Blockchains (L2) – Weekly fundamentals #79

A walkthrough of the most interesting charts and trends in crypto, with a focus on key business drivers and protocol fundamentals.

This week’s newsletter focuses on the blockchains (L2) market sector, which has a designated dashboard on Token Terminal.

We discuss what purpose L2s serve, what problems they solve, and how they achieve this. We observe why now is a prime time for L2s to flourish, and the potential market size for L2s. We compare L2s with various alternative L1s and each other, and discuss common L2 architectures. Finally, we go over the teams building these L2s, and examine their financials.

Let's dig in!

Purpose

L2s scale L1s by batching transactions on a separate chain and sending them back to L1 for settlement, resulting in lower gas costs and higher throughput. L2s can also be application-specific, introducing benefits such as granular scalability, finer control over MEV, and developer composability.

Problem

Transactions on Ethereum L1 cost up to 980x more than on alternative L1s. Today, transferring USDT costs $2.16 and $0.0022 on Ethereum and Fantom, respectively. Furthermore, due to Ethereum L1’s limited throughput, transaction-intensive dapps such as perpetual DEXs cannot be built on L1. If dYdX operated on Ethereum L1, it alone would account for 18% of the L1’s total transaction count. This led to the rise of alternative L1s, which have been attracting dapp teams and end-users deterred by Ethereum L1. Ethereum desperately needs to scale to retain users.

Solution

L2s solve these issues by batching transactions on a separate chain and sending them back to L1 for finalization. 1,000 L2 transactions become 1 L1 transaction, resulting in lower gas costs and higher throughput. L2 gas costs now become comparable to alternative L1s, while also allowing new types of transaction-intensive dapps to be built. L2s like Arbitrum and Polygon now host 4 and 6 perpetual DEXs and onchain games as their top 20 gas-consuming projects, respectively. In contrast, Ethereum L1 hosts neither of these sectors in its top 100 gas-consuming contracts.

Why now

Ethereum became congested in 2020-2021 as MAUs more than tripled (from 2.3m to 8.3m), and daily average gas prices increased tenfold as a result. Coupled with rising ETH prices, end-users now had to pay ~50x more to perform the same transaction vs. a year prior. This led to L2s gaining adoption, with L2 TVL going from $750m to $7b in a matter of 3 months.

Market size

L2s need to appeal to both dapp teams and end-users. Currently, there are 4m-5m blockchain DAUs, of which L2s have a 20% market share (750k-900k). The most popular L2 by DAU count is Polygon, with just under 400k DAUs.

Competition

Arbitrum is the leading L2 by TVL ($5.2b), while Polygon leads by DAUs. Base, an L2 incubated by Coinbase, is a rising competitor and has attracted ~$400m in TVL within a month of its launch.

Product

There are several types of L2s, and all offer significantly higher throughput and lower gas fees than Ethereum L1. These include optimistic rollups (Arbitrum, Base, OP Mainnet), zero-knowledge rollups (Starknet, zkSync), and sidechains (Polygon). Sidechains regularly submit their separate transactions to L1, while rollups operate with the following process:

1. Transact. Users perform transactions on L2, which get submitted to the L2’s transaction sequencer.
2. Order transactions. The sequencer receives transactions and orders them, typically ordered by the time of reception.
3. Soft finality. The sequencer provides a real-time feed of transactions. These are not yet posted on L1, so this is called “soft finality” because it depends on the sequencer to keep its promises.
4. Create block. The sequencer runs transactions through the state transition function to create an L2 block.
5. True finality. The transactions inside the L2 block are compressed and published to L1.

Business model

The revenue model for L2s is to take a cut of the gas fees paid by end-users, while the remaining amount is used to pay for L1 settlement. Polygon currently has the lowest gas fees, while Starknet has the highest ($0.02 and $0.30 on average, respectively). L2s optimize gas costs to attract more users, and while it hurts their revenue on a unit basis, their aim is to onboard more users overall and compensate through scale.

Team

L2s tend to have technical founders with backgrounds in Computer Science. The core contributor teams also tend to be large (57 - 134 staff, according to LinkedIn).

Financials

Most L2s run ecosystem grant programs to bootstrap their ecosystem, which means that many of them currently operate at a loss. On average, L2 developer teams have raised big VC rounds ($123.7m-$451.5m) and have, as a result, allocated a sizable % of their cap tables to core contributors and investors (36%-49.9%).

Video of the week

In this episode of the Fundamentals podcast, we’re joined by Niklas Kunkel, the Founder of Chronicle – an oracle service born out of MakerDAO’s Oracle Core Unit that will be launching publicly in September 2023.

Listen to the episode

To cover the basics, oracles are decentralized networks that bridge critical information from the real world to the blockchain.

Chronicle currently provides exclusive support to MakerDAO’s total user deposits of $5.2b, meaning that it has captured a 22% market share of the total value secured by oracles, making it the second largest oracle behind Chainlink.

In this episode with Niklas, we discuss what Chronicle is and the story behind it, how it works, and what sets it apart from other oracle solutions on the market. We speak about ensuring hyper-scalability and ensuring the security of the protocol after which we cover Chronicle’s business model, quantify the market opportunity at hand, learn about the team behind the protocol, and hear what Niklas thinks will be the biggest drivers and challenges related to growth.

Finally, we speak about how Chronicle’s relationship with MakerDAO will develop going forward, and what we can expect to see coming out of Chronicle Labs over the next few months.

Check out the Chronicle Dashboard: https://chroniclelabs.org/dashboard

Timestamps:
00:00 Introduction
01:42 Chronicle’s mission
04:10 From MakerDAOs Oracle Core Unit to being the Chronicle Protocol
07:27 Maker-grade quality
08:39 Chronicle’s position within the market & unique selling propositions
14:59 Achieving hyper-scalability with Scribe: a 66% reduction in gas usage
26:09 Chronicle’s approach to building a truly secure protocol
28:26 Chronicle’s business model
31:01 Quantifying market potential
37:56 The team behind Chronicle
40:01 What will Chronicle’s relationship with MakerDAO be like going forward?
42:39 Expected challenges and growth drivers post-launch
45:04 The biggest learnings Niklas has taken away from his time building in crypto
48:24 Upcoming milestones: Scribe, RWAs, and expansion

This episode is sponsored by Chronicle Labs.

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