Scalability challenges have long plagued blockchains. Bitcoin and Ethereum can only process a few dozen transactions per second, and the network fees can surge to exorbitant levels during peak use periods. Within Ethereum, a galaxy of complementary networks known as ‘Layer 2s’ emerged to overcome these bottlenecks. Some have grown so quickly that they are among the largest blockchains in the world in their own right. They each offer tokens that have garnered multibillion-dollar valuations from investors as well.
There has always been a question about how these blockchains would exist in a world where Ethereum can scale, as it has long planned, and the resulting impact on these tokens vis-a-vis ether. That question is about to be answered. Next month Ethereum will undergo a significant update, known as Dencun, that could boost its throughput to 100,000 transactions per second.
Layer 2 protocols boost the performance of Layer 1 blockchains, such as Ethereum, by offloading and batching transactions to a secondary layer. These transactions then get cryptographically linked together and posted to the main network as a single entry. Other networks, such as Bitcoin have their own L2 protocols, but their size is comparably smaller than Ethereum’s counterparts.
Not all L2s are built the same way. The largest category is rollups, where transactions are bundled and added to Ethereum en masse. Still, there is significant variance in how these approaches operate. They subdivide into optimistic rollups and ZK-rollups.
- Optimistic rollups group transactions into a single block, assuming by default that each transaction is valid (thus the ‘optimistic’ moniker), and then anchor them back onto Ethereum every minute or so.
- ZK-rollups bundle multiple transfers into a single cryptographic proof that is then verified to be accurate by the base Ethereum chain. The significant difference between the two is that zk-rollups transactions can be proven correct. In contrast, optimistic ones provide a challenge period for users to dispute something (similar to how someone can dispute a credit card charge).
Optimistic rollups are far more popular today, the biggest being Optimism and Arbitrum in terms of the total value of assets locked on the network. Among ZK-rollups, some of the prominent ones are Loopring, StarkWare and Matter Labs zkSync, which house a much smaller amount of assets.
zkSync Era is posting the highest throughput numbers of any L2, including market leader Arbitrum. However, it is interesting to note that Ethereum currently posts faster transactions per second than any L2s. Their max daily TPS numbers are many multiples higher than what Ethereum can process.
There are some other notable L2 networks, the largest of which is Polygon, which has grown to become its own ecosystem and has a token, matic, with a market capitalization of $8 billion.
Over the past year, ether has outpaced its L2 competitors, with the notable exception of ImmutableX (IMX), a platform focused on gaming that surged on the back of a few big announcements in December.
However, most of these tokens have surged past ether over the past three months, likely due to investor anticipation of a spot ether ETF this spring. L2s can trade as high-beta plays on top of ether.
Outlook and Implications
As the anticipation of an ether ETF grows, associated tokens will likely continue to surge along with the base asset. Given that the U.S. Securities and Exchange Commission has until May 23rd to decide on the first application in the queue, there could be a halo effect for the next few months. Conversely, if the SEC denies an ether spot ETF, the entire world of Ethereum tokens could struggle.
But before that happens, the Dencun update will be adopted by Ethereum. Kavita Gupta, a venture capitalist and founder of Delta Fund, tells Forbes that if L2s are just going to serve as excess capacity for Ethereum, they could struggle after the update, which could be weeks away. However, she is sanguine about their prospects, saying that many top projects such as Polygon, Optimism, and Arbitrum “have all moved into offering something beyond providing excess capacity for Ethereum.”
Cosmo Jiang, a portfolio manager at Pantera Capital, a blockchain investment firm in Menlo Park, California, agrees. For starters, he points out that Dencun is not designed to cannibalize L2 volume but to make it cheaper for L2s to post transactions to the network.
“Its basic economics will make it 10x cheaper for L2s to settle transactions on Ethereum. If one pays on average 10 cents a transaction, it will only have to pay one to 2 cents moving forward,” Jiang said.
But within the world of L2s, fortunes will vary. Jiang is particularly bearish of zk-rollups, which he says are still largely experimental, adding “there’s no measurable organic activity on those chains. Part of the reason is because they all claim to still be in beta. But they just haven’t been able to get many defi applications to go there.”
It’s not all doom and gloom, as zk-rollups, in theory, should be much cheaper and faster than their optimistic counterparts at scale, but that remains far off in his opinion.
Both Jiang and Gupta agree that Arbitrum is head and shoulders above the competition, as it has staked a strong claim to the world of decentralized finance applications. It is not just taking advantage of the faster transactions for simple trades, but the cheaper fees also make it possible to put in more complex operations that require more computation power, such as options trades. So that is an important area for growth.
Although Optimism has yet to see quite the same growth so far, its technology stack has been used by other developers to launch their chains, notably Coinbase with Base. When Base launched in August 2023, it saw a dramatic influx in activity, but it quickly tapered off. Aside from challenges in getting users, Jiang noted that Coinbase might need help to attract growth because it conducts anti-money laundering and knows your customer checks on users as a regulated institution.
Investors bullish on the outlook for a spot ether ETF may consider branching out into L2 tokens as a high-beta play on the broader market. Regarding a longer investment, the highest weighting of an L2 portfolio is best served by focusing on optimistic rollup platforms such as Arbitrum and Optimism. zk-Sync could be a good diversifier, but it does not have a token right now, and the team has yet to announce any plans to launch one. ImmutableX (IMX) could play a small role in portfolios, but given that blockchain gaming has not gone mainstream yet, investors should be cautious about buying into too much hype. Potential IMX investors should wait until the price reverts to the mean before making an allocation.