Written by: IOSG Ventures
1. Crypto’s business model
There have been many criticisms recently about the value accumulation of Ethereum and L2. The rapid exploratory development of Ethereum and L2 has brought difficulties to their value assessment. This article attempts to give some thinking directions. Before talking about how to look at the business model of Ethereum and L2 specifically, let's take a look at the business model of the entire Crypto.
1.1 "Enterprise" category
Core: Control + monopoly (licensing), price discrimination brings profits
The key point of this model is to achieve the goal of increasing revenue through a high degree of control over services and protocols, which is no different from the operating principles of traditional companies. Decentralization is highly disposable here, and it only needs to be done to a degree that users can accept. As a profit-oriented company, it needs to ensure efficient operation, and control diplomacy should not occur.
For such projects, the competition is about the business model, namely the ability to discriminate prices, the speed of response to meet user needs, and the ability to bring about user growth. Tokens are mainly a means of acquiring customers and assetization.
Take Solana Foundation as an example. It has a high degree of control over the ecosystem, and it can be said that it even has the right to shut down. Solana calls itself the Global Onchain Nasdaq, and has always emphasized fundamentals, especially business models and profits, which constitute the core value of this story. Solana's revenue mostly comes from MEV revenue, that is, the price discrimination generated after monopolizing the block space, and the SOL asset itself is a centralized assetization tool.
1.2 "Protocol" class
Core: No permission to participate (asset issuance, business), open and relatively fixed fee standards
The focus of this category is to create open, almost unchangeable protocol standards. There are DAOs and foundations behind the governance, but they are less involved and allow the protocol to run autonomously. The use of the protocol is permissionless, and the profit model is open and difficult to change. Anyone can use the protocol to create markets and assets to obtain their own business or profits. "Protocols" often have an assessment of the degree of autonomy, that is, the degree of decentralization has a range. The lowest is that the team has the right to update the protocol and is supervised by the market; the worst is to destroy their own update rights and hand over the product to the market. There are different degrees of hard or soft decentralized governance differences in between. Tokens here play more of a dividend and governance role.
For such projects, the test is the sustainability of product operation, the sustainability of demand, and the network effect brought about by the entry time. It is often found that the pioneers of PMF have significant competitive advantages.
1.3 "Assets" category
Core: Focus on the value of the asset itself
Including BTC, Memecoin, decentralized algorithmic stablecoins, etc. The asset itself has gained consensus based on its characteristics, and the empowerment of the asset is continuously completed based on this. The attributes of the asset itself include three aspects. The first is the consensus and network effect brought about by "early adoption" in a specific scenario, such as BTC as a value storage, USDT as a payment medium, and ETH as an asset issuance; the second is the asset mechanism attributes, including scarcity, deflation mechanism, price anchoring, etc.; the third is the wide acceptance and dissemination brought about by its own symbolic meaning, such as the widely understood BTC as "digital gold", ETH "programmable credit currency", and the cultural effect of Memecoin.
For such projects, the test is the strength of consensus, asset adoption and sustainability.
In the Crypto world, different projects and assets correspond to the above business models or a combination of models. We can also try to use this perspective to evaluate the current Ethereum and L2.
2. What is L2’s business model?
2.1 Current Positioning of L2
L2 was originally positioned as Ethereum's Scaling, carrying Ethereum's transactions on a large scale. This goal has actually been achieved to a certain extent. From the perspective of diverting Ethereum transactions and bringing incremental growth, it is relatively successful. At present, L2 has become an important part of the Ethereum ecosystem, with the number of transactions accounting for 85% of the total and the transaction volume accounting for 31%, becoming an important part of Ethereum's fundamentals.
The number of active addresses is 3-4 times that of Ethereum
Since L2 transactions are cheap, the actual improvement in Ethereum's overall transaction data will be slightly inflated, but the impact of L2 adoption can still be seen.
However, L2 did not bring the same proportion of revenue to Ethereum under such transactions. The revenue brought by L2 is mainly divided into two aspects. The first is DA fees, which were transaction data fees before EIP4844 and Blob fees after EIP4844. The second is MEV. In addition to the current Based Rollup, L2 has completely swallowed this revenue into its own pocket, and in the short term, the expectation of giving back to Ethereum is low. This actually makes Ethereum enter inflation at present, and the concept of ultrasonic currency is gradually declining.
Here is an explanation as to why DA fees cannot be L2’s income contribution to L1.
DA only generates priority fees when it reaches saturation, i.e. monopoly pricing power
DA is a commodity in an unsaturated state. In the long run, users can hedge and find substitutes.
