Original author: James Ho

Original translation: TechFlow

Investing in L2 vs ETH

Layer 2 (L2) solutions on Ethereum have made significant progress over the past few years. Currently, the total locked volume (TVL) of Ethereum L2 exceeds $40 billion, compared with only $10 billion a year ago. On @l2 beat you will find more than 50 L2 projects, but the top 5-10 projects account for more than 90% of the TVL.

After the implementation of the EIP-4844 proposal, transaction fees were greatly reduced, and transaction fees on platforms such as Base and Arbitrum were even less than US$0.01.

Despite the huge progress L2 has made in technology and usage, L2 tokens have generally performed poorly as liquidity investments (although as venture investments they have performed well). You can find many jokes and memes about the poor performance of L2 tokens relative to ETH.

We review the primary L2 valuation situation relative to ETH. One notable observation is this: although the number of L2s listed has increased, their total fully diluted valuation (FDV) as a proportion of ETH has remained the same.

Two years ago, the only listed L2s were Optimism and Polygon, with 8% of ETH’s FDV. Today, we have L2 projects like Arbitrum, Starkware, zkSync, and others, with 9% of ETH’s FDV.

Every new L2 token listed actually dilutes the valuation of previously listed L2 tokens.

The result of investing in L2 tokens is significant underperformance relative to ETH. The returns over the past 12 months are as follows:

  • ETH：+ 105% 

  • OP：+ 77% 

  • MATIC：-3% 

  • ARB：-12% 

The FDV of major L2 tokens has long been around $10 billion. To a certain extent, this is quite arbitrary and market participants do not have a strong reason as to why it is $1 billion and not $2 billion or $300 million. Ultimately, there is significant supply pressure due to demand liquidity and/or massive unlocks.

The aforementioned L2 generates $20-30 million in fees per month. Since the implementation of EIP-4844, fees have dropped to $3-4 million per month, with an annualized fee of about $40-50 million.

Includes: ptimism, arbitrum, polygon, starkware, zksync

Currently, the total FDV of major L2 tokens is approximately $40 billion, with annualized fees of $40 million and a valuation multiple of approximately 1,000x.

This is in stark contrast to large DeFi protocols, which typically trade at valuation multiples between 15-60x (based on last month’s annualized fees):

  • DYDX: 60x

  • SNX: 50x

  • PENDLE: 50x

  • LDO: 40x

  • AAVE: 20 fold

  • MKR: 15x

  • GMX： 15 倍

As more L2 projects come to market, the FDV of L2 tokens may continue to be pressured and diluted. There is too much supply in the market for the liquid market to easily support.

Conclusion

  • In the long run, L2 could generate significant fee revenue. L2 generates $150 million in annual fees (including Base, Blast, Scroll), and this number is likely to grow significantly as L2 activity increases.

  • The above is not specific to a particular L2 project, but rather a broad observation about the category as a whole. It seems difficult to buy a basket of L2 tokens with ~$40B FDV and ~$40M in fees (1000x) and expect it to outperform ETH in the long term.

  • Clearly, there is no shortage of blockspace between L2, high throughput chains like Solana, Sui, Aptos, etc. The limiting factor is the applications that use that blockspace. I expect more focus to be placed on the application layer in the future, and that liquidity markets will reward the application layer over the infrastructure layer in the coming years.

  • In the last cycle, it was more common for projects to be listed significantly early. MATIC was listed on the liquid market with less than $50m FDV and now has over $5bn, an increase of more than 100x. However, this is not the case recently with $OP, $ARB, $STRK, $ZK, and most other L2 tokens that may eventually be listed.