Research Summary
The report discusses the role of Layer 2s (L2) in scaling Ethereum, a leading smart contract blockchain. It highlights the significant growth of BASE, Arbitrum, and Optimism, three L2 blockchains built on Ethereum. The report also outlines the broader L2 competitive landscape and discusses the centralization risks posed by L2s.
Key Takeaways
The Importance of Layer 2s in Scaling Ethereum
- Layer 2s Enhance Ethereum’s Scalability: Layer 2s process transactions from decentralized applications and then batch them together before sending a compressed version back to the main Ethereum network for settlement. This makes the network 100x cheaper for users and increases its scalability.
- Value Accrual to Ethereum: Layer 2s accrue value back to Ethereum. For every transaction on a L2, a user pays a transaction fee. The L2 keeps a portion of that fee while the Ethereum network receives the remaining. For every transaction sent by a L2, the Ethereum network also burns a small portion of total ETH supply.
Significant Growth of BASE, Arbitrum, and Optimism
- BASE’s Impact: Coinbase’s Layer 2 scaling solution built on Ethereum, BASE, has opened up distribution of decentralized applications to over 110 million Coinbase users. BASE surpassed Layer 2 competitors and Ethereum itself in daily transactions, hitting over 1 million on September 14th, 2023.
- Arbitrum and Optimism’s Performance: Arbitrum and Optimism, two of the largest Layer 2 blockchains built on Ethereum, have surpassed large Layer 1s like Solana in Total Value Locked (TVL). Arbitrum currently has the third most TVL of any smart contract blockchain at $1.69 billion, trailing only Tron and Ethereum itself.
Layer 2 Competitive Landscape
- Increasing Adoption: Layer 2 scaling solutions have been growing in usage consistently over the past year. Top performing Layer 2s including Arbitrum and Optimism each surpass Ethereum competitor Layer 1s in Solana and Avalanche in TVL.
- Leading Layer 2 Projects: Among the 31 total active Layer 2 projects listed by L2Beat, five currently stand out above the rest in terms of fundamental metrics. These include Optimism and Arbitrum, which have market caps near $1 billion.
Centralization Risks Posed by Layer 2s
- Decentralization Challenges: Layer 2s sacrifice decentralization for speed and efficiency. Currently, 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 and potentially extractive actions.
Actionable Insights
- Investigate the Potential of Layer 2s: Layer 2s offer significant scalability potential and reduce cost barriers on Ethereum. They are pivotal to Ethereum’s growth and could solidify its position as the leading Layer 1 blockchain.
- Consider the Risks: While Layer 2s present significant opportunities, they also pose centralization risks. Investors should carefully consider these risks when evaluating Layer 2 projects.
- Monitor the Competitive Landscape: The Layer 2 landscape is competitive, with several projects standing out in terms of fundamental metrics. Keeping an eye on these projects could provide valuable insights into the future of Ethereum scaling.
