Turning to the strategy of ‘small profits and high sales’? Discussing the business secrets behind ‘Ethereum Layer2’.

Produced by: TechFlow Research

Written by: David

Building Layer 2 (L2) solutions seems to be a trend lately.

From emerging projects to established public chains, everyone is actively exploring and implementing L2 solutions.

On July 17th, Mantle Network, a modular L2 solution using Optimistic Rollup and incubated by BitDAO, went live on the mainnet;

On July 18th, Linea, an L2 solution developed by Consensys, the parent company of the MetaMask wallet, also released its mainnet Alpha version;

Earlier, Coinbase also announced the testnet for its L2 solution BASE.

Recently, even the well-established public chain Celo proposed in its internal forum to change its development direction from an independent Layer 1 public chain to an Ethereum-compatible L2 solution.

I vaguely remember the battle of new public chains two years ago, where various contenders appeared with the intention of being an “Ethereum killer” and trying to “kill” Ethereum; but now, everyone is gathering to build L2, which is more like “Ethereum builders,” aiming to “relieve” Ethereum’s scalability issues through technological optimization.

These are two completely different approaches: the former is direct competition, while the latter is elegant parasitism.

Now, why are people enthusiastically embracing L2 instead of focusing on building new public chains? Is it because new public chains are no longer attractive, or is it because L2 can indeed bring new narratives and benefits?

L2, a faster and more effective business

We won’t go into detail about solutions like Mantle and Linea, which were designed from the start as L2 solutions. Their narrative is nothing more than improving the scalability of ETH and reducing fees to create a better interactive experience for applications and users.

When a public chain like Celo, which is originally an L1 chain, chooses to become an L2, the initial intuitive reaction is “compromise and backpedaling” — a public chain competing with ETH solves Ethereum’s shortcomings through “improving what I can do better”; but then it chooses to become Ethereum’s L2, which somewhat implies surrendering and joining.

Let’s see what Celo has to say about this:

The benefits of compatibility, security, and liquidity are undeniable, but the author believes that it doesn’t touch upon the core interest: what determines whether a project chooses to build its own independent L1 or parasitize on Ethereum and expand through L2?

The answer is cost and benefit.

The article “Doing Rollup is a Good Business” from Lightning HSL provides a very good business perspective: whether it is developing L1 or L2, it is to solve existing problems and create value. However, from a business point of view, L2 seems to be more profitable.

Business model: L2–>equivalent to ETH main chain functionality–>lower gas fees, faster speed–>attract dapps and users–>increase on-chain transaction volume;

L2 revenue: gas fees paid by users for transactions on L2 chain;

L2 expenditure: L2 operators regularly batch upload Rollup transactions to Ethereum L1, incurring gas fees;

The difference between revenue and expenditure is the approximate gross profit of operating L2 rollup mode. Therefore, as long as there are more applications and TVL on L2, it is possible to generate more user transactions, allowing the L2 operator to generate larger revenue and increase profits while incurring relatively fixed expenditures.

In terms of costs, Rollup does not require the development of complex consensus mechanisms, and theoretically does not require tokens (even though current projects have them). It only needs a server to start running at a minimum, and the core technical components can be built using Optimistic or Arbitrum, equivalent to having a complete open-source solution, with a difficulty definitely lower than building a separate L1 chain.

In comparison, the cost and difficulty of developing a new public chain (L1) are much higher:

  • First, you need to develop a marketable consensus mechanism, which requires a lot of research and development resources, time, and accumulation;
  • Second, you need to attract enough nodes to participate in your network to ensure network security and decentralization;
  • Finally, you need to build some differentiated narratives, such as focusing on privacy or security, etc…

At the same time, the data also confirms the analysis of cost and benefit.

According to data from Token Terminal, in the past six months, among the top ten projects in terms of revenue, if only considering the public chain layer, only Ethereum, Tron, and BNB Chain made the list, with Arbitrum also included in this ranking. Considering the comparison of construction time between these L1 chains and Arbitrum, it is obvious that Arbitrum has a better cost-effectiveness in terms of pure revenue.

