How high fees in Ethereum led to the creation of a multi-billion dollar market. How layer 2 networks work, why there are so many of them and what to expect from the market of their tokens
With the start of the bull market in 2020, the Ethereum blockchain experienced a significant increase in network fees. And which rarely dropped below $3 per transaction, reaching hundreds of dollars at times of peak activity. Vitalik Buterin, founder of the second most capitalized cryptocurrency, called the situation a security threat to the entire network, calling for reform of transaction mechanisms.
Network fees in the Ethereum blockchain are determined by market demand for processing transactions on the network. At times of increased user activity, transaction fees can rise to huge values. Transaction fees also depend on the complexity of the transaction. An ordinary token transfer will be a simple transaction. And interacting with decentralized financial applications is more complex. The price difference can exceed hundreds of times.
In 2021, Buterin published a long-term vision for the development of accumulation packets (so-called rollups) as one of the main technologies for scaling Ethereum. The essence of the solution is to move the transaction load to Layer-2 (L2) networks. The principle of rollups is to accumulate multiple transactions into packets and send this mass of transactions for verification to the main "ether" network, thus unloading this network.
The ideas of the Ethereum founder were also supported by venture capital firms. Dan Morehead's Pantera Capital, the oldest US crypto fund, called L2 and rollups "an immediate and long-term solution to the growing congestion on the Ethereum network" at the end of 2021.
L2 solutions have become so popular that about 50 such networks have already been created since 2021. And most of them have their own token. The total capitalization of these tokens already exceeds $19 billion. And the number of applications running in such networks exceeds 1 thousand in Ethereum-based L2 networks alone, according to Defillama. The number of unique active addresses from the daily calculation in Arbitrum alone amounted to more than 550 thousand.
All of the networks have a unique set of applications leveraging different cryptoassets - each of these networks allows for different formats of tokens to be issued on it. This diversity is complicated by a lack of standardization. For example, to transfer ETH from one network to another, one or even two specialized "bridges" must be used. In addition, many crypto-assets from one L2 network cannot be used in any other network.
How Layer 2 networks work
All of these networks did not appear at once, and some of the existing ones use pioneer software solutions. The first protocols based on rollup technology were Optimism, Arbitrum, Loopring, Metis or zkSync. These are all projects with strong venture capital backing from leading funds. Matter Labs alone (developer of zkSync) has raised more than $400 million in several investment rounds.
The projects were divided into two categories by the method of technology implementation: ZK (zero-knowledge) and Optimistic. To simplify, the Optimistic group of rollups implies that any transaction is correct unless proven otherwise. And the ZK group implies that the transaction data is correct and has been verified without the need to double-check it.
Technically, this means that Optimistic solutions imply a time period where the fairness of the network's transaction calculations can be challenged by the system. For example, it would take several days to withdraw ETH coins from such a network. ZK-based solutions do not have such long withdrawal periods. Optimistic technology is used by projects such as Arbitrum or Optimism. ZK is used by zkSync or Starknet.
In the long term (in a decade or more), ZK rollups are likely to surpass Optimistic rollups, Buterin said in a commentary for The Block.
The implementation of such protocols has indeed partially offloaded Ethereum's core network. However, commissions on the L2 networks themselves have remained relatively high. As of May 2022, the average size of simple transactions like normal ETH transfers in Layer 2 solutions hovered around $1. At the same time, on the main Ethereum network, fees for normal transfers exceeded tens, and at points hundreds, of dollars, according to Bitinfocharts data.
"An adequate transaction fee, in my opinion, should not exceed $0.05. But we are definitely making a lot of progress already," Buterin commented.
To solve this problem, Ethereum developers made an update in March 2024 under the working name Dencun.
As a result of the new mechanisms, Ethereum's second-tier networks have seen a tenfold reduction in commissions: the average price per transaction in the Optimism network has dropped to almost $0.04 instead of about $1.4 before the upgrade. In Arbitrum and Base, the commission dropped to $0.004 and $0.001 respectively. In zkSync's L2 solution, the commission dropped to $0.01.
New networks and their tokens
In addition to application benefits for the Ethereum blockchain, by reducing the load on the network and, consequently, transaction costs for users, Layer 2 solutions generate significant revenues for their beneficiaries.
In particular, since the beginning of 2024, the L2-network Base from the largest U.S. crypto exchange Coinbase has brought it more than $51 million in revenue in the form of commissions. The revenue of Arbitrum creators amounted to more than $35 million, Optimism - $28.4 million, zkSync - $23.4 million, according to Token Terminal. And the combined daily revenue of the top six L2 solutions is in the $200,000 to $300,000 range, according to intoTheBlock Terminal.
Analysts at management company VanEck believe L2 network tokens have the potential to grow to $1 trillion by 2030. However, the market may not end up "absorbing" that many protocols, given the uncertainty surrounding the development of many of them.
They predict we should expect fierce competition among L2 solutions, whose main advantage will be the network effect that forms around their native token, rather than the fundamentals.
In total, the top seven tokens collectively already have a capitalization of around $40 billion, and there are many more strong projects that plan to enter the market in the medium term. This means another $100 billion or so in L2 tokens could pour into the market in the next 12-18 months. The market is too far away from absorbing even a fraction of this supply without large-scale price sagging. There is reason to believe that some L2 tokens will indeed be in demand. But the ways to create value for them are harder to predict than for other groups of cryptoassets - L2 tokens are not even base money in their own ecosystems.
The fact is that most L2 project tokens have no options for use other than the ability to vote on a protocol governance proposal. For example, in many Ethereum-based Layer 2 networks, the token is not even used for voting, although it is openly traded on the markets.
Following this, analysts are generally negative on the long-term value prospects of most L2 tokens. $ETH
