Blockchains are great inventions. They coordinate people via economic incentives enforced by technology. They maintain a public, trustless and neutral ledger for anyone to use. And most importantly, the consensus mechanisms that incentivize people to secure the blockchains also necessitate native tokens in order to reward miners and validators. This is a game-changer, as the token becomes trustless “money” that can be used for transferring value and paying transaction fees. This continuous reward mechanism (issuance of new coins to block producers) functions like monetary policy and transaction fees taken for each transaction on chain is very much like tax of fiscal policy in nation states. Using this nation states model, we are able to value the blockchain economy via its GDP (value settled on chain). However, as Ethereum becomes modular and Layer 2s are being built on top of the network, it makes us wonder what roles these Layer 2s play in the Ethereum nation.

Some people view Layer 2s as parasites to the Layer 1 chain and think they will vampire attack the Layer 1 and make the Layer 1 a no man’s land. People make this mistake largely because they are only looking at the number of transactions but not the value being settled, which I have detailed explanation in the previous article of this series. The transaction count is misleading, as lower fees fuels higher transaction volume, but not necessarily total value settled. When we measure a country’s economic activity, we are looking at GDP, which is a value measure, not a count measure. Therefore, large transactions or whale activities (over $100k per transaction) are still likely to occur on Layer 1 and Layer2s will aggregate small transactions into large transactions on Layer 1. Therefore, Layer1 is not a no man’s land but giants’ land. This layered framework is very similar to how big countries operate, e.g., the US has Federal level and State level authorities. Monetary policy and fiscal policy are mostly done at the federal level, but states have their own state tax or state laws. A person is a resident of a state, doing most of the activities at the state level — birth certificate, driver license, house/car titles, healthcare benefits, and business registration etc. Most of the day-to-day activities such as working, shopping or entertainment take place at state level and are counted towards the state economy. Even when you shop on-line, you buy a product from a merchant registered in another state, that transaction is cross-states but still captured at states’ level. It will be the same way with blockchain nation states. Most people or individuals don’t need to directly interact with Layer 1 but will reside in Layer 2s. And Layer 2s can focus on serving its people and bootstrapping a robust economy because they don’t have to worry much about security, which they inherit from Layer 1. Just like the national security and military budget is handled at the federal level, states don’t have to worry about defending themselves but focus on improving the quality of life of their residents. This layered approach allows for segregation of duties, which enables each layer to specialize in and focus on its own mission and maximize the value it provides to the ecosystem. In this way, Layer 1 will maximize its objective of decentralization and security while Layer 2s can invest most of its resources in user experiences and economic growth. This represents the best of both ends — the residents live in a highly secure place with a vibrant economy.

Some argue that because Layer2s will issue their own tokens, and many centralized exchanges and cash on-ramp services will enable direct deposit and withdrawal on Layer 2s so a user only need the Layer 2 token and never need to hold ETH to use the DAPPs on Layer 2s. Therefore, Layer 2s become their own countries with their own currencies and ETH will have no use. This is like saying California will become a country if it issues its own token and this token will replace USD as the main currency in the state. Whether this will happen depends on what this token is. If the token is created to be a currency, then it has a chance, but it will have to be better money than USD to replace USD. While this sounds easy, the currency status is extremely hard to earn. Of the tens of thousands tokens we have today, one could hardly pick a handful that can be called “Money”. In the real world, the currency of a country is ultimately backed by its military power. If a country cannot defend its border or is politically unstable, people will not have enough confidence in that currency because they don’t know how long it can last and how much value it can hold. The Layer 1 token exists for security, like military spending, thus has strong backing and have a permanent monetary policy due to consensus mechanism. In contrast, Layer 2s don’t have this backing, nor do they need a monetary policy. They exist for incentivizing economic development and user adoption, which is more like equity or state bonds. They don’t have much “soundness” qualities of money. Additionally, unlike many countries enforcing their own currency by banning other currencies in that country, California cannot ban USD in the state. And if other states issue their tokens, California cannot ban them either. This means the California token has to compete directly with USD and all other states’ tokens, further limiting its demand. Similarly, Layer 2 tokens are not money and will have a smaller market cap and less liquidity. They are more likely to be issued as DAO tokens or community tokens that function as equity.

The second reason why Layer 2 tokens are not likely to be very big is that there will be so many Layer 2s. We already have more than 7 Layer 2s and will have more as anyone can spin up a rollup on Ethereum. When there are so many Layer 2s and each has a token, it again creates a greater demand for a common currency. Think about the cost and time needed for all the exchanges and bridging of different assets and the complexity created for users and developers. For good user experience and cost minimization, people are way better off just using ETH or a dominant stablecoin (backed by ETH) everywhere. This, in turn, strengthens ETH as premium currency and a common collateral across all Layer 2s. In real world, the birth of Euro to replace all the different smaller currencies of member countries exemplifies this effect. When there are so many small countries that are closely tied to each other, there is greater need for a common currency.