In addition, in a bear market environment, it is harder for VCs to fundraise and retail investors to buy into the story. Building a new L1 chain from the primary market to the secondary market will inevitably encounter twists and turns. The project team itself realizes the Token through the capital market, making it more difficult to make money. Therefore, it is far more practical and cost-effective to do an L2.

Instead of starting from 0 to 1 to build a unique public chain, which requires a large investment and slow results, it is better to parasitize on Ethereum’s L2, which requires a smaller investment and relatively faster results.

More importantly, the “traffic business”, that is, where users come from.

As mentioned earlier, TVL and transaction volume are the key factors for L2s to generate revenue, which depends on more users entering.

Coinbase, Metamask, or Binance doing L2 can naturally bring their existing users from their CEX or wallet businesses into L2 through product integration, giving them an unparalleled advantage in customer acquisition cost;

And L1s like Celo can also migrate their existing users to L2, although it may require more incentives and guidance.

But in any case, most projects and capital choose to do L2, starting from their own product ecosystem or the existing users in the Ethereum ecosystem, and then expanding to more cooperative scenarios (such as Polygon’s actions in the Web2 field).

Is L1 a Dead Sea and L2 a Red Sea?

The above analysis is based on the internal characteristics of L1 and L2, but if we look at the external competitive environment, it becomes easier to understand why L2 is chosen.

Data from DeFiLlama shows that there are nearly 200 public chains on the market. Excluding dozens of L2s, there are about 190 L1 public chains.

Therefore, the current L1 track is more like the Dead Sea: the salt (density) exceeds the standard and the competition is fierce.

There are only a few public chains that occupy users’ minds, not to mention that many public chains that were once popular have now disappeared from various indicators such as user activity, revenue composition, and transaction volume due to black swan events and capital withdrawal in recent years.

Most L1s still exist in concept, but they are not thriving. It is not a wise choice to jump into the Dead Sea in terms of business.

In contrast, the situation in the L2 big pool is slightly better.

L2’s total TVL is still in a growth trend over time;

In terms of competition, L2Beat can currently count 26 L2s, which is about one-seventh of the competition pressure on L1. Although Arb and OP have taken the lead in market share, the market share of other projects is relatively scattered and average, providing a greater opportunity for another leader to emerge.

However, considering the technical architecture, there are already typical representatives of different technology stacks in the existing market of L2s:

  • OPtimism and Arbitrum, which use Optimistic rollup;
  • Zksync and Starknet, which use Zk-Proof;
  • Base, built on OP Stack;
  • Linea, an EVM-compatible chain launched by Consensys;
  • Zk-EVM, launched by Polygon, etc.

Although not a blue ocean, there are still opportunities compared to L1.

With the completion of Ethereum’s technical upgrades this year and subsequent upgrades, the narrative around performance will continue to exist, and L2s will still have a long window for development. At the same time, there are not many narratives and tracks that can sustain heat in a bear market. In the environment of scarce attention and funds, L2 also has the advantage of continuous attention.

Therefore, from the perspective of competitive landscape and external environment, doing L2 seems to be a profitable business.

Whom does L2 serve?

Outside of business, the author feels a kind of “redundancy” in the circle.

We often see a project migrating from one L1 to another, from supporting one L2 to supporting more L2s. Projects run across chains, and the number of chains themselves is increasing.

Changing to a different ecosystem can once again enclose the land, gather a wave of resources, and capture a wave of users. In a way, L1 and L2 are like undeveloped colonies. Ignoring the differences in technical details, the same business can be carried out in a different place.

Do we need so many “places”? Who do these many places serve?

Capital needs, profit needs, scam needs, narrative needs… but normal needs may not be necessary.

If all L2s are indiscriminately discussing lower fees and faster speeds, what is their essential difference?

After all, as end users, the technical process is not important. When the results of use are consistent, increasingly crowded L2s can be interchangeable.

History has shown that after a round of new public chain movements, Ethereum is still Ethereum and has become even stronger in competition.

Is it the same for the current state of L2? From a blue ocean to a red ocean and then to a dead sea, after a round of money throwing, the density of projects becomes higher and in the end, there may only be one or two left on the surface, and there may not be many users in the pool.

The business experience of L2 can take effect quickly, but hopefully, it won’t be overfished.

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