is we are not likely to have many, if any, new Layer 1s reach scale in the coming years.
Second, Layer 2 tokens can be more creative with supply issuance, dilution rates, and the rights associated with their tokens. What makes Layer 2 tokens so interesting is that these networks do not have to issue tokens to incentivize miners the way base layer platforms need to do. Most Layer 1s, such as Bitcoin and Ethereum, issue new tokens as incentives for miners to contribute computing power to the network. That computing power operates and secures the blockchain. Layer 2 already have that functionality built into Ethereum so they do not need token issuance to incentivize miners. This gives Layer 2 network much more freedom and ability to innovate with regards to their tokenomics. This flexibility also means that how tokens accrue value beyond just speculation is much less clear.
One way Layer 2 tokens may accrue value is by charging a small premium on the transactions. By doing so, Layer 2 networks can capture the spread between the transaction fees paid by users and the cost of purchasing Layer 1 blockspace. Because Layer 2 networks are dependent on volume, this premium could be very small for individual users (pennies or fractions of a penny) but add up to large numbers as the network grows to process an increasingly larger number of transactions. This profit could then flow through to the token holders.
This is what Optimism has done through implementing what it calls a “fee scalar,” a dynamic additional fee charged to users per transaction. Optimism is currently targeting a 10% premium. This profit represents a potential source of value that can be directed to a Layer 2 token and its holders.
However, that may not be the only model implemented nor is it clear as of yet who will emerge as the winners. But what is more certain is that we will live in a multi-layer 2 world for the foreseeable future. As stated previously, we believe we will see a fair amount of experimentation and innovation in the next several years. Some, if not many, of these models may fail but it’s likely that at least a couple will prove wildly successful. This is why at Blockforce, we continue to monitor the on-chain data to better inform our viewpoint as the industry continues to evolve.
Challenges Going Forward
Despite their enormous potential, Layer 2 networks still face several challenges. The first, and arguably most important, is a sub-optimal user experience. Today, Layer 2 scaling solutions place additional burdens on users and aren’t as simple to use as most alternative Layer 1 platforms.
Second, while transactions can be completed faster and cheaper, withdrawing tokens on an optimistic based layer 2 can have long wait times depending on the type of transaction. Transactions such as swapping of tokens on layer 2 using Uniswap will be completed in seconds and at a much lower fee than if it were performed on Ethereum because the transaction took place on layer 2 and had no interaction with the base layer. If instead, the transaction involves moving assets from L1 to L2, it could take upwards of a few minutes and have higher fees since the transaction is now interacting directly with the base layer. Finally, if the transaction involves moving tokens through a bridge, that could require the user to wait for at least 7 days for they are able to claim their assets. There are a number of solutions currently in development to reduce these withdrawal times. It’s also worth noting that these wait times are for optimistic based layer 2s while zero-knowledge based layer 2s do not suffer from the same inconvenience.
Finally, competition from other Layer 1 networks such as Solana, Avalanche, Binance Smart Chain, and others will likely intensify in the coming years. These platforms already have hundreds of different projects building on top of and around their respective ecosystems and have a sizable head-start in terms of user adoption compared to Ethereum Layer 2 networks.
Conclusion
Despite having deployed their technology in just the past year, many rollups have demonstrated early product market fit and seen billions of dollars’ worth of assets moved onto their platforms. For this reason, we believe the adoption of Layer 2 networks is just beginning to hit an inflection point and many of these networks are likely to experience exponential growth as they continue improving reliability, decreasing fees, and increasing accessibility. Blockchain-based smart contracts are a multi-trillion-dollar market opportunity. We believe that ETH and a few of these Layer 2 tokens are likely to capture a significant amount of that value in the coming years.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
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