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Commoditization and Consolidation: The Future of Ethereum Layer 2 Solutions

Lincoln Murr

Summary: With 58 Layer 2 (L2) solutions and new ones being released almost every week, it’s evident that Ethereum’s roadmap-centric development has resonated strongly with builders. Users have also been receptive, as transactions on L2s now surpass those on the Ethereum mainnet. However, each new L2 diminishes the value propositions of all existing and future L2s, ...

With 58 Layer 2 (L2) solutions and new ones being released almost every week, it’s evident that Ethereum’s roadmap-centric development has resonated strongly with builders. Users have also been receptive, as transactions on L2s now surpass those on the Ethereum mainnet. However, each new L2 diminishes the value propositions of all existing and future L2s, leading to a commoditization of the chains. This has sparked a race to zero in L2 valuations. As long as liquidity is fractionalized and interoperability remains limited, the L2 ecosystem will likely follow a winner-takes-most model, where only a few dominant players thrive.

To understand why L2s are becoming commoditized, it is important to understand their brief history and motivation. In the 2020 bullrun, before L2s existed, it was evident that Ethereum had a massive scaling problem. Simple DEX transactions cost hundreds of dollars in transaction fees, leading to competitors like Avalanche, Solana, and Fantom stealing market share and user interest. During the subsequent bear market, it became evident that Ethereum's market effects and first-mover advantage were real, as it remained strong despite prohibitively high fees. 

Optimism and Arbitrum, launched in 2021, were the first two EVM-compatible rollups, promising the security of Ethereum at a fraction of the cost. They became near-instant hits as liquidity and user interest, especially among retail users who valued the decentralization of Ethereum but could not pay high transaction fees, flocked to the new ecosystems. Though the hurdle of creating an entirely new liquidity hub was immense, both protocols garnered enough interest from developers and investors to create flourishing DeFi ecosystems. 

Though Optimism and Arbitrum remain leaders in the L2 landscape by total value locked and daily users, dozens of other rollups have sprung up, some with compelling and interesting features and others with no real market differentiator. Zero-knowledge rollups, like Scroll and ZKsync, offer a similar UX with higher security, while StarkNet offers a new virtual machine environment and programming language. Dozens of other rollups, like Redstone, Blast, and Metis, focus on gaming, yield generation, DAOs, and numerous other niches within the blockchain space. Rollup-as-a-Service providers like Gelato and Conduit have made creating an L2 or L3 easier than ever, and the process is nearly as simple as creating a token. 

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Thousands, if not hundreds of thousands, of rollups is part of Ethereum’s long-term goal, but it is clear that there are growing pains and lessons to be learned on the way to this milestone. Though having a specific rollup for each sub-industry may seem beneficial, a problem is beginning to reveal itself. There is a lack of onchain liquidity to bootstrap all of these different successfully, resulting in a few market leaders with the other rollups left to produce empty blocks and hope that a “killer app” finds its way to their chain to entice users back. The only reward rollups can dangle in front of prospective developers and users are native tokens, which lead to multi-million dollar grant programs and DeFi liquidity incentives. Though this has proven successful, these rewards eventually dry up, and users have shown little loyalty. Take the recent ZKsync airdrop as an example: 41% of users who received the tokens sold most, if not all, of it. 17.5% of the total supply of ZK tokens, a completely unprecedented amount, were distributed to users in this airdrop, yet there was still no loyalty. 

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The L2 market has shown itself to be winner-take-most, with the three biggest rollups controlling two-thirds of the market share. This is especially true among general-purpose EVM-compatible rollups, as the only differentiating factor is their business development strategy and available applications. Beyond those two factors, rollups must compete on the basis of yield, which is unsustainable. Scroll, the next big rollup to release a token after ZKsync, has seen an influx in total value locked after announcing its points program, but there are no compelling applications that create genuine, organic users. ZKsync suffers from the same problem, as its three biggest applications are Uniswap clones, with the fourth being a lending market. On the other hand, Arbitrum’s top five include a DEX, lending protocol, restaking protocol, yield platform, and derivatives platform. Though Arbitrum has had more time to establish itself, this is a critical issue that Scroll and ZKsync must solve if they want sticky users. 

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L2 tokens are experiencing this realization in real-time, as tokens for even the largest projects suffer price declines. Arbitrum, for example, is at its highest market cap but the lowest token price, as continuous investor token unlocks have stifled price appreciation. The “low float, high FDV” narrative that has been so heavily criticized is finally starting to have a real impact on token prices and shows no signs of slowing down. This will create a negative flywheel effect, where investors will continue to sell tokens because of a lack of price appreciation, but the prices will stay flat until the next token unlocks, furthering this cycle of poor performance. Though this is not exclusive to L2s, many of the leading rollups raised during this meta are poised to have their consequences.

Though the state of future L2s looks grim, interoperability solutions like AggLayer could help solve this problem by abstracting chain interactions away, allowing users to seamlessly bridge between chains and utilize the best apps and liquidity on each. 

This is not a criticism of L2s but merely their inability to adequately differentiate themselves and find a niche in which to operate. As with any new technology, there are dozens of competitors, and only a few will survive, and the L2 squeeze is just getting started. The appchain vision is still alive and well, but there is no foreseeable way for dozens of general-purpose L2s to survive and thrive alongside one another. 

By Lincoln Murr

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