The state of Optimism: An Ethereum Layer 2 scaling solution

This is the eighth post in our research series. In this series, we publish data-driven analysis on specific blockchains, dapps, and market segments. Let’s dig in!

Topic: Optimism, a Layer 2 scaling solution for Ethereum.

Optimism is a scaling solution that increases Ethereum’s throughput by performing some computation off-chain. In technical jargon, Optimism is an optimistic rollup.

This article provides an overview of the protocol and looks at it historical performance using Token Terminal’s data.

Purpose

Optimism aims to make Ethereum better by increasing its transaction speed and transaction throughput. Faster transaction finality and lower transaction costs greatly improve the user experience.

Problem

As Ethereum’s popularity has grown, the blockchain’s inability to scale has become painfully clear to users who have to pay high transaction fees. This is because Ethereum blocks have a limited maximum computational capacity and new blocks are generated at a roughly constant rate. As the number of users and decentralized applications (dapps) has grown, the increased demand has pushed the gas prices up. Gas is the unit in which the amount of computation is measured.

Solution

Optimism is a blockchain designed to facilitate scaling Ethereum. It belongs to a conceptual category of layer 2 (L2) scaling solutions. L2s add another layer of computation on top of layer 1 (L1), i.e., the Ethereum Mainnet, while taking advantage of L1’s security features. Optimism executes transactions on L2 and submits them in batches to L1 for finalization. This results in roughly 5-20 times lower gas fees depending on the type of transaction.

The name Optimism refers to it being what is known as an optimistic rollup. Optimistic rollups assume that transactions submitted to L1 are valid by default. This is contrast to zero-knowledge rollups that do not make this assumption.

Why now

Over recent years, interest in blockchain technologies has grown exponentially and Ethereum has become the leading blockchain for deploying dapps. Decentralized finance (DeFi), non-fungible tokens (NFTs), and other blockchain applications have grown from fringe movements to multi-billion dollar industries. The demand for scalable blockchains and dapps is higher than ever before and investors are willing to fund teams building scaling solutions.

Market

Optimism is a part of the growing Ethereum ecosystem. Ethereum is the leading blockchain for dapps and DeFi. Demand for ETH reached its all-time high in the end of 2021 when ETH’s circulating market cap (i.e., the number of ETH multiplied by its price) reached over 500 billion USD before the bear market of 2022.

An upcoming Ethereum upgrade expected to occur in 2023 will introduce sharding (i.e., parallel processing of transactions across separate blockchains known as shards) to greatly increase Ethereum’s throughput. Until this, demand for L2 scaling solutions is expected to stay high. Moreover, if blockchain technologies reach mass adoption, the global demand will be sufficient for many successful scaling solutions and parallel blockchains to thrive simultaneously.

Competition

Optimism competes with other Ethereum scaling solutions and L1 blockchains.

In the short term, Optimism’s closest competitor is Arbitrum. Like Optimism, Arbitrum is an optimistic rollup designed to scale Ethereum. Currently, Arbitrum is significantly larger than Optimism when measured by total value locked (TVL), i.e., the value of assets on the blockchains.

Several zero-knowledge rollups, i.e., L2 scaling solutions based on sophisticated trust-minimizing mathematical algorithms, are expected to launch in 2022 and later.

Ultimately, the success of Optimism will depend on the success of the entire Ethereum ecosystem and thus other scaling solutions do not necessarily need to be seen as direct competitors. Other L1 blockchains such as Solana compete more directly with the Ethereum ecosystem.

Product

Optimism is an independent blockchain that relies on Ethereum for its security. It is compatible with the Ethereum Virtual Machine (EVM), making it very similar to Ethereum for users and developers. Deploying smart contracts on Optimism is nearly identical to Ethereum and users can transfer assets between the blockchains using bridges.

Optimism blocks are stored on Ethereum. New block production is coordinated by a program called the sequencer that provides instant transaction confirmations and state updates, constructs and executes L2 blocks, and submits the transactions to L1 in batches. Because interaction with the sequencer has near instant finality, the user experience is significantly snappier than on Ethereum. Currently, the sequencer is centralized and run by the company behind Optimism. They have stated that their aim is to decentralize control over the sequencer in the long run.

Team

Optimism is developed by a U.S.-based for-profit public benefit corporation Optimism PBC. Optimism PBC has raised nearly 180 million USD in two funding rounds led by well-known crypto investors Andreessen Horowitz and Paradigm. Optimism Foundation is a non-profit organization dedicated to growing the Optimism ecosystem. Optimism Collective is a decentralized autonomous organization (DAO) designed to help govern the project in the long term.

Business model

Users pay transaction fees that consist of L1 security fees and L2 execution fees. The L1 security fees are paid to the miners on Ethereum and the L2 execution fees are paid to the sequencer on Optimism.

Financials

This section provides an overview of Optimism’s historical performance using Token Terminal’s data. For more information and to be able to explore our data using interactive charts, make sure to check out our Optimism dashboard!

Note that although Optimism launched earlier, we are only showing data since the 11th of November 2021. This is when Optimism underwent a significant redesign to make it more similar to the EVM, resulting in a regenesis of the blockchain.

The figures below show the value of the fees paid by Optimism’s users and how the revenue is split between the protocol (Optimism sequencer) and supply-side participants (Ethereum miners). Protocol revenue typically makes up just a few percent of the total revenue.

Optimism’s success ultimately depends on the success of the dapps running on it. The figure below shows the total value locked of the largest dapps on Optimism. Although TVL has not grown recently as we are in a bear market, the DeFi ecosystem has diversified significantly as more dapps have been launched.

Optimism launched its governance token OP in the beginning of June 2022. The initial supply of OP is 4.3 billion at an inflation rate of ~2% per year. The figure below shows the fully diluted market cap of OP since its launch. The market currently values OP at around 5 billion USD.

Conclusion

Optimism is one of the leading scaling solutions Ethereum. It has proven to be able to reduce gas fees and efficiently host Ethereum-native dapps. Its DeFi ecosystem is growing and the project will be able to fund a lot of new dapps using its token. However, it faces significant competition from existing and future projects.

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