The Value Proposition and Business Model of L2

L2’s Value Proposition and Moat

L2 offers a product similar to L1, that is, a stable, censorship-resistant, and open blockchain space. It can also be perceived as a specialized on-chain cloud service. Compared to L1, the primary advantage of L2’s blockchain space is its cost-effectiveness. Taking OP as an example, its average gas cost is only 1.56% of that of Ethereum.

Because blockchain space functions like a specialized cloud service, its demand isn’t ubiquitous; most internet services don’t need to operate on L1 or L2. Financial services, constrained and lacking transparency in the conventional world, find the most extensive application possibilities on the blockchain.

The demand from service builders and users for L2’s blockchain space determines L2’s value ceiling. Like L1, L2 can establish a moat based on network effects. As more users of diverse types join L2, collaboration becomes easier, nurturing innovative service models. Each new user boosts the potential value of the L2 network to other users.

In the Web3 realm, the network effects of L1 & L2 are second only to stablecoins represented by USDT. The leading L1 & L2 networks have higher barriers and, consequently, often command higher valuation premiums.

L2’s Revenue Model

L2’s revenue model is clear and straightforward: on one hand, by procuring storage space from the trusted Data Availability (DA) layer for backing up its own L2 data (enabling data restoration in case of L2 operational issues), and on the other, by providing users with affordable blockchain space services and charging accordingly. Profits come from: fees charged by L2 (base fee + MEV income) minus the costs paid to DA service providers.

Using OP and ARB as examples, they’ve chosen Ethereum, the most decentralized and trustworthy L1, as their DA layer. By paying Ethereum in Gas, they store their compressed L2 data on Ethereum. The fees they charge encompass the gas users pay when using their L2 and the MEV income. Subtracting costs from the income gives their gross profit.

It’s termed ‘gross profit’ as it doesn’t account for other project expenditures like human resources, ecosystem rewards, marketing expenses, etc.

The Role of Sequencers in L2 Operations

L2’s fee collection and L1’s cost payments are executed by L2’s sequencer, with profits also attributed to them. Presently, both OP’s and ARB’s sequencers are operated officially, with profits going to the official treasury. A centralized sequencer, however, carries high single-point risks. Both OP and ARB have long-term pledges to decentralize their sequencers.

Decentralized sequencers might operate via a PoS mechanism, requiring them to stake native L2 tokens like ARB or OP as collateral. Failure to fulfill duties could result in penalties (getting slashed). Users can either stake as sequencers themselves or use staking services like Lido, where they provide collateral tokens while professional, decentralized sequencer operators manage sequencing and uploading. In a mechanism like Lido’s, users could receive the majority of the fees and MEV rewards earned by sequencers (90% in Lido’s case).

Eventually, both ARB and OP tokens might have economic values beyond mere governance.

Competitive Advantage of OP vs ARB

Advantage of OP

Since its inception, ARB has consistently outperformed OP in various L2 business metrics. Based on the L2 network effect mentioned earlier, as a leading L2, ARB should have stronger competitiveness and thus should enjoy a higher valuation premium. However, this dynamic began to change gradually after OP introduced the Superchain strategy in February this year and began to heavily promote OP stack.

The OP stack is an open-source L2 technology stack. This means that any project wishing to run on L2 can use it for free to quickly deploy their own L2, significantly reducing the costs of development and testing. Superchain is the future vision laid out by OP. L2s that use the OP stack, due to their consistent technological architecture, can communicate and interact with each other securely, efficiently, and on an atomic level. This is analogous to the “Interchain” concept of Cosmos and is referred to as Superchain.

Following the launch of the OP stack and Superchain, they were first adopted by Coinbase. Announced in February alongside the Superchain strategy, L2 Base, built using the OP stack, officially went live on August 10th. With Coinbase setting an example, the OP stack has been adopted by more and more projects, including Binance’s opBNB, Paradigm’s NFT project ZORA, Loot ecosystem project Adventure Gold DAO, the Public Goods Network (PGN) supported by Gitcoin, leading options project Lyra, well-known on-chain data dashboard Debank, and even Celo, originally an L1, chose the OP stack as their L2 solution.