The third reason that Layer 2 tokens won’t replace ETH is the community support and alignment of incentives. Like federal laws that prioritize national security over everything else, the ETH community has an overarching consensus to place ETH in front of Layer 2 tokens because ETH is the security budget. The whole country depends on ETH for security therefore ETH is the top priority of all Layer 2s. If ETH is not successful, then everyone loses. As a result, Layer 2s must align their incentives with ETH otherwise they’ll have trouble with the community and will likely be outlawed.

Overall, the most important reason why Layer 2s won’t devalue ETH is ETH’s network effects and lindy effect. This works behind all scenes and is ultimately the driving force of the whole ecosystem. Layer 2s capitalize on ETH’s liquidity and network effects and their success in brining more developers and users is a multiplier to these effects. In fact, not just Layer 2 rollups, even on sidechains (Layer 1 chains) like Polygon or Ronin, ETH still accounts for a large share of liquidity and trading volume of both token swaps and NFTs.

Another interesting perspective Tascha brought up is that end users moving to Layer 2s will cause Layer 1 to lose brand recognition among people. As most people are only interacting with Layer 2s, the “B2B” model of Layer 1 — Layer 2 relationship is unfavorable to the Ethereum brand. Again, there is confusion of the relationships between layers. Layer 1 and Layer 2s belong to the same brand “Ethereum”. A big company like Microsoft also has many “layers” inside its ecosystem with both “B2B” products and “B2C” products. But they all fall under one name — Microsoft. The fame of the product lines of Microsoft such as LinkedIn, Office, Windows, Xbox or Azure have not diluted the value of the big brand. Moreover, you can also argue against the theory of “B2B” being inferior to “B2C” in terms of valuation, as for Amazon, AWS (“B2B”) probably contributes more to its valuation than the E-commerce arm (“B2C”). Furthermore, all this time we are talking about blockchains being more like nation states than companies. So it is more appropriate to use a country as an example, and I have no doubt that most people in the world know USA the country, but not all 50 states. The name of a country is almost always bigger and louder than those of states or provinces.

To conclude, Layer 2s are the states of the Ethereum country and they will specialize in serving their residents (Developers and users) while Layer 1 focuses on security, decentralization, and the monetary policy. In this way, Layer 2s will help fend off external competition of alternative Layer 1 chains and multiply the network effects of ETH. When network effects grow, ETH grows, and the upcoming POS transition will dramatically reduce ETH supply (triple halving) much like Fed tightening up monetary policy resulting in stronger USD. Lastly, branding does not depend so much on user interaction but storytelling. Given the fact that there is already a book published, a documentary and a movie in-line, it will be really hard to ignore the Ethereum story in the next 5 years.

Blockchains are great inventions. They coordinate people via economic incentives enforced by technology. They maintain a public, trustless and neutral ledger for anyone to use. And most importantly, the consensus mechanisms that incentivize people to secure the blockchains also necessitate native tokens in order to reward miners and validators. This is a game-changer, as the token becomes trustless “money” that can be used for transferring value and paying transaction fees. This continuous reward mechanism (issuance of new coins to block producers) functions like monetary policy and transaction fees taken for each transaction on chain is very much like tax of fiscal policy in nation states. Using this nation states model, we are able to value the blockchain economy via its GDP (value settled on chain). However, as Ethereum becomes modular and Layer 2s are being built on top of the network, it makes us wonder what roles these Layer 2s play in the Ethereum nation.

Some people view Layer 2s as parasites to the Layer 1 chain and think they will vampire attack the Layer 1 and make the Layer 1 a no man’s land. People make this mistake largely because they are only looking at the number of transactions but not the value being settled, which I have detailed explanation in the previous article of this series. The transaction count is misleading, as lower fees fuels higher transaction volume, but not necessarily total value settled. When we measure a country’s economic activity, we are looking at GDP, which is a value measure, not a count measure. Therefore, large transactions or whale activities (over $100k per transaction) are still likely to occur on Layer 1 and Layer2s will aggregate small transactions into large transactions on Layer 1. Therefore, Layer1 is not a no man’s land but giants’ land. This layered framework is very similar to how big countries operate, e.g., the US has Federal level and State level authorities. Monetary policy and fiscal policy are mostly done at the federal level, but states have their own state tax or state laws. A person is a resident of a state, doing most of the activities at the state level — birth certificate, driver license, house/car titles, healthcare benefits, and business registration etc. Most of the day-to-day activities such as working, shopping or entertainment take place at state level and are counted towards the state economy. Even when you shop on-line, you buy a product from a merchant registered in another state, that transaction is cross-states but still captured at states’ level. It will be the same way with blockchain nation states. Most people or individuals don’t need to directly interact with Layer 1 but will reside in Layer 2s. And Layer 2s can focus on serving its people and bootstrapping a robust economy because they don’t have to worry much about security, which they inherit from Layer 1. Just like the national security and military budget is handled at the federal level, states don’t have to worry about defending themselves but focus on improving the quality of life of their residents. This layered approach allows for segregation of duties, which enables each layer to specialize in and focus on its own mission and maximize the value it provides to the ecosystem. In this way, Layer 1 will maximize its objective of decentralization and security while Layer 2s can invest most of its resources in user experiences and economic growth. This represents the best of both ends — the residents live in a highly secure place with a vibrant economy.