The growth rate of DA demand is not proportional to the growth rate of supply. There are a large proportion of robot transactions in L2, and these transactions are not as necessary as real user transactions. If the C-end costs brought by DA fees are too high, this part of the transaction will naturally slow down. Therefore, it is not a reasonable conclusion that the so-called Blob will be saturated if the number of transactions increases several times.
In essence, capacity expansion itself is contrary to DA charging. In the pursuit of continuous capacity expansion, making money should not be designed based on the degree of transaction congestion. The architecture of Ethereum L2 also naturally refers to this. Previously regarded as ETH's Beta asset, it is still in the narrative, and L2 still calls itself "Ethereum L2". In terms of fundamentals, it has gone further and further. In the future, L2's income will no longer mean Ethereum's income. The two should have their own valuation systems.
2.2 What are the business models of different L2s?
2.2.1 Universal L2
Universal L2 refers to the general-purpose L2, which is more committed to becoming an application ecosystem. Many early Universal Rollups have moved towards alliances. Currently, most of the better-performing Universal Rollups have made innovations in the profit distribution mechanism to better motivate developers to innovate and retain, and users to actively participate. The trend of L2 is to gradually stop relying too much on Ethereum and maximize its customizability through some modular solutions.
The management method of Universal L2 is to expand outward with each team as the core. The competition faced by Universal L2 comes directly from the external L1. Under its profit distribution mechanism, Universal L2 obtains almost 100% of its revenue.
Such positioning is more in line with the "enterprise" model we described, and is suitable for valuation in a similar way to Alt L1, which means that its value is an assessment of its ecology, fundamentals, and especially revenue. Compared with Alt L1, its advantage is that it can fully utilize the community and ecology of Ethereum, as well as the liquidity of ETH. The disadvantage is that the ability to capitalize tokens is relatively lacking, and the ability to acquire customers is slightly insufficient compared to Alt L1.
2.2.2 Alliance L2
Alliance L2 is similar to Ethereum, both have their own first and second layers (L2/L3). The difference between the Alliance and Ethereum is that the issuance of L2/L3 within the Alliance requires permission, which guarantees the business model of Alliance L2.
Early Universal L2s all moved towards Alliance L2s, which means that after gaining a certain amount of market attention, Alliance L2s are often better businesses. Arbitrum and Optimism before the transformation, and zkSync and Initia recently are all working in this direction. Alliance-type L2s are essentially developing their own L1 ecosystems, but they still rely on the security of Ethereum and use ETH as a settlement currency. The characteristic of Alliance L2s is that they change the business model and participants within the ecosystem through their own management capabilities. Therefore, it is more appropriate to regard Alliance L2s as "protocols" with a higher degree of centralization.
Alliance L2 is more regarded as a controlled Ethereum. Ecosystems like Optimism still delegate the task of application development. The difference from Ethereum is that such decentralization is more strategic. Through the licensing model and centralized management model, resources can be concentrated, synergy effects can be expanded, excellent resources can be brought in to share liquidity and ecology, and after the new ecology is launched, the original ecology can be fed back through the revenue gate. This is why Coinbase and Sony both choose Optimism. With the "enterprise" capabilities of L2, more breakthrough applications are expected to be born.
We have mentioned before that "protocol" models have different decentralization ranges. In the process of exploring protocol decentralization, chains or applications often flee, such as DyDx in the early Arbitrum ecosystem and TreasureDAO later. How to develop and consolidate one's own ecosystem while balancing the degree of protocol decentralization is the core value of measuring the alliance L2.
2.2.3 Appchain L2
Appchain L2 is more of an App with a new business model and value capture. Its valuation should return to the application itself and the new value that the L2 business model brings to the application, regardless of whether the application itself is more suitable for the "enterprise" or "protocol" model. Most App Rollups will choose to be attached to the Alliance L2, which has lower startup costs and stronger ecological radiation effects to rely on.
Appchain currently relies more on alliance L2 and RaaS, and the cost of building a chain is very low. However, in the design of chain adaptability, supporting infrastructure (such as data browsers, etc.) still needs to be invested. For Appchain, the visible benefits are more efficient use of tokens and capture of MEVs, while what is given up is the Lego effect and stronger liquidity on a chain. In terms of input-output alone, not all applications are suitable for Appchain. Suitable applications have a strong endogenous cycle, such as Perp DEX, Gamefi, etc. In the long run, without the narrative heat of transformation to L2, how to reasonably evaluate ROI is more important.
