Author: Michael Nadeau, The DeFi Report; Translated by: Tao Zhu, Golden Finance
Ethereum is executing on its roadmap. The network is scaling with Layer 2. Sometime this summer we should have ETFs trading. Larry Fink won’t stop talking about tokenization. We are on the brink of a Fed rate cut.
Now is a good time to be bullish on Ethereum.
Should you own ETH? Or a basket of L2s? Or both?
In this week’s report, we offer a data-driven portfolio construction framework.
L2 Data and Ethereum
We’ll start our analysis with some high-level data, comparing the top L2s vs. ETH across multiple KPIs.
We also looked at the best L2s in each metric.
Total value locked:
Data: Token Terminal as of June 23, 2024
The top 12 L2s collectively account for 15% of Ethereum’s daily locked value.
Here are the TVL rankings in L2:
Data: Token Terminal as of June 23, 2024
Arbitrum ranks first with the following top 5 drivers:
Aave - $790 million;
Pendle - $659 million;
GMX - $612 million;
Renzo - $371 million;
Uniswap - $306 million.
Notably, Blast made it to the second spot by offering yield in Ethereum (via staking) and stablecoins (via MakerDAO, Treasury Bills). We’ll be keeping an eye on this to see how sticky it is after the token drop.
Daily active addresses:
Data: Token Terminal as of June 23, 2024
Currently, the number of daily active addresses of the top L2 is 4.7 times that of Ethereum. Here is the L2 ranking:
Data: Token Terminal as of June 23, 2024
Arbitrum once again takes the top spot and is the first L2 to have more sustained daily users than Ethereum L1.
Data: Token Terminal as of June 23, 2024
The fees from the top 11 L2s account for 15% of the fees collected by Ethereum in the last 90 days.
Let’s take a quick look at the L2 leaderboard:
Data: Token Terminal as of June 23, 2024
Over the past 90 days, Base’s fees were more than twice as high as the second-ranked Scroll and accounted for 6% of total Ethereum fees.
90-day trading volume:
Data: Token Terminal as of June 23, 2024
On average, top L2s now process 6.7 times more transactions per day than Ethereum L1.
Here is the breakdown of L2:
Data: Token Terminal as of June 23, 2024
Base has about 66% of the average daily user base of Arbitrum. However, Base users trade 6.9x more on Arbitrum per day, compared to only 2.5x on Arbitrum.
Cost/Transaction:
Data: Token Terminal as of June 23, 2024
Average cost/transaction reveals why Arbitrum’s fees are in the middle despite being second in terms of transactions: transactions on Arbitrum cost $0.02, while transactions on Base cost $0.15. For reference, the average transaction fee on Ethereum during the same period was $5.30.
Developer:
Data: Token Terminal as of June 23, 2024
The top L2s have roughly twice as many active core developers as they do today. *Token Terminal defines core developers as the number of unique Github users who have made 1+ commits to a project’s public repository in the past 30 days. These numbers do not include ecosystem/application developers.
Let’s see how L2 compares:
Data: Token Terminal as of June 23, 2024
Here, Optimism appears in the#1spot for the first time, with more than twice as many active developers on Arbitrum today. Notably, Base is in the middle — suggesting that they are reaping more benefits from developers than their competitors, taking into account applications, users, and on-chain fees.
But what do market participants hold? ETH or L2 tokens?
Data: Token Terminal as of June 23, 2024
The L2 portfolio only accounts for 2% of Ethereum’s current token holders (note that 4 top projects do not yet have tokens: Base, Blast, Linea, and Scroll).
Here are the details of the 8 leaders who own tokens in the market:
Data: Token Terminal as of June 23, 2024
In terms of mind share among L2 token holders/investors, Optimism and Arbitrum have 80% of the market share, but only 1% of Ethereum L1.
Finally, let's summarize the valuation:
Data: Token Terminal as of June 23, 2024
As mentioned above, the top-level L2 has:
15% of Ethereum TVL;
15% of Ethereum fees;
4.7 times the number of active addresses;
6.7 times the number of daily transactions;
2x the number of developers.
only……
2.4% token holders;
9% of Ethereum’s fully diluted market cap;
And 2.7% of Ethereum’s circulating market capitalization.
Here are the fully diluted market caps for the top L2s:
Data: Token Terminal
On a fully diluted basis, Arbitrum and Optimism account for 40% of the top 10 and 3.7% of Ethereum’s market cap (1.06% of circulating market cap).
L2 Token Utility/Demand vs ETH
Now that we have some data, let’s examine the utility and demand for ETH tokens vs. L2 tokens.
ETH
Today, ETH is used for the following:
Pay gas fees on the Ethereum network (including L2!). If you want to transfer stablecoins, trade on a DEX, mint NFTs, play games on the chain, get a loan, etc., you need some ETH.
Collateral for Yield. Want to earn yield on the Ethereum network? You’ll need some ETH to do that.