Some argue that because Layer2s will issue their own tokens, and many centralized exchanges and cash on-ramp services will enable direct deposit and withdrawal on Layer 2s so a user only need the Layer 2 token and never need to hold ETH to use the DAPPs on Layer 2s. Therefore, Layer 2s become their own countries with their own currencies and ETH will have no use. This is like saying California will become a country if it issues its own token and this token will replace USD as the main currency in the state. Whether this will happen depends on what this token is. If the token is created to be a currency, then it has a chance, but it will have to be better money than USD to replace USD. While this sounds easy, the currency status is extremely hard to earn. Of the tens of thousands tokens we have today, one could hardly pick a handful that can be called “Money”. In the real world, the currency of a country is ultimately backed by its military power. If a country cannot defend its border or is politically unstable, people will not have enough confidence in that currency because they don’t know how long it can last and how much value it can hold. The Layer 1 token exists for security, like military spending, thus has strong backing and have a permanent monetary policy due to consensus mechanism. In contrast, Layer 2s don’t have this backing, nor do they need a monetary policy. They exist for incentivizing economic development and user adoption, which is more like equity or state bonds. They don’t have much “soundness” qualities of money. Additionally, unlike many countries enforcing their own currency by banning other currencies in that country, California cannot ban USD in the state. And if other states issue their tokens, California cannot ban them either. This means the California token has to compete directly with USD and all other states’ tokens, further limiting its demand. Similarly, Layer 2 tokens are not money and will have a smaller market cap and less liquidity. They are more likely to be issued as DAO tokens or community tokens that function as equity.

The second reason why Layer 2 tokens are not likely to be very big is that there will be so many Layer 2s. We already have more than 7 Layer 2s and will have more as anyone can spin up a rollup on Ethereum. When there are so many Layer 2s and each has a token, it again creates a greater demand for a common currency. Think about the cost and time needed for all the exchanges and bridging of different assets and the complexity created for users and developers. For good user experience and cost minimization, people are way better off just using ETH or a dominant stablecoin (backed by ETH) everywhere. This, in turn, strengthens ETH as premium currency and a common collateral across all Layer 2s. In real world, the birth of Euro to replace all the different smaller currencies of member countries exemplifies this effect. When there are so many small countries that are closely tied to each other, there is greater need for a common currency.

The third reason that Layer 2 tokens won’t replace ETH is the community support and alignment of incentives. Like federal laws that prioritize national security over everything else, the ETH community has an overarching consensus to place ETH in front of Layer 2 tokens because ETH is the security budget. The whole country depends on ETH for security therefore ETH is the top priority of all Layer 2s. If ETH is not successful, then everyone loses. As a result, Layer 2s must align their incentives with ETH otherwise they’ll have trouble with the community and will likely be outlawed.

Overall, the most important reason why Layer 2s won’t devalue ETH is ETH’s network effects and lindy effect. This works behind all scenes and is ultimately the driving force of the whole ecosystem. Layer 2s capitalize on ETH’s liquidity and network effects and their success in brining more developers and users is a multiplier to these effects. In fact, not just Layer 2 rollups, even on sidechains (Layer 1 chains) like Polygon or Ronin, ETH still accounts for a large share of liquidity and trading volume of both token swaps and NFTs.

Another interesting perspective Tascha brought up is that end users moving to Layer 2s will cause Layer 1 to lose brand recognition among people. As most people are only interacting with Layer 2s, the “B2B” model of Layer 1 — Layer 2 relationship is unfavorable to the Ethereum brand. Again, there is confusion of the relationships between layers. Layer 1 and Layer 2s belong to the same brand “Ethereum”. A big company like Microsoft also has many “layers” inside its ecosystem with both “B2B” products and “B2C” products. But they all fall under one name — Microsoft. The fame of the product lines of Microsoft such as LinkedIn, Office, Windows, Xbox or Azure have not diluted the value of the big brand. Moreover, you can also argue against the theory of “B2B” being inferior to “B2C” in terms of valuation, as for Amazon, AWS (“B2B”) probably contributes more to its valuation than the E-commerce arm (“B2C”). Furthermore, all this time we are talking about blockchains being more like nation states than companies. So it is more appropriate to use a country as an example, and I have no doubt that most people in the world know USA the country, but not all 50 states. The name of a country is almost always bigger and louder than those of states or provinces.

To conclude, Layer 2s are the states of the Ethereum country and they will specialize in serving their residents (Developers and users) while Layer 1 focuses on security, decentralization, and the monetary policy. In this way, Layer 2s will help fend off external competition of alternative Layer 1 chains and multiply the network effects of ETH. When network effects grow, ETH grows, and the upcoming POS transition will dramatically reduce ETH supply (triple halving) much like Fed tightening up monetary policy resulting in stronger USD. Lastly, branding does not depend so much on user interaction but storytelling. Given the fact that there is already a book published, a documentary and a movie in-line, it will be really hard to ignore the Ethereum story in the next 5 years.