Understanding Layer-2 Economics

The 2021 bull run showed how congested Ethereum Mainnet could get. At the peak of the bull market, it cost almost $200 dollars to send a transaction using the Ethereum blockchain. High transaction fees clearly prevented mass adoption and scalability of the network. This is when layer 2s (L2s) started building to solve this problem.??

Figure 1: Ethereum Mainnet has been losing market share to its L2s due to their rapid growth and adoption

Currently, total value locked (TVL) across Ethereum L2s has exceeded the USD 44 billion mark. This growth in TVL has been accelerated especially since the recent launches of Base and Blast. Many experts also believe that as more activity migrates away from the base layer (aka Mainnet/L1), L2s will heavily influence this cryptocurrency market cycle.

Therefore, it is key for investors to understand the economic relationship between an L2 and L1 to properly assaess and forecast value accrual within the tech stack. In today’s Crypto Market Monitor, we look at the economic model of L2s and which L2s currently dominate the market.??

What are Layer-2s and how do they work?

Simply put, Ethereum L2s are resellers of Ethereum’s block space. They help settle transactions on Ethereum Mainnet through their own blockchains in exchange for a transaction fee. This transaction fee is magnitudes lower than that of Mainnet and hence, L2s are in demand.?

L2s provide execution services to the application layer of the tech stack by batching transactions, compressing the data and (in the case of zero knowledge rollups) attach proofs of the data to Ethereum as L1 transactions (final settlement).? Here are the players involved in the rollup game:?

• Users: Users send their transactions on the L2 blockchain network as they would on L1. They own assets and interact with smart contracts deployed on the L2/rollup.?
• Rollup operator: The rollup operator here represents all the infrastructure necessary to process transactions received on the L2 network, to verify those transactions and post them on the base layer. The rollup operator compresses batches of user transaction data into smaller data sizes and publishes them on the base layer. Think of this as being similar to when we share multiple large-sized folders through a ZIP file in order to compress the size of the folder being shared.?
• The base layer: A base layer 1 protocol like Ethereum secures the data published by its rollups. This layer provides the economic security required for the rollup chain and is ultimately where all the rollup transactions are settled after execution.??
• Data availability layer: Most rollups today opt for the base layer both for security and to store data that contains their submitted transaction batches. However, there exist some rollups that opt for a separate data availability (DA) layer. When this separate DA layer is plugged into the framework by an L2/rollup, it removes significant data load from the base layer which boosts throughput, speed, and response time. For example, Celestia is a DA layer and some rollup frameworks like that of Arbitrum Orbit, the Optimism Stack, zkStack and those built using the Polygon CDK allow for rollups to integrate this.??

Figure 2: Transaction life cycle on rollups?

Breaking down the L2 economic model?

Let’s now look at the different costs incurred by the above players in an L2 framework. They are as follows:?

• Cost of data publishing: Once an operator has assembled a large enough set of transactions, they post a compressed summary of the same to the base layer. This has an associated cost. Operators incur this cost and pay the same to the base layer. This cost reduces exponentially as the size of the transactions batch increases. This Dune query depicts the current cost of data publication on the different Ethereum rollups.?

Figure 3: L2 data publishing costs

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• Proof Cost: In zero knowledge rollups like Scroll and zkSync Era, transactions can be executed only after proven. This is different from optimistic rollups where integrity of transactions is an assumption and proofs are not submitted at the time of submission. Therefore, in the case of zero knowledge scaling solutions, there is an additional cost associated with submitting this validity proof for each block. This is paid by the rollup operator.?
• Congestion cost: During times of high activity and congestion, rollup block space must be allocated according to certain rules.? Within the Ethereum ecosystem, operators rely on fee markets to arrive at this allocation. For more details, you can read this article that delves into congestion fee markets. This is incurred by the user and is paid to the rollup operator.?
• Computation cost: Operators incur the cost of hardware and computational resources required to maintain the rollup network. This is a tangible cost and this can be quantified by individual operators according to their hardware setups.?
• In addition to the above, there is the cost of MEV. (Maximum Extractable Value) This involves operators/MEV bots ordering transactions in a certain way so that it results in on-chain liquidation or arbitrage opportunities, resulting in extra profit besides transaction fees and block rewards. An example is sandwiching transactions where a user’s buy order is sandwiched between the operator’s/MEV bot’s buy and sell orders. For the sake of this article, let’s assume that this MEV is captured by the L2 operator.?

Please note that the base layer will have costs at an L1 level. Since we are talking only about the L2 framework in this article, we consider the cost to L1s to be zero in this regard.?

Below is a table summarising the revenues, costs and profits for each of these players in the L2 framework.?

?Now that we know how the L2 economic model runs, let’s have a look at the current state of Ethereum rollup markets.?

The current state of L2 markets?

Currently, Arbitrum, Optimism and Base are the leading layer 2 solutions for Ethereum. Blast was also one of the major L2s launched earlier this year and joined the pack of major L2s this cycle after a much-hyped launch. Let’s delve into the revenues, costs and profitability of each of the rollups.?

In terms of revenue, Base and Blast are the top two in the Ethereum L2 space. While there’s no favourite for the #2 spot, Base is consistently seeing the highest revenue and is leading the lot.??

Figure 4: Revenues by Ethereum L2s?

As far as L1 data publishing costs are concerned, Blast and Scroll are the highest according to data from Dune. It is important to note that since Scroll is a zero-knowledge rollup, it also incurs the cost of submitting and verifying proofs on the network in addition to this.?

?Figure 5: Base layer data publishing costs for Ethereum L2s?

Finally, we look at profits. Over the past three months, Base saw a percentage increase in daily transaction count which is 200% more than that of Arbitrum and 400% more than that of Optimism.

Daily active address growth was the second highest for Base (280%) with Arbitrum (370%) in the #1 position. In terms of trading volume too Base leads the way with a 1600% jump. Therefore, it comes as no surprise that Base is making the highest profits as is also clear from Token Terminal data.?

Figure 6: Gross profits for top Ethereum L2s

Going forward, we expect to see L2 margins compress over time as competitors enter the market. We believe rollups are positive sum for Ethereum. As more apps deploy on L2s, this should bring in more users.

This creates more demand for block space on L2s, leading to more demand for ETH since it is the gas fees currency on L2s and more ETH being burned in transaction fees. This way, value accrues back to ETH. In the long run, we think L2s will be the primary driver of value accrual back to ETH as Mainnet gets increasingly congested with rising retail and institutional interest.?

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