Collateral for loans. Currently, more than 1% (2.3 million) of the circulating supply of ETH is locked in MakerDAO smart contracts as collateral for on-chain loans.
Medium of exchange. Want to buy your favorite NFT on OpenSea? You’ll need some ETH.
Real-world assets. Want to tokenize an asset so it can be freely traded around the world? You need some ETH.
Deploy smart contracts. Want to build something on Ethereum? You need some ETH.
Re-staking. ETH can be used as collateral to earn fees directly from Ethereum, as well as from applications and protocols within the Ethereum ecosystem. This is done by "re-staking" ETH. In order to earn this yield, you need some ETH.
As we can see, ETH has abundant utility within the Ethereum ecosystem. This utility drives demand for the asset in a similar way to how oil’s utility drives demand for assets/commodities.
For these reasons, we believe ETH has more utility than any other asset in cryptocurrency today.
Layer 2 Tokens
Today, Layer 2 tokens are used for… governance.
Indeed, some networks allow users to pay gas fees with L2 tokens, but most of the time, these fees are paid with ETH.
Additionally, L2 must pay for block space on Ethereum (where transactions are settled) in ETH.
Key Point: L2 does not have the utility or incentive structure to drive demand for tokens today. Ethereum does.
L2 Token Value Accumulation and ETH
How does the value of ETH accumulate? Through actual returns generated by staking (and re-staking).
How do L2 tokens appreciate in value? Today there is no such value accrual mechanism, as user fees are paid to the L2 sorter, not the distributed validator network.
Execution (L2) and Settlement (ETH)
What is more valuable? Execution? Or settlement?
First, let's set the difference between the two horizontally:
Execution: A helpful analogy might be to think of execution as ordering food at a restaurant. You choose what you want. You communicate with the waiter. The waiter then confirms your order.
Settlement: Settlement can be thought of as paying the bill, receiving the receipt, and accounting for the transaction.
Today, the relationship between L1 and L2 is this: users perform transactions on L2, and L2 settles transactions on L1 (paying fees for it).
So, what is more valuable?
Some thoughts from the "L2/execution" camp:
In traditional finance, the vast majority of value accrues to the execution layer of the technology stack — brokers, market makers, and high-frequency traders. Less value is generated by settlement — think of it as clearing/accounting (DTCC).
It is possible that transaction fees on all blockchains will eventually drop to zero (or close to zero). If that is the case, then MEV will be how these networks are monetized in the future. For now. If all execution happens on L2, then that is where we expect MEV to come from - since execution includes batching and ordering of transactions.
Some thoughts from the Ethereum L1/settlement camp:
As far as the Ethereum ecosystem is concerned, there is only 1 settlement layer. Everything on top ends up on Ethereum and pays ETH fees for it.
L2 inherits the security and decentralization of Ethereum.
The utility of the token (and subsequent network effects) may ultimately be the only thing that matters. For example, Ethereum could lose most of its fees at the L1 level, but still get cash flow from other applications and protocols that “rent” Ethereum security (including L2s that don’t have tokens like Base).
L2 Margin vs ETH
Ethereum's margin is essentially 100% and will not change in the future.
Here are the current L2 margins, which have increased significantly since EIP4844:
Data: Token Terminal
Base has a lower profit margin because it pays 15% of its total revenue to Optimism.
Blast balances are low due to delays in upgrading the network to support upgrades associated with EIP 4844. Since the May 27 upgrade, Blast profitability has increased to 91%.
L2 Correlation with ETH
ARB & OP Price Conversion to ETH
Data: Token Terminal
The historical price correlation coefficient between ARB and ETH is 0.71 (highly correlated).
Likewise, optimism has a low correlation with ETH, with a historical correlation of 0.61 (moderately correlated with periods when it was completely uncorrelated with ETH).
ARB price to users
Data: Token Terminal
Arbitrum's historical correlation coefficient is -0.009 (negative correlation). This is not a typo.
How does the negative correlation between user activity and price compare?
Token unlocking. This is largely due to a lack of regulation by the SEC and Congress.
Stay tuned as we'll cover unlocks in the next section.
ARB Prices and Fees
Data: Token Terminal
Not surprisingly, prices are also negatively correlated with fees (historical correlation is -0.004). You can’t make that up.
L2 Catalyst and ETH
Ethereum Catalyst
The biggest catalyst for ETH next year is an ETF — which should be traded sometime this summer. Other catalysts include re-staking (additional yield for ETH holders), tokenization of real-world assets, enterprise adoption, and maturation of DeFi and NFT use cases.
With the ETF approved, we expect Wall Street to start doing some real due diligence on the network and the asset. We ultimately believe Ethereum has a larger addressable market than Bitcoin, so it will be interesting to see if large institutions ultimately come to the same conclusion.
L2 Catalyst
We see two potential catalysts for L2 next year.
Ethereum price. If ETH outperforms the ETF following ETF approval, we may see some investors jump directly to L2 — seeking allocations to projects with smaller market caps.