3. How does L2 affect Ethereum’s business model?
After the Merge, especially after EIP1559, before obtaining a large amount of L2 expansion and EIP4844, Ethereum still relied on the transaction volume in the limited block space to capture higher priority fees and MEV. After the L2 expansion, it actually gave up the MEV of the expansion transactions and reduced the priority fees brought by L1 native transactions. After EIP4844, it gave up this part of the income as a DA. The active abandonment of such income is not a typical corporate practice. In fact, Ethereum has never developed into the "enterprise" model we define. The concession of this part of the profit is actually to give the DA and the settlement layer the maximum space under the premise of adhering to a high degree of decentralization and autonomy, so that L2 can sacrifice a certain degree of decentralization under the minimum economic burden, develop as large an ecosystem and as many applications as possible.
3.1 Ethereum as an L2 issuance protocol
Since establishing the path of Rollup Centric, Ethereum has been moving towards a direction that is more "protocol" than "enterprise". Although some requirements for Rollup have been put forward, such as L2beat Rollup stages, there has been no actual interference. Currently, Vitalik has put forward some requirements for Ethereum Alignment, which will make the governance model of the Ethereum "protocol" move closer to a more cohesive direction. However, the overall level is still a "protocol" with a high degree of autonomy, and its long-term role is to issue Ethereum L2.
Currently, Ethereum L1 still carries more than half of the transaction volume in the entire ecosystem. In the long run, Ethereum is more like a platform (settlement layer) for issuing L2 without permission, which is highly decentralized, autonomous, censorship-resistant, and the most secure.
Generally speaking, the model of unlicensed issuance platforms is to extract a certain percentage from the issuance and trading of new assets, such as Uniswap extracting user handling fees, Pumpdotfun charging users coin issuance fees in the early days, and prediction markets extracting user transaction fees, etc.
Therefore, although Ethereum is an L2 issuance protocol, it did not set a profit gate through L2 in the early stage. This has led to the birth of a large number of L2 ecosystems that rely on Ethereum's liquidity and community but do not contribute revenue to Ethereum, which means that Ethereum is the most decentralized and autonomous type in the "protocol" model. Looking at the relatively successful non-permissioned protocols, such as Uniswap, the fee switch is turned on in some pools with absolute monopoly and network effects. After the protocol has achieved network effects, it tries to obtain fees at a scale acceptable to users. This is the advantage brought by centralized management. At present, for Ethereum, on the one hand, it is making some attempts to try fee gates through Based Rollup, etc., and on the other hand, it does not force the pursuit of profits, allowing the L2 ecosystem that originally had no profit gate to continue to develop at a high speed.
3.2 Ethereum as a Store of Value Asset & Programmable Trust Currency
It has been difficult to value ETH through the "enterprise" and "protocol" models for a long time, because the early L1 business model no longer holds after expansion. After all, a company willing to sacrifice its own profits and a protocol willing to permanently turn off the fee switch should no longer be valued from the traditional perspective of enterprise and protocol fundamentals.
The original intention of Ethereum to abandon fundamentals is to give more space for the overall ecological development. As the ecology prospers, the value of Ethereum will eventually fall on the monetary value of ETH. So, what value can the potential prosperity of the Ethereum ecology and ETH bring to each other?
Some people think it is the security attribute brought by ETH. But at the same time, some technical people who believe in the value of distributed networks and anti-crypto believe that P2P networks should not be bound to specific and speculative currencies to provide incentives for nodes. Some people believe that incentives should be provided in a more non-speculative model, such as stablecoins or early PoW mining. The decentralization pursued by distributed networks and the continuous reduction of costs and the pursuit of capital-intensive PoS mining are not naturally adapted, and many governance methods need to be improved. At the same time, the security value of ETH itself is affected by its own price and has considerable reflexivity. We mentioned these two points in the previous article discussing economic security. At present, ETH is doing well in both incentives and security models, but in the long run, it is not its best.
So what is the most important value of ETH relative to the Ethereum network that will be recognized by the market?
We may be able to find some clues from the development history of Ethereum. So far, there are five highlights in the history of Ethereum:
Direct Token Issuance
DeFi Summer Liquidity Mining
Liquidity Staking
L2 Mining
Re-staking AVS Mining
The earliest direct issuance of token assets through Ethereum opened up a new world of asset issuance and also allowed Ethereum to find its initial PMF. Since then, the main development nodes of ETH have been closely related to asset issuance.
In the DeFi Summer era, the asset issuance model evolved into liquidity mining, which not only made ETH an asset supporting asset issuance, but also made it a liquidity target with pricing power. So ETH found its second PMF - liquidity pricing asset. From then on, the issuance of assets in the Ethereum ecosystem will be accompanied by the consideration of liquidity improvement.
