Original author: Messari - Kunal Goel

Compiled by: BlockTurbo

Arbitrum launched an airdrop of its ARB token in March, which was met with enthusiastic feedback from users and supporters. The launch of the token transferred decentralized control of the protocol to the ArbitrumDAO, which is governed by token holders.

Things have changed dramatically since the token launch. The first improvement proposal, which aimed to set up the Arbitrum Foundation and allocate funds to it, was rejected by token holders due to transparency and unclear communication issues. However, the proposal was simply an approval of actions already taken, and therefore failed to satisfy token holder objections. Concerned token holders and community members raised questions about the utility of the token and why the ARB token deserves a multi-billion dollar valuation when it has no cash flow, is not Arbitrum’s gas token, and may not even have full governance control.

Why Token？

The rights and responsibilities of traditional financial asset holders (equity and debt) are largely standardized across the globe and between issuers. However, cryptocurrencies allow issuers to craft unique rights and responsibilities for each token, allowing for varying degrees of value capture even between similar protocols. These rights and responsibilities form part of the token economic model and play a role in determining the success of the token and protocol.

ARB's Token Economic Model

ARB is the governance token of ArbitrumDAO, which exercises significant control over Arbitrum One and the Nova network. According to the protocol document, the DAO controls the following:

Chain Upgradability and Technical Future DAO Treasury Token Inflation Sequencer Profits — the net difference between fees collected for on-chain operations and L1 fees paid by the Sequencer All Arbitrum social media platforms and accounts

While the protocol is still in its growth phase, the protocol and DAO are protected by a Security Committee composed of elected superusers, which can quickly take action via multisig to respond to any potential vulnerabilities or risks. The DAO has the power to change the composition of the Security Committee by electing and removing members.

The Arbitrum Foundation, a legal entity registered in the Cayman Islands, also supports the DAO. It has responsibilities such as signing OTC agreements, allocating funds to the growth of the protocol, and managing social media. The DAO has the right to change the directors who manage the Arbitrum Foundation.

The token was launched with a supply of 10 billion, with a maximum annual inflation rate of 2%. In the initial distribution, 7.5% of the total supply, or 750 million ARB tokens, were transferred from the DAO treasury to the foundation's wallet. The transfer of these 750 million ARBs was not disclosed in the initial token distribution. This became a pain point for token holders and was the main reason why AIP-1 was rejected.

Governance

AIP-1 was the approval that was already in action, raising concerns about whether the ARB token would have any governance capabilities. However, token holders rejected the proposal, leading to improvements in transparency and clarity in the protocol design, where the governance capabilities of the token lie. The Foundation has taken multiple steps to address token holders’ concerns, including:

Released a transparency report with more detail on the Foundation’s setup and costs; Proposed an alternative AIP-1.1 that added a budget and phased unlocking schedule for funds transferred to the Foundation; Proposed an alternative AIP-1.2 that updated the document to more clearly articulate the Foundation’s role and the DAO’s control over it.

Additionally, community member Alex D. proposed AIP-1.05, which would require the foundation to return all funds transferred to it. However, based on the current vote count, this proposal is likely to fail.

Concerns about the token’s lack of governance capabilities appear to have no real basis due to the direct improvements that active governance brings.

cash flow

Layer 2 (L2) protocols generate cash flow through two main revenue streams:

Sequencer profit is the difference between fee income generated from L2 users and fee expenses paid to the base layer. Arbitrum's sequencer profit will be transferred to the DAO treasury. The sequencer can generate maximum extractable value (MEV) by reordering user transaction requests. Currently, the Arbitrum sequencer does not capture MEV, but the DAO can earn profits in MEV by auctioning block production rights once decentralized sequencing is implemented. As the main development team of Arbitrum, Offchain Labs has reservations about the MEV auction and is exploring ways to reduce MEV.

