Competition end for Layer2 tokens

Investing is an exercise in forecasting. Savvy investors don’t make decisions based on current conditions, but rather on the potential for future and long-term value creation.

In the cryptocurrency market, one area where traders are currently showing short-term thinking is L2 tokens. This is a huge opportunity for forward-thinking investors.

Competition end for Layer2 tokens

L2 Rollup technology on Ethereum continues to grow in terms of user adoption, developer attention, and utility value. It represents the cutting edge of Web3.

Recently, with the release of OP tokens by Optimism, these L2 tokens, especially their valuation, have been in the spotlight.

OP has already received skepticism from traders and investors across the cryptocurrency market.

Let’s analyze the three areas that I know are the most worried about:

1. No practical value

Currently, OP is only used for Optimism’s community governance (through Optimism’s bicameral governance system). In this governance system, OP holders form a so-called ” token house “.

This Token House can vote on upgrades within the Rollup ecosystem and the distribution of incentives to different projects.

2. The token will not add any value

The network revenue created by the Rollup Sequencer (more on that below) is not earned directly by token holders, but is used to raise funds for retrospective public goods.

The distribution of this value will be determined by Optimism’s second branch of governance , the citizen’s house , which grants citizenship to citizens by issuing non-transferable NFTs.

3. Low circulation and excess unreleased supply

OP’s current market cap is 187.9 million, and its fully diluted valuation is 3.7 billion. This means that only 5% of the total OP supply is in circulation.

These criticisms are valid, but they are only based on the current OP token – not its future prospects with the L2 token.

The disconnect between the two valuations represents an opportunity, and the OP token, and similar L2 tokens, are on the path to massive growth in utility and high appreciation, as the future design of the L2 token will be very different from the current design.

Let’s see why this happens…

L2 business model

In order to better understand how the L2 token increases in value, readers need to first understand the business model of the L2 platform.

You can think of Rollup technology providers as middlemen for block space: they buy L1 block space, use it in a more efficient way, and sell it to users at a premium via L2.

income

Rollup generates revenue from two sources: transaction fees and miners/maximum extractable value (MEV).

MEV is a rent-seeking way of extracting value that speculative block proposers (PoW miners, PoS validators) can do by specifically reordering transactions (David explains more about MEV here).

Just as users pay gas fees to miners or validators on Ethereum, they must also pay a fee to so-called sequencers on L2. The sequencer is responsible for sorting, packaging, and sending transactions to L1.

Sequencers can earn money by withdrawing MEV as they perform their duties of determining the order of transactions.

Competition end for Layer2 tokens

Competition end for Layer2 tokens

L1 and L2 fee rankings, data from cryptofees.info

overhead

In order to work, some overhead incurred by rollup is passed on to users in the form of gas fees.

The first part of this overhead structure is the computational resources required to execute the transaction on L2, and the second part is the overhead of packaging and validating the transaction.

In the case of optimistic rollup, it requires fraud/error proofs, whereas zkRollup requires zero-knowledge proofs.

Publishing transaction data (ie calldata) on L1 also incurs an overhead on L2.

The calldata overhead forms a core part of the so-called ” data availability problem “, which refers to the expensive cost of publishing and storing data on a network such as Ethereum.

Competition end for Layer2 tokens

L2 cost ranking, data source l2fee.info

There are a number of solutions in the pipeline to deal with the L2 overhead problem.

The first solution is Calldata compression, which reduces the size of the data sent from L2 to L1. While rollups themselves can take advantage of data compression techniques, the upcoming EIP-4488 proposed by Vitalik aims to help in this regard as well.

Other options include  danksharding  and  proto-danksharding , which can increase the amount of data stored on Ethereum or Celestia (a dedicated data availability layer scheme).

profit

The way rollups can “ profit ” through this model is by charging a “ premium ,” for example, the difference between earning transaction fees paid by users and the cost of buying L1 block space.

This is what Optimism accomplishes by implementing a “fee scaling factor,” which charges users a dynamic additional fee for each transaction.

Optimism’s goal is to generate a 10% profit for sequencers. This profit represents a potential source of value for L2 tokens and their holders.

(Translator’s Note: ” Fee Scalar ” is a dynamic fee that Optimism rollup charges its users. Currently, the fee scaling factor on Optimism is set at 1.24 times.)

MEV

Another source of revenue for Rollup is MEV. It has gradually become a key differentiator between L2 projects, and the way each L2 platform handles MEV has a significant impact on the future value of its native token.

To better understand this concept, let’s explore the differences in how Optimism and Arbitrum handle MEVs.

