Exploring the Economics and Network Effects of Layer 2 Solutions

Introduction

Layer 2 (L2) scalability solutions have emerged as a promising approach to address the scalability limitations of Layer 1 (L1) blockchains like Ethereum. By leveraging L1 services that are supported by its validator set, such as data availability (DA) and settlement, L2 solutions aim to enhance scalability while maintaining the security and decentralization properties of the underlying L1 chain. In this blog post, we will delve into the economics of L2 solutions and analyze their potential network effects.

Economics of L2s

One of the key considerations in evaluating the viability of L2 solutions is their economic model. Profits in L2 systems are typically derived from gas fee spread, which is the difference between gas fees collected on the L2 and the costs incurred on the L1 chain to inherit its security guarantees. 

The potential for long term value for L2 networks arises from the same elements that were discussed in our first post on modular economics.

L2 networks will have an “intrinsic value” component, and may also have a “monetary premium” component.

Intrinsic value for L2 networks comes from the total gas fee spread that is generated by the network, which ultimately must be returned to token holders (in the form of dividends, burning tokens, or re-investing into the ecosystem). At present, L2 tokens have no explicit value accrual mechanism. Said differently, there is no public plan for Arbitrum or Optimism to distribute the fee spread that they are realizing (which is currently substantial). 

This raises the question of how value will ultimately be driven to L2 tokens. A charitable view is that current profits are being reinvested wisely into their respective network communities, not unlike many venture-backed startups reinvest revenues for many years to build their customer base, with the goal of maximizing future profits over a long time horizon.

Monetary Premium may be possible for L2 networks as well. Indeed, current market caps for liquid L2s seem to imply that the market expects this, considering the uncertainty around intrinsic value described above. However, there are a number of critical assumptions that need to be made in order to believe L2s will achieve Monetary Premium. Because these seem unlikely to become a reality at this time, we are currently quite skeptical that this will ever come to pass. 

As a refresher, Monetary Premium arises from Sustainability and Sovereignty. By definition, because L2s aim to make a positive spread (they are forced to), so they are Sustainable. But are they Sovereign?

Today, all L2s are reliant upon Ethereum mainnet for data availability and settlement. They must pay Ethereum for these services in ETH, meaning that their primary expense is paid in a currency that they do not control, and thus they are not sovereign. Think of a trading partner that is reliant on goods and services from other countries that it must pay for using a currency that is independent of their own - at the end of the day, their monetary policy is inextricably linked to their trading partners. Consider the fact that most of the developed world follows the Federal Reserve’s monetary policy. The same will be true for L2 rollups that are dependent on Ethereum. 

One crucial aspect that can enable Layer 2 (L2) solutions to generate monetary premium is their ability to configure sovereign architectures. By achieving independence from any single L1, settlement, or data availability layer, L2 solutions can establish themselves as self-contained ecosystems with their own monetary policy, economic incentives and governance mechanisms. With sovereignty, L2 solutions can create their own native tokens that serve as the primary medium of value exchange within their ecosystem. This independence grants L2 tokens the ability to obtain value beyond their intrinsic worth.

L2 sovereignty will exist along a spectrum, as we laid out in our piece on the [l2 market map]. Architectures along this spectrum must weigh tradeoffs - sovereignty on the one hand may provide additional benefits from a monetary perspective but may have security implications, which in the end may limit adoption or the scope of its addressable market. 

Its important to note that L2s also differ from L1s in that they do not force users to pay gas fees in their native token. Although fee payment in the native token, or more broadly, usage directly as money, is not a strict requirement of obtaining Monetary Premium, the result will be a more speculative form of premium. Just as gold and bitcoin are not used as money, but still have money-like properties and Monetary Premium, the objective of holding those assets is to trade them at a higher price, rather than for transactional purposes. 

L2 Network Effects

To understand the potential for L2 network effects, we need to revisit the network effects observed in L1 chains. L1 chains benefit from shared execution, virtual machine (VM) and language commonality, liquidity, and security. In theory, L2 solutions should also exhibit similar network effects due to shared execution and atomicity. The extent of these network effects will depend on use cases that require atomicity within the same block or transaction.

However, one concern is that since becoming an L2 on an L1 chain is permissionless, the fee spread that we currently see successful L2s earning may be at risk of being competed away, especially considering that L2 solutions can be easily copied. Without the need to bootstrap a validator set, non-sovereign L2s have a much lower barrier to entry than L1s.

Despite this, it may be the case that L2 fees are so low that the motivation for users to move to new chains is non-economic, in the sense that incrementally lower gas fees will be irrelevant. In this case, network effects are strong enough to outweigh purely fee driven motivations, and other factors related to user experience will drive user flows. If this turns out to be true, then the permissionless-ness of L2 creation will be less likely to weigh on L2 economics and compound network effects will compound value capture to the winners. This is in contrast to the initial premise for alt-L1s where the motivation for user flows was almost entirely for reduced transaction fees.

Moreover, dApps have incentives to create application-specific rollups to capture superior value opportunities. This could drive the proliferation of specific instances of L2 and forks. Effective state-sharing and bridging mechanisms further enhance the motivation for creating app-specific rollup instances. However, it is important to note that currently, no L2 tokens have a mechanism for capturing value on child chains, new instances, or forks.

Conclusion

In the short to medium term, L2 solutions are poised to become strong profit centers. While gas fees may face pressure due to competition, the cost of operating an L2 is likely to decline even faster as multiple data availability options become available. Over time, L2 solutions may fragment into numerous discrete instances with specific adaptations and architectures. However, the intrinsic value capture mechanism for L2 tokens remains an open question, as is the willingness of the projects to define one.

The degree to which an L2 solution can accrue value beyond its intrinsic worth (monetary premium) depends on its sovereignty, which necessitates independence from any single settlement or data availability layer. 

In Part 3 of this series, we will discuss the modularity of data availability and settlement, along with the envisioned changes for Ethereum, which should contribute to lower costs for L2 solutions.

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