L2 Token Endgame: How to Predict L2 Token Value

Dear Bankless Nation,

The Layer 2 competition is underway.

In terms of the ranking of fees earned by all Layer 1 and Layer 2 networks, Arbitrum and Optimism rank fourth and fifth, respectively, behind Ethereum, BSC, and Bitcoin.

But the value appreciation of the Layer 2 network (especially the Layer 2 token) has only just begun, and the future will show a huge growth curve.

Whether or not Layer 2 tokens will succeed depends entirely on how they can add value to their native tokens in the future.

This is why investing in L2 tokens is essentially a prediction of its future.

This article joins Bankless analyst Ben Giove for a deep dive into the endgame of Layer 2 token investing.

There will definitely be alpha gains in there.

— Bankless

How to predict the value of L2 tokens

Investing is an exercise in forecasting. Smart investors make decisions not based on current market conditions, but on the potential for future and long-term value creation. 

In the cryptocurrency market, traders are currently exhibiting short-term thinking on the L2 token space. This is a great opportunity for forward-thinking investors.

Layer 2 rollup technology on Ethereum continues to improve in terms of user usage, developer attention, and usability. It represents the cutting edge of Web3. Recently, with the launch of Optimism Token OP, Layer 2 Tokens — especially the valuation of L2 Tokens — have been in the spotlight. 

The OP has been questioned by traders and investors across cryptocurrencies.

Let’s break down the three main doubts I see:

1. Not practical

At the moment, OP is only used for governance through Optimism’s bicameral governance system. In this system, OP holders form a so-called “token house”. In the Rollup ecosystem, token houses can vote on upgrades and incentive allocations for different projects.

2. Tokens do not generate any appreciation

Network revenue — from the rollup’s sequencer (more on that later) — doesn’t go directly to token holders, but goes to a traceability public goods fund. This distribution of value is determined by the second branch of Optimism governance – the citizen’s house – whose membership will be identified by a non-transferable NFT. 

3. Low circulating supply and large excess supply

OP currently has a market cap of $187.9 million and FDV of $3.7 billion. This means that only 5% of the total OP supply is in circulation.

These criticisms are justified. But these criticisms are for the current OP token, not for the future OP token and Layer 2 token. 

This disconnect also presents opportunities. OP Tokens, and similar L2 Tokens, are moving in the direction of greatly increasing utility and value appreciation. Because the design of the L2 token in the future will be completely different from the design of today.

Let’s see why this is the case.

L2 business model

To better understand how L2 tokens generate value, you need to understand the business model of the Layer 2 platform. 

You can think of rollup technology vendors as resellers of blockspace: they buy blockspace on L1, use it more fully, and sell it to users via Layer 2 for a premium. 

income

Rollup’s revenue comes from two sources: transaction fees and miners/maximum extractable value (MEV). MEV is a rent-seeking form of value extraction that opportunistic block producers (miners in PoW, validators in PoS) can do by reordering specific transactions.

Just as users pay gas fees to miners or validators on Ethereum, they must also pay gas fees to so-called sequencers on L2. The sequencer is the entity responsible for ordering, batching, and submitting transactions to L1. Since the sequencer fulfills its duty to determine the order of transactions, it can also earn money by extracting MEVs. 

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cost

Running a rollup incurs some costs that can be passed on to users in the form of gas fees. 

In this cost structure, the first component is the computational resources required to execute transactions on L2. The second component is the cost of batching and validating transactions. For optimistic rollups, this requires spoofing/failure proofs, and for zkRollups, zero-knowledge proofs. 

There is also a cost for Layer 2 to publish transaction data (called calldata) on L1. The calldata cost is at the heart of the so-called “data availability problem,” which is associated with the high cost of publishing and storing data on a network like Ethereum.

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Layer 2 fee cost ranking, data from l2fees.info

There are currently many solutions to the Layer 2 cost problem.

The first is calldata compression, which reduces the size of data published from L2 to L1. While rollup can use data compression techniques on its end, the upcoming EIP (EIP-4488) proposed by Vitalik aims to help in this regard as well.

Other options include danksharding and proto-danksharding to increase the amount of data that can be stored on Ethereum and specific-purpose data availability layers like Celestia.

profit

Through this model, rollup can “earn profit” by charging a “premium”, that is, the difference between the transaction fee paid by the user and the cost of buying L1 blockspace.

That’s what Optimism does, charging users a dynamic additional fee per transaction by implementing what it calls a “fee scale.” Optimism’s goal is for the sequencer’s profit to reach 10% of the profit. This profit represents a potential source of value that goes directly to L2 tokens and their holders.