Optimism is taking a so-called ” offensive ” approach to MEVs. Rooted in the notion that MEV is the foundation of blockchain and trying to eradicate it would be futile, Optimism will eventually incorporate what is known as the  MEV Auction (MEVA).

MEVA attempts to segregate and redirect the proceeds generated by MEV by auctioning off the MEV extraction rights to the highest bidder.

Competition end for Layer2 tokens

Optimism intends to distribute the proceeds earned by MEVA to eligible public goods through retroactive public goods fundraising.

By doing so, L2 Platform believes it will be able to create a self-sustaining ecosystem that will provide more value to all stakeholders in the long run.

Arbitrum, on the other hand, is taking a ” defensive ” approach to MEV, based on the idea that ” MEV is actually a tax on users “. Aribitrum does not attempt to capture and redistribute the MEV, but instead strives to minimize it system-wide.

To reduce MEV, the Arbitrum network will implement fair ordering or fair ordering, where all transactions in a batch are processed according to the ordering they received.

In the process, Arbitrum intends to reduce the extracted MEV, thereby reducing the cost of Rollup and making it more attractive to users and builders.

The debate over how various L2 platforms should handle MEVs is nuanced and complex, and well beyond the scope of this article. But if we’re talking about an investment strategy, here’s where we can talk about its impact on the value of L2 tokens.

What does MEV mean for your L2 investment strategy?

Offensive MEVs provide L2 with a revenue stream that can directly add value to its native token.

While Optimism’s MEV proceeds will initially be fully funded for public goods, a portion or even all of the MEV proceeds can eventually be distributed to token holders through traditional unilateral staking pools, or through decentralized sequencers There are (more on this later).

In funding public goods use, MEV may help its token add more value indirectly by improving the overall health and long-term sustainability of the L2 platform ecosystem.

While a defensive MEV deprives the native token of a revenue stream that can directly add value or strengthen its ecosystem, it can indirectly increase the value of the L2 token.

Users may be more inclined to transact on networks where MEVs are less rampant, strengthening the adoption of the network and its network effects.

While it remains to be seen which approach will lead to longer term adoption, it is clear that MEV can be used for L2 token appreciation.

L2 platforms that embrace MEV will more easily add value to their native assets than other platforms that do not.

Decentralized Sequencer

Although L2 tokens can be used to decentralize various protocol functions. However, the most obvious way to capture transaction fees and MEV value (while also enhancing its utility) is to decentralize sequencers.

Currently, sequencers on many great Rollups are centralized and run by a single entity. For example, Offchain Labs and Optimism PBC are the sole operators of sequencers for Arbitrum and Optimism respectively.

Since each platform is in its nascent stage, these systems are placed there like guardrails.

In future developments, it is important that these sequencers are eventually decentralized to maximize censorship resistance.

Sequencers on L2 platforms like Arbitrum and Optimism are able to do this with their native tokens. There are currently several designs of decentralized sequencers that could take shape.

For example, the sequencer can be selected through the PoS methodology.

Here’s how the methodology works : Similar to PoS on L1, potential sequencers stake a Rollup project’s native token for the right to hold that position.

The probability of a staker being selected will be proportional to the size of their stake. Selected new sequencers are able to capture the value generated by Rollup by earning transaction fees, MEV and potential token rewards.

In the case of Rollup with an offensive MEV strategy like Optimism, this mechanism can be implemented in conjunction with the MEV auction mechanism:

Competition end for Layer2 tokens

The staking mechanism can provide a source of utility value for L2 tokens—and therefore a source of demand. In order to join the system and earn the aforementioned cash flow, potential sequencers need to purchase tokens on the open market.

Although the details are yet to be finalized, zkSync  has decided to use its tokens for this purpose.

clear road

The L2 token has a clear development path in terms of its usage and token appreciation.

Rollups generate profits from transaction fees and MEVs that can be used as a way to add value directly to the native token, or indirectly by reinvesting in areas such as public goods.

It can capture this value by being used for decentralized sequencers or other protocol functions (eg through PoS systems). This further creates utility value and demand for L2 tokens.

If these token economies look similar, because they all reflect the ETH token economy itself.

After the merger, ETH will be used within the PoS system, which allows stakers to earn cash flow in the form of insurance money, gas fees, and MEV.

While L2 tokens are unlikely to be net deflationary or have the same monetary premium as ETH, they will still trade at an ” exponential premium ” as they represent the broadest access to their respective ecosystems.

While many of the specifications for L2 token design are still in flux, one thing is certain: today’s L2 token economy will not be tomorrow’s L2 token economy.

Savvy investors should focus on how each L2 platform implements a value-add strategy for its tokens, i.e. what the L2 token represents in 2023 and beyond, and then act accordingly.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/competition-end-for-layer2-tokens/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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