Previously, the target audience for L2 projects was users utilizing their own block space. Superchain and OP stack have expanded this definition to include L2 operators. The business shifted from being B2C (considering L2 developers as consumers) to B2B2C, creating new value streams and protective moats for OP:

1. Multi-Chain Network Effect: The concept of “network” in the network effect is expanded from a single chain to a “multi-chain network.” Different chains, connected via the standardized OP stack, increase the total user base of the multi-chain network. An increase in the total user base enhances the value of each individual user and every L2 within the network.
2. Economies of Scale: While OP bears the fixed technological infrastructure costs (like upgrades and maintenance of the OP stack), feedback and improvements provided by other users of the OP stack enhance its quality. This reduces the cost of tech maintenance, upgrades, and indexing incentives on individual chains, increasing its attractiveness to potential L2 adopters.
3. Community of Interests: By bringing more Web3 industry giants into the OP ecosystem, there’s a unified interest which makes it easier to gain support in terms of technology, users, developers, and investment.

Transitioning from a single-chain ecosystem to an interconnected chain ecosystem, not only does OP benefit from anticipated growth in total chain users and developers, but the primary business data of the OP main chain is also continuously approaching, and in some cases surpassing, the figures of ARB, which once had a significant lead:

a. Monthly Active Addresses: OP’s monthly active addresses compared to ARB’s rose from a low of 32.1% to the current 73.6%.

Source: tokenterminal

b. Monthly L2 Profit: OP’s profit relative to ARB’s rose from a low of 16.4% to the current 100.2% (surpassing ARB).

Source: tokenterminal

c. Monthly Interaction Count: OP’s monthly interaction count relative to ARB’s rose from a low of 22.4% to the current 106.5% (surpassing ARB).

Source: tokenterminal

d. On-Chain Funds: The ratio of funds on-chain (TVL) for OP compared to ARB increased from 1/3 to the current 1/2. For OP, it was around 20 billion in March and is currently around 30 billion. For ARB, it was around 60 billion in March (peaking at 70 billion) and remains around 60 billion.

Source: https://l2beat.com/

ARB chain funding TVL, which was around $6bn in March (and surged to a high of $7bn), remains around $6bn at present

Data source: https://l2beat.com/

Comparison of OP and ARB Valuations

As OP’s business data rapidly rises, the valuation of OP’s main chain in relation to ARB is becoming increasingly attractive. Calculating from the recent weekly revenue, OP’s P/E (market capitalization over L2’s annualized profit) has dropped below 80, while ARB’s is at 113. This is achieved even as OP’s price has significantly strengthened in recent months and its circulation continues to unlock and increase.

Data source: tokenterminal

Rapid Development of New Forces in the OP Ecosystem

OP’s main chain business data is catching up with ARB. This resurgence is influenced by its inherent ecosystem’s revival and is majorly contributed by business partners joining the OP camp. For example, among projects contributing the most transactions to the OP main chain in the last 30 days, the Gnosis Safe contract operation ranks first, and Worldcoin ranks fourth.

Data source: https://dune.com/optimismfnd/Optimism

In fact, a significant amount of Gnosis Safe transactions are contributed by the Worldcoin team. By the end of June this year, World App had deployed over 300,000 Gnosis Safe accounts, resulting from the migration of World App accounts to the Optimism mainnet. According to Worldcoin’s official website data on August 11th, it currently has over 2.2 million registered users, with 257,000 new accounts created in the past seven days. The World app’s daily transaction count averages 126,000, approximately 21% of the current daily transfer counts of both OP and ARB main networks.

Data source: https://worldcoin.org/

Currently, Worldcoin has only migrated its ID system and tokens to the main network. Subsequent developments will be based on the OP stack, promising more active users and developers.

Apart from Worldcoin’s contribution to OP’s mainnet, the data growth of Coinbase’s Base L2, the first and largest supporter of OP stack L2, is also robust. On August 10th, its active address count reached 136,000, just shy of L2 TOP1 ARB’s 147,000.

Data source: https://dune.com/tk-research/base

Among all L1 & L2 smart contracts, this number only falls behind Tron (1.5M), BNBchain (1.04M), Polygon (0.37M), and Arbitrum (0.14M). Furthermore, the first blazingly popular application launched on Base post its official release on August 10th wasn’t the traditional DeFi or Meme, but a social application called friend.tech, a pleasant surprise.

ARB’s Dilemma

ARB’s predicament is that while it boasts the robust L2 main chain, Arbitrum one, and the higher-performing Arbitrum nova, it also introduced the Orbiter L3 stack to compete with OP stack. However, during the flourishing phase of L2, willingly defining itself as L3 and relying on Arbitrum one as its DA layer isn’t favorable. Projects with good industry resources (users, developers, IP content) often prefer building on L2, implying a higher valuation ceiling and broader user orientation.