MEV

Another source of revenue for Rollup is MEV. The MEV approach of each rollup platform has a significant impact on the future value appreciation of its native token, which will be an increasingly critical distinction between L2s.

To better understand this, we need to explore the differences between Optimism and Arbitrum’s MEV methods.

Optimism is taking what it calls an “offensive” approach to MEVs. Optimism is convinced that MEV is the foundation of the blockchain and that trying to remove it is futile, so it ended up including it in the so-called MEV Auction (MEVA).

MEVA attempts to segregate and redirect MEV-generated revenue by auctioning off the right to withdraw MEV to the highest bidder.

Optimism plans to distribute revenue from MEVA to public goods through a retroactive public goods fund. Optimism believes that doing so creates a self-sustaining ecosystem that will provide more value to all stakeholders in the long run.

Arbitrum, on the other hand, takes a “defensive” approach to MEVs, based on the fact that MEVs are a form of taxation on users. Arbitrum is focused on minimizing MEV within its system, rather than pursuing capture and redistribution of this benefit.

For this, the Arbitrum network will implement what is called fair ordering, where all transactions packaged in the same batch are processed according to the order in which they were received. By doing this, Arbitrum wants to reduce the number of MEVs extracted, making rollups less expensive and more attractive to users and builders.

The debate surrounding how L2 should handle MEVs is nuanced and complex, and goes well beyond the scope of this article. However, if we are talking about investment strategies, some of our interpretations of the significance of L2 token value appreciation are still worth a look.

What MEV Means for Your Layer 2 Investment Strategy 

Offensive MEVs provide L2 with a revenue stream that can be used to directly add value to their native tokens. While Optimism’s MEV revenue will initially be used entirely to fund public goods, a portion—or even all of it—may eventually be distributed to token holders through traditional one-sided staking pools, or the decentralization of sequencers (will be described in detail later). 

When funding public goods, MEVs can indirectly help L2 tokens gain more value by improving the overall health and long-term sustainability of their ecosystem.

While a defensive MEV deprives a rollup of revenue streams that can be used directly to increase the value of the native token or strengthen its ecosystem, it may indirectly increase the value of the L2 token. Users may be more inclined to transact on a MEV-controlled network, increasing the acceptance and network effects of this L2.

It remains to be seen which method will bring more users to use in the long term, but it is clear that MEV can be used for L2 token value appreciation. Layer 2 platforms that use MEV will more easily add value to their native assets than those that do not.

Decentralized Sequencer

While L2 tokens can decentralize various protocol functions, the clearest way to capture transaction fees and MEV value—while also increasing their utility—is to decentralize sequencers.

As each platform is still in its infancy, a centralized sequencer acts as a safeguard. 

Going forward, it is critical that these sequencers are ultimately decentralized in order to be maximally censorship resistant. 

Layer 2 like Arbitrum and Optimism can do this by using their native tokens. Some decentralized sequencer designs are also taking shape. The sequencer can be chosen, for example, by Proof of Stake (PoS). 

It works as follows: Similar to PoS on L1, to become a sequencer requires staking the rollup native token for the right to assume that role. The probability of each staker being selected is proportional to how many tokens he staked, and the new sequencer being chosen can earn revenue through transaction fees, MEV, and potential token rewards. 

In rollups with offensive MEV strategies, such as Optimism, this mechanism can be used in conjunction with MEV auctions.

The staking mechanism will provide a source of utility for L2 tokens, thereby increasing the demand for L2 tokens. In order to participate in the system and obtain the aforementioned cash flow, potential sequencers will be required to purchase tokens from the open market.

While details are yet to be confirmed, zkSync has confirmed that their tokens will be used for this purpose.

the road is clear

There is a clear future development path for the use and appreciation of L2 tokens. Rollup’s profits from transaction fees and MEVs can be used directly to add value to the native token, or indirectly reinvested in areas such as public goods.

L2 tokens can capture value through a decentralized sequencer or other protocol functions such as through a PoS system. This creates more utility and demand for L2 tokens. 

If these token economics look familiar to you, that’s because: they mirror ETH itself. 

After the merger, ETH will be available in a PoS system that enables stakers to earn cash flow in the form of rewards, gas fees, and MEV.

While L2 tokens are unlikely to be net deflationary – or have a monetary premium like ETH – they may still trade at an “index premium” as they represent the broadest way to gain exposure to their respective ecosystems.

While many of the details surrounding the L2 token design are still in flux, one thing is certain: today’s L2 token economics will not be the same as tomorrow’s L2 token economics. 

Savvy investors should focus on how each L2 platform implements value-accretive strategies in its tokens, and what those strategies mean for L2 tokens in 2023 and beyond, and then act accordingly.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/l2-token-endgame-how-to-predict-l2-token-value/
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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