Hey Edge readers,
In the last installment of our Layer 2 mini series, we break down the economics behind a L2 blockchain and how it can potentially accrue value back to the native token.
Here's what we're covering this week:
- The economics of Layer 2 blockchains 📘
The business model of L2 blockchains and how they accrue value to native tokens.
- Ethereum Spot ETF decision delayed 🗞️
zkSync multichain vision, Polkadot struggles and more.
Stay sharp. 🫡
-The Exponential team
Scaling Up: The Essential Guide to Layer 2s
Welcome to the final issue of our mini-series, “Scaling Up: The Essential Guide to Layer 2s,” where we’ll explore the economics behind L2 blockchains and how they can add value to their native tokens.
Issue 4: The economics of Layer 2 blockchains
At its core, a blockchain sells block space—the limited data storage available in each block. For instance, Bitcoin’s block size is 1 megabyte (MB), accommodating around 2,000 transactions per block. The demand for this block space, paid in gas fees, is how blockchains generate revenue.
Let’s take Ethereum as an example. Ethereum’s revenue is generated from user demand for gas fees. Its costs include total fees paid to validators (supply-side fees) and newly issued ETH rewards (token incentives). Recently, Ethereum hasn’t been profitable as gas fees have declined while expenses remained constant.
Low gas fees on Ethereum means less demand for block space, which results in cheaper fees and higher throughput. However, as more apps are developed and new users join, the high costs and scalability issues will return. This is where L2s come in, playing a crucial role in accommodating the next billion users.
The business model for Layer 2s
Think of L2 blockchains as “resellers” of block space. They buy block space on the Ethereum L1, optimize it by compressing the data, and then resell it to users and applications looking for lower transaction fees and higher throughput. This is similar to how credit cards batch transactions and later settle them with banks, reducing fees and increasing throughput.
Just like any other blockchain, L2s still incur fees to function. Fees on an L2 serve two main purposes:
- Network security: L2 fees serve as an economic incentive for validators (responsible for ordering transactions on L2) to process transactions and ensure smooth network operations.
- Blockchain sustainability: L2 fees are used to cover operational costs, as well as serve as a barrier from spam attacks. By imposing a cost on each transaction, it incentivizes users to submit only legitimate transactions.
At a high level, L2 fees consist of two main components:
- L2 execution fee: The L2 fee is the cost to execute your transaction on the L2.
- L1 rollup fee: The L1 fee represents the estimated cost to publish your transaction on the L1.
Value accrual to Layer 2 tokens
The valuation of a specific L2 is closely tied to the value of the underlying L1. Most L2s charge gas fees in ETH and must pay Ethereum for settlement costs in ETH, meaning they cannot enforce their own monetary policies (Ethereum determines the price of operating a L2). Instead, they operate as a spread business: they charge fees to end users and retain a portion to cover Ethereum-related costs.
As such, most L2 tokens today are primarily “governance” tokens, only allowing token holders to vote on important platform decisions. However, some L2s, like Starknet and Mantle, have opted to use their native tokens for gas fees. So instead of using ETH to pay for gas, users pay with the native token, thus providing a similar utility to ETH.
Despite the reliance on ETH for transaction fees, L2 tokens can capture value in other ways. For instance, sequencers are entities on L2 rollups that manage the ordering of transactions in exchange for fees. These fees are kept in-house today but there is the possibility of a “fee switch” proposal down the line (e.g. Uniswap) where a portion of these fees flow to token holders instead. By establishing robust ecosystems and fostering network effects, these L2s have the potential to become more independent and valuable over time.
Conclusion
We believe L2 scaling solutions will help attract the next billion users to crypto and DeFi. While L2s overall are positive for Ethereum, the value of their native tokens is still evolving. We expect to continue to see a proliferation of L2s as more apps build on these efficient networks, with the most dominant L2s likely seeing significant value accrual in the coming cycles.
In the news
- Ethereum ETF approval delayed until July 8th - Read
- Circle is now Europe’s first compliant stablecoin issuer - Read
- zkSync unveils its vision for the multichain future in its latest protocol upgrade - Read
- Mantle launches incentives campaign to reward users of its liquid staking protocol - Read