In smaller Rollup project markets, Arbitrum’s Orbiter faces competition from RaaS (Rollup as a service) projects, exemplified by ALTLayer. They offer low-threshold, low-code rollup building and operation solutions, integrating various rollup modules available in the market, allowing users to mix and match like Lego.

RaaS modular solution provided by ALTLayer

In the Rollup menu offered by RaaS projects, Orbiter provided by Arbitrum is just one of the options. Smaller users might choose a more economical L2 solution rather than defining themselves as L3.

Despite this, Arbitrum one, as a single L2 chain, still maintains a slight lead in business data relative to other L2s. However, its user share in the entire L2 market is rapidly declining, as a vast number of both new and old users are flowing to OP and hybrid L2 systems.

In general, OP, with its open-source L2 suite, introduces users from partnering businesses through a B2B2C model, which in the long run has clear business advantages over Arbitrum’s strong single chain approach. If ARB doesn’t adjust its strategy soon, its dominant position in the L2 single chain market may be in jeopardy.

How Cancun Upgrade Improves L2 Project Fundamentals

Valuation Estimates of Current ARB and OP Projects

Taking into account the income data of ARB and OP over approximately the last three months and their current prices, we can estimate their valuation levels.

If we assume the P/E ratio remains constant and, after the Cancun upgrade, the L1 costs of ARB and OP decrease by 90% (EIP4844 is expected to reduce 90-99% of L2 L1 costs, and we take a conservative value here), with L2 charging standards remaining unchanged, the price projections for ARB and OP are as follows:

The L1 cost savings brought by the Cancun upgrade directly result in increased profits, leading to an increase in corresponding valuations.

Effects of Cancun Upgrade on L2 Valuations

Following the Cancun upgrade and the resultant L1 cost reduction, neither ARB nor OP can avoid reducing corresponding L2 fees. Therefore, when estimating valuations, we need to consider two variable factors:

1.What proportion of cost savings will ARB and OP pass on to users by reducing L2 fees?

2.How much will the reduction in L2 fees increase L2 transaction activity?

Under the same premise based on the P/E multiple, I deduced the price of ARB and OP tokens after the Cancun upgrade based on the changes in “the ratio of cost reduction translated to expense reduction” and “the increase in transaction counts resulting from expense reduction”:

The core logic behind the two token price estimation tables above is:

1. After the Cancun upgrade, the more an L2 reduces costs without passing those savings to its users, the higher its operating profit.

2. The higher the increase in transaction activity due to the L2’s reduction in layer 2 fees, the higher the L2’s operating profit.

   Additionally, since OP’s current Gas fee is roughly 30-50% lower than ARB’s, as L1 costs decrease, OP has a larger margin to retain the saved costs. Therefore, I believe that OP will pass on 60-100% of the saved costs as subsidies to users, whereas for ARB it’s 70-100%.

Considering only the impact of the Cancun upgrade on OP and ARB on individual chains, the potential price growth of OP and ARB seems fairly similar.

However, this price sensitivity analysis for ARB and OP after the Cancun upgrade is relatively mechanical. Factors not considered include:

• The estimates are based on the current project P/E, which already accounts for expectations of the Cancun upgrade.
• By the time of the Cancun upgrade, OP will have emitted more tokens; assuming market capitalization remains unchanged, the token price should be lower.

But the consistent logic is that the higher the L2 operating profit, the higher the intrinsic value of its token, making it easier to achieve a higher market valuation. The Cancun upgrade, in terms of cost savings or boosting on-chain activity, can bring significant marginal improvements for L2 projects.

Potential Risks of OP

As mentioned above, OP has been elevated from a single-chain L2 to an interconnected L2 ecosystem, relying on the narrative of Superchain and the widespread adoption of the OP stack. With B2B2C tactics, OP relies on partners in the OP stack, drawing in more ecosystem participants. In the long run, this approach with stronger network effects, economies of scale, and allies with shared interests is a better business model than ARB. Moreover, OP’s mainnet has been steadily catching up or even surpassing ARB in recent months, with other OP stack L2s like BASE also rapidly expanding, further squeezing ARB’s market share.

Given that OP and ARB’s main L2 chains both benefit from the Cancun upgrade with similar token price appreciation expectations, but with OP having the backing of the Superchain narrative, it might be the better investment option right now.