Although the protocol will not distribute cash flows at present, these cash flows will be accumulated in the treasury and used for further growth. In modern finance, generating free cash flows and reinvesting them is generally considered a good approach as long as the business is in a high-growth period. Layer-2 is a high-growth industry, and the cryptocurrency industry is also high-growth. If future growth is saturated, the DAO can vote to distribute its free cash flows.

Non-Gas Assets

ARB may never become a gas token on Arbitrum, but that does not need to be a prerequisite for it to be valuable. ARB will likely gain additional utility in the future as it moves toward a decentralized set of sequencers. DAOs could mandate ARB staking by Sequencers to economically align incentives and allow for slashing in the event of any misbehavior, similar to validators in a proof-of-stake network. This would increase the value of the token as users demand greater security from the protocol.

Competition with Optimism

It is clear that the ARB token has value through its cash flow, governance, and security. We can estimate its value by comparing key metrics to its closest competitor, Optimism.

Daily Trading Volume

In 2022, Arbitrum and Optimism had similar average daily volumes of 153,000 and 155,000 respectively. However, Optimism's activity appears to be primarily due to the support of its incentive program, which ended in January 2023 and experienced a sharp decline. On the other hand, Arbitrum experienced a sharp increase in 2023 due to the anticipation of the airdrop, with activity reaching 2.7 million on the day of the airdrop. As of now, Arbitrum's average daily volume is 663,000, more than double that of Optimism, which has an average daily volume of 302,000.

Daily Active Users

The trend of active addresses is similar to transactions, with Arbitrum having higher daily active addresses than Optimism. In 2022, Arbitrum had an average of 27,000 daily active addresses, while Optimism had 17,000. As of now, Arbitrum has 164,000 daily active addresses, with a peak of 612,000 on the airdrop day. Optimism had an average of 48,000 daily active addresses in 2023.

Sequencer Revenue and Profit

Due to its higher activity volume, Arbitrum generates higher Sequencer revenue and profits than Optimism. In 2022, Arbitrum generated $22 million in Sequencer revenue and $6 million in profits, while Optimism generated $18 million and $4 million in Sequencer revenue and profits, respectively. In the first quarter of 2023, Arbitrum generated $10 million in revenue and $4 million in profits, further surpassing Optimism, which had $6 million in revenue and $1 million in profits.

TVL

Arbitrum has had a higher TVL than Optimism for most of 2022 and 2023. Arbitrum’s dominance has further increased after the launch of its token, as ARB has become an important collateral asset in its DeFi protocol. Currently, Arbitrum’s TVL is $2.2 billion, while Optimism’s is $900 million.

Relative Valuation

Although Arbitrum's fully diluted market cap is 20% higher, it's significantly undervalued on all key valuation metrics. Although Optimism has an incentive plan, Arbitrum was able to outperform for much of 2022. Now with the ARB token, Arbitrum can run its own incentive program and further extend its lead.

other factors

Although Arbitrum and Optimism are close competitors, the comparison is not entirely accurate. Here are some additional details that should be considered.

Airdrop Event

Arbitrum experienced a large increase in activity on the day of the airdrop, including higher transaction volume, active users, sorter revenue, and profits. Since the period analyzed is 2023, this somewhat inflates Arbitrum’s adoption metrics.

Superchain Ecosystem

Optimism has an early lead in creating a superchain ecosystem, with Coinbase announcing it is building on OP Stack. Arbitrum has also announced its own rollup ecosystem, Arbitrum Orbit, but has yet to announce any significant builders.

Differences in governance structures

The ARB token has more governance control over Arbitrum than OP holders have over Optimism. OP holders share governance with their Citizens' House, which controls the revenue generated from the collator. Therefore, ARB should generate more value than OP from the same revenue.

in conclusion

Arbitrum is Ethereum’s largest Layer-2 solution, already ahead of its only major competitor, Optimism, on all metrics. The DAO and Foundation should ignore this minor annoyance and act together to ensure Arbitrum builds on its early lead. With Ethereum’s Shanghai upgrade now behind us, the L2 war is far from over. Optimism is also planning its own upgrade, and more rollup releases are coming soon.

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