Liquidity pledge not only solves the pledge demand, but also enhances the liquidity valuation value. Since then, asset issuance has gradually introduced the attributes of ETH time opportunity cost mining, that is, pledge, which is the third PMF of Ethereum.
L2 mining is a manifestation of such asset issuance + liquidity pricing + time cost mining. By bridging ETH to L2, staking and mining native Tokens/DeFi protocol Tokens, while providing liquidity, this liquidity flows to various protocols through the liquidity engine on L2. The three PMFs of ETH are combined into one.
Re-staking and AVS mining are another way to combine the three. The liquidity re-staking agreement releases liquidity, similar to the EigenLayer re-staking agreement that provides staking, and mines AVS native tokens indefinitely through time costs.
Ethereum has been repeating and improving this model, creating demand and value for ETH itself in asset issuance and DeFi use cases. It has also been strengthening ETH's position as the first choice in interest-bearing assets, asset issuance, liquidity provision, asset exposure, and gas demand, all of which have allowed ETH to be distributed to protocols and users, becoming the primary target of infrastructure and protocols in the Ethereum ecosystem and the first choice of value currency in the minds of users.
Currently, the competition for this value is not fierce. For example, in the mainstream pool of Uniswap, currency pairs with ETH as the settlement unit account for more than 80%. However, ETH still faces some potential competition. This includes competition in value storage between L2 native assets and derivative assets, such as $cbBTC on Base, and competition for off-chain liquidity brought by the intent network.
But in the long run, the network effects brought about by the construction of ETH and the incremental market of economic activities will bring about increased demand, and as Myles said, all value will become more valuable.
4. Conclusion
There are three types of valuable business models for Crypto: enterprises, protocols, and currencies themselves. The differences between the first two are mainly in the centralized control, monopoly, adjustment, and price discrimination capabilities of the protocols, and the protocols themselves also pursue different degrees of autonomy. Currency itself lies in the network effect generated by early use in a scenario with traction.
Due to the early positioning of Ethereum and its L2 strategy, the value of Ethereum was pushed towards the level of permissionless "protocol" and ETH "currency". Due to Ethereum's vision, leadership structure and early L2 strategy, Ethereum semi-actively and semi-passively gave up revenue from L2, reducing the burden of L2 to open up growth space for L2. Although the standards of Ethereum Alignment from the Ethereum Foundation are becoming clearer and clearer, the overall open and autonomous positioning also makes Ethereum no longer positioned as a simple "enterprise".
The powerful early L2 ecosystem evolved into Alliance L2, which is essentially a more centralized leadership, and a licensed L2 issued "protocol", continuing the mission of Ethereum in a more centralized mode. Universal L2 returned to the L1 level as a "enterprise" competition, and compared with L1 outside the Ethereum ecosystem, it has advantages at the startup level and disadvantages at the token level. The value of Appchain should return to the "application" itself with an improved business model (more "enterprise" or a more centralized "protocol"), and it is more necessary to consider the ROI of the chain. The more centralized and vigorous development of L2 is based on the support and space brought by giving up income under the highly decentralized model of Ethereum.
Ethereum, under the premise that DA has been proven to be not a suitable business model, has gradually positioned itself as a permissionless L2 issuance protocol that has abandoned the profit gate. It has proactively abandoned its monopoly in the stock market, hoping to gain the ability to generate revenue in the incremental market. How the L2 Alliance and some L2s with strong corporate nature can bring new growth without the burden of paying taxes to Ethereum is Ethereum's biggest bet.
The value of Ethereum as a currency comes from the continuous asset issuance and liquidity games on Ethereum. The five PMF moments continue to bring value and usage inertia to the ETH asset itself. With the expansion of the overall Ethereum ecosystem, ETH, as the most valuable asset in the ecosystem, plays a vital role in every link from the launch to the operation of the new ecosystem, which relies on the strong network effect of ETH. As the ecosystem stabilizes, some native assets/Wrap assets will certainly play a supplementary role, but it is difficult to affect the absolute share of ETH.
If the L2 ecosystem prospers one day in the future, ETH, as a network effect, will still be able to obtain huge returns from incremental adoption even if it does not necessarily have a monopoly effect. By then, Ethereum will gradually establish a value form dominated by ETH assets.
After understanding the trade-offs of Ethereum for the ecosystem and the value positioning of ETH and L2, we are more convinced that L2, as the new force of the Ethereum ecosystem, will move forward lightly in a commercial interest-driven mode, and quickly open up the ceiling of use cases with rich technical architecture options, multi-directional development, and internal vertical integration. ETH, as an asset with the most network effects, will be discovered in value as the entire ecosystem flourishes.