However, the competitive landscape of the L2 track remains intense. It’s essential to pay attention to the following risks associated with OP:

ARB might choose to open its L2 license, competing for the overall L2 network population in a way similar to OP.

Currently, Arbitrum still employs a Business Source License (BSL). Partners wishing to use the Arbitrum stack to build a Rollup ecosystem either need formal authorization from the Arbitrum DAO or Offchain Labs (the developer of Arbitrum), or they base their work on Arbitrum One to develop L3. However, with the rapid expansion of the OP stack and a surge in the network population in recent months, there is growing unease within the Arbitrum community. On August 8th, ARB team member stonecoldpat initiated a discussion in the governance forum, hoping the community could participate in discussing the “conditions and timing for granting code licenses to partners.” The specific discussion points include:

• Understanding the community’s attitude towards granting code use licenses to other partners.
• Discussing whether there should be additional conditions attached to the authorization of the code.
• Establishing an evaluation mechanism to decide whether to issue a license to a party.
• Outlining both short-term and medium-term roadmaps for the above content:
  • In the short term, identify which qualified partners can be granted licenses.
  • In the medium term, set clear standards, so that any partner meeting the criteria can receive a license.

The discussion thread also summarized feedback received on the topic, mentioning:

“The Arbitrum Foundation or Offchain Labs has not yet granted licenses for the Arbitrum software stack to major strategic partners. This seems to be a strategic oversight. Such indecision could potentially harm the Arbitrum ecosystem.”

“We haven’t received any feedback suggesting that the Arbitrum Foundation shouldn’t grant licenses for the Arbitrum tech stack to strategic partners. The main focus is on the standards for granting licenses and the conditions that should be attached, allowing the DAO to provide preliminary opinions on the process.”

Given the above, it’s clear that Arbitrum’s strategy is firmly headed towards OP adoption and it will soon join the competition in the “L2 Interlink” market. This will undoubtedly target the current flourishing form of the OP stack. On August 9th, Andre Cronje, co-founder and architect of Fantom Foundation, mentioned in an interview with The Block that they are considering the Optimism L2 solution. Their considerations include both the Op stack and the Arbitrum stack. In the writer’s view, Fantom, being a once top-tier L1, is unlikely to consider operating as an L3 for Arbitrum. What AC referred to as “Arbitrum stack” should be an L2 solution.

However, the concern is: how long will it take for the Arbitrum community to reach consensus with partners and start granting licenses? By that time, how many core clients will be left to woo in the market? The longer this process takes, the more collaborators will join the OP stack ecosystem, putting ARB at a disadvantage.

Intensifying Competition in the L2 Service Market

Beyond ARB and OP, the ZK-series L2 is rapidly developing or awaiting launch. This includes the impressive ZKsync, which, despite significant inflation due to airdrop hunters, boasts remarkable operational data. There’s also Linea, backed by Consensys (with its Metamask having 30 million monthly active users and Infura boasting over 400,000 developers), and the highly anticipated Scroll. Furthermore, platforms like Altlayer, representing Rollup as a Service, offer modular assembly and operational services with extremely low barriers to entry for Rollup developers and operators. By positioning themselves upstream of the OP stack, they could potentially squeeze the bargaining power within the OP ecosystem.

Altlayer’s Product and Customer Ecosystem

The development of the Superchain ecosystem as a whole, and whether value can be transferred to the OP Foundation and OP tokens

Currently, the OP token does not have a direct means of value capture. Among the many adopters of the OP stack, only BASE has committed to donating 10% of its L2 profits to the OP Foundation. No other collaborative projects have made similar promises yet. The validation of the OP token’s value capture might only be apparent after the official launch of its decentralized orderer protocol. Observing the acceptance level of the major OP stacks will be revealing. If they all support and adopt the decentralized orderer system collateralized by OP, it will naturally generate a direct demand for OP, achieving value transfer. However, if individual L2s continue to adhere to their own orderer standards or operate through their own node systems, it will not only prevent OP from capturing value but will also weaken the synergistic effect within the OP ecosystem.

Valuation Risks

As previously mentioned regarding OP’s valuation, the author’s calculation of the price increase brought about by the Cancun upgrade assumes that the post-upgrade OP L2’s PE remains consistent with current levels. Given that the Cancun upgrade is one of this year’s most-watched market events, current OP PE valuations have, to some extent, already factored in these expectations. Some pessimists might even argue that the current PE has overpriced the benefits of Cancun.

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