L2 re-rating relative to ETH. Currently, the top L2s represent only 2.7% of Ethereum’s market cap (9% fully diluted). If the market believes that this percentage should be closer to 10%, then L2s may outperform.
Token Unlock
This is probably the most important section of this report.
There is no “unlocking” of tokens in Ethereum, as the supply is fully circulated. Additionally, the Ethereum whales who received a large allocation through the initial ICO have now experienced two bull runs and can sell/recycle their tokens back into the market/new hands.
That being said, during periods of slow on-chain activity, the supply of Ethereum may increase and “fee burn” may not be enough to offset the new issuance/consensus rewards paid to incentivize validators to provide their services.
For reference, Ethereum was deflationary in 2023 (-.28%) and has been deflationary so far in 2024 (-.02%). Here are Ethereum’s inflation rates since inception:
Data: Etherscan
Notably, with L2 fees falling as a result of EIP4844 (network upgrade), we are observing a slowdown in the rate of “fee burn”.
In fact, Ethereum’s ETH issuance has increased by 75,951 since March 13, or about 767 new ETH per day (EIP 4844 implementation). This year, the network’s supply has still decreased by 23.3k ETH. But if we don’t see an increase in on-chain activity in the second half of this year, the network may see slight inflation this year.
L2 differs in the following factors:
L2 distributes tokens to investors, advisors, and contributors, typically with a vesting period of 4 years or more.
Today, the vast majority of L2 tokens (especially major ones) do not have a “buyback” or “burn” mechanism.
L2 tokens have almost zero utility and therefore have no structural purchase support.
As mentioned earlier, we predict that Ethereum will experience mild deflation this year.
We can compare this to what is known about L2 token unlocks, for example Arbitrum will unlock 1.15 billion tokens over the next year (36% inflation on existing supply).
Over the next three years, Arbitrum will unlock 3.2 billion tokens, most of which will be distributed to investors and contributors who hold large amounts of unrealized gains.
We should expect them to be sold at the end of the vesting period - increasing the supply of tokens on the market.
We can see the impact of token unlocks in the chart below. For example, Arbitrum’s unlocks started in March and we can see the impact on the price below. This offset the amazing growth in Arbitrum’s fundamentals (pink represents active user growth).
Data: Token Terminal
Given that Arbitrum will unlock 1.15 billion tokens over the next year, nearly $1 billion in new money must enter the asset for its price to remain at $0.82 — all else being equal (ARB price at time of writing).
Predicting Prices
Remember, no matter how much data, foresight, or luck we have, no one can predict prices. In this section, we are just sharing some high-level predictions so that we can get back to reasonable price targets.
Data: Token Terminal
*The above forecasts assume that ETH's circulating token supply remains constant. BTC's supply is known. Therefore, actual values are used and one year of inflation is added. Additionally, "BTC Dominance" and "ETH as % of BTC MC" are taken from cycle peaks.
We use our predictions for ETH to regress the potential valuations of the top 2 Layer 2s: Arbitrum and Optimism.
Data: Token Terminal
The above data table assumes the following:
In its base case and bear case scenarios, Arbitrum accounts for 0.62% of ETH’s projected market cap (as it is today).
In a bull case, Arbitrum would account for 1.24% of ETH’s market cap (2x its current value).
In both the base case and bear case scenarios, Optimism accounts for 0.46% of ETH’s projected market cap (as it is today).
In a bull case, Optimism accounts for 0.92% of ETH’s projected market cap (2x its current value).
One year of token unlocking is factored into the price/token of each asset.
A bet on Ethereum L2 is essentially a bet on ETH. That is why our forecast starts with a high-level forecast for ETH.
in conclusion
If you are bullish on the Ethereum ecosystem, we think you need to emphasize having ETH as part of your portfolio. Why? Because investing too much in any one L2 can produce negative returns - even if the thesis on Ethereum is correct. For this reason, we believe that at least 50% of the Ethereum portion of a liquid portfolio should be in ETH. Note that this number depends on risk tolerance, goals, investment timeline, etc.
Token unlocks are real. They clearly impact forecasted returns. For example, Arbitrum’s base case projects a 315% increase in market cap next year, but only a 210% increase in price per token. ETH outperforms L2 in both the base and bear scenarios for exactly this reason.
In order for the top L2s to outperform ETH, the market needs to re-price them based on their percentage of Ethereum’s market cap. We saw this happen with Solana last year — in December 2022, it had a market cap of just 2.5% of Ethereum’s market cap. This was clearly wrong. The market has since re-rated Solana at 15% of Ethereum’s.
On a fully diluted basis, ARB and OP represent 3.7% of Ethereum's market cap. If you believe the top L2s should represent closer to 10% of Ethereum's market cap, this could change your portfolio allocation. Given the lack of utility, unlocks, and competition for the tokens, we don't think this will happen in the next year, but a re-rating is likely in the long run.