Ethereum Price Compression Through Layer 2 Scalability Solutions

Overview

Ethereum Layer 2 (L2) scaling solutions, such as Optimism, Arbitrum, and zk-rollups, have become pivotal in addressing the inherent limitations of Ethereum’s Layer 1 (L1) network, primarily by improving scalability and reducing transaction costs. These solutions function by processing transactions off-chain and only settling them on L1 periodically, thus alleviating network congestion and accelerating transaction throughput. While this enhances the overall efficiency of the Ethereum ecosystem, it also introduces concerns regarding the long-term demand for Ethereum’s native token, ETH, and its market valuation.

The Impact of Reduced Transaction Fees on Ethereum Mainnet

The core of the Ethereum network utility is its native token, ETH, which users tend to hold for paying gas fees on the Layer 1. As transactions shift to L2, where fees are significantly lower and transactions are bundled before being posted to L1, demand for on-chain gas fees drops. Fewer transactions on L1 translate into lower competition for block space, which drives down the gas fees that validators rely on for revenue.

With Ethereum validators facing diminishing fee revenue, the economic incentive to hold ETH for transaction purposes weakens. Validators may see reduced profitability, especially in cases where Layer 2 scaling absorbs significant portions of network activity. This reduction in on-chain transaction volume could further erode demand for ETH, potentially placing downward pressure on its market price as its primary use case, paying gas fees, is mitigated.

Less Network Congestion Lowers Fee Pressures

One of the key issues of ETH has historically been Ethereum’s network congestion, which has led to price spikes in gas fees during periods of high network activity. Users required ETH not only for regular transactions across the L1 network, but also to ensure priority execution during network congestion. However, with Layer 2 solutions efficiently managing transactions off-chain and committing them in bulk to Ethereum's L1 network, this congestion is greatly reduced, which, in turn, decreases gas fee spikes.

This reduced need for ETH to cover high gas fees further weakens the demand for the token. As users no longer need to stockpile ETH to safeguard against rising transaction costs, the incentive to hold large amounts of ETH diminishes. Over time, this could potentially lead to a reduction in demand, exerting further downward pressure on the token’s price as its utility declines in a less congested ecosystem.

Value Migration to Layer 2 Tokens

In addition to providing a network layer, L2 solutions commonly introduce their own native tokens, which serve multiple functions within their respective network ecosystems, such as governance, rewards distribution, and fee payments. As users migrate to L2 networks, they increasingly rely on these L2-native tokens instead of ETH for transactional purposes, among other use-cases. This shift represents a significant shift of value away from Ethereum’s native token, as users find that they no longer need ETH to the same degree for day-to-day transactions.

Furthermore, as Layer 2 ecosystems mature, their tokens could appreciate in value, especially if they are integrated into decentralized finance (DeFi) applications, providing staking rewards or voting power in governance protocols. This could lead to a long-term erosion of ETH’s utility, further reducing demand and weakening its price. If users begin to view L2 tokens as more valuable within specific ecosystems, the reliance on ETH may gradually diminish.

Diminished Ethereum Use Cases

Ethereum's reputation as a secure, decentralized platform with smart contract functionality positions it as a leader in the blockchain ecosystem. ETH's critical roles in gas fee payments and staking for network security underscore its utility within this framework. However, as Layer 2 solutions like Optimism, zk-rollups, and Arbitrum streamline off-chain transactions, they reduce the necessity for interactions on Ethereum’s L1.

With most transactions and dApp (decentralized application) interactions migrating to L2, ETH’s utility becomes increasingly concentrated on its role in staking and securing the network rather than in transactional activity. This shift not only narrows ETH’s use case but also highlights the potential vulnerability in its value proposition. As fewer users interact with L1, the need for ETH in routine operations diminishes, weakening the overall demand for the token. In a worst-case scenario, ETH could face a significant reduction in value as the token’s day-to-day use becomes more specialized and less widespread.

Uncertain Future of ETH in the Ecosystem

While Layer 2 scaling solutions have undeniably improved Ethereum’s scalability and user experience, they have simultaneously decoupled ETH’s utility from its ecosystem. With Layer 2 networks handling most transactions at a fraction of the cost, the need for ETH as a transactional asset is gradually being undermined. If this trend continues, ETH’s role in the Ethereum ecosystem may transition to a more limited function, primarily focused on staking and governance, while Layer 2 tokens dominate transactional and operational utility.

For investors, this dynamic introduces uncertainty surrounding the future of Ethereum as a whole. Ethereum’s continued development must strike a balance between embracing Layer 2 innovations and maintaining a healthy economic model for L1. If Ethereum fails to maintain ETH’s relevance across its growing multi-layered ecosystem, the long-term investment case for ETH could weaken considerably.

Potential Solutions to Restore ETH Demand

Despite the growing concerns, there are several potential solutions that could restore demand for ETH and bolster its price. One path forward is to create high-value use cases that rely on Layer 1’s unparalleled security and decentralization. For example, applications requiring maximum trust and reliability, such as institutional-grade financial contracts, could still justify the need for L1. However, given the rapid pace of L2 adoption, it seems unlikely that a sufficient volume of users will return to L1 for such use cases in the near future.

Another potential solution lies in the sheer growth of L2 ecosystems. If the volume of transactions grows rapidly enough, even reduced L1 fees may still generate meaningful revenue through periodic settlement of large batches of transactions. However, this would require extraordinary growth in Layer 2 adoption, outpacing current expectations to restore the demand for ETH-driven gas fees on the mainnet.

Finally, one of the more controversial proposals involves repricing Ethereum’s "blob space" (aka data availability space) used for L2 settlements. By increasing the cost of L2 settlements on L1, Ethereum could recapture some of the lost fee revenue and restore ETH’s deflationary pressure via EIP-1559's fee-burning mechanism. However, this would risk destabilizing the economics that have made L2s so appealing, potentially driving developers and users to competing platforms like Solana, Binance Smart Chain, or even alternative L2s with lower settlement costs.

Conclusion

Layer 2 solutions have become critical for Ethereum’s scalability and long-term growth, but their success comes at a price — namely, reduced demand for ETH on Layer 1. As transactions and dApp interactions increasingly shift to L2, Ethereum’s core network sees less activity, diminishing the need for ETH as a transactional token. To maintain its relevance, Ethereum must adjust its economic model to account for these shifts, or else risk undermining the long-term value of ETH.

Ultimately, Ethereum’s future hinges on its ability to balance innovation with economic sustainability. Whether through repricing data availability for L2s, introducing new use cases for Layer 1, or fostering rapid L2 growth, Ethereum’s community faces critical decisions that will determine the fate of ETH’s role in its evolving ecosystem.