Kyle Reidhead
GM PRO DOers! 😎
It’s time to put our money where our mouth is.
We talk a big deal about L2s and now it’s time to find out which L2 tokens are the best investments. 🤑
I believe that L2s will play a crucial part in shaping the web3 infrastructure.
Additionally, I think the tokens associated with these L2s have potential to be the next $ETH in terms of sustainable and useful tokens with massive investment returns.
In last week’s PRO report we covered the current and potential activity growth across the 4 top L2s: Arbitrum, Optimism, Polygon and Immutable.
Today we will cover the economics of the Layer 2 business model and dive into the tokenomics and value accrual of $OP and $ARB.
Next week we will finish off this L2 series by looking at the same for $IMX and the coming new Polygon token, $POL. 🚀
Which of these tokens should you hold in your portfolio now and for the long term… if any? That’s what I’m about to answer.
Let’s get right into it, shall we? ⏬
As shown last week, here is the cumulative revenues of Optimism, Arbitrum, Polygon and Base.
These things generate some serious revenues, and they’re only just getting started. 🌊
As a reminder, L2s earn revenue the same way that L1s do, requiring fees to transact onchain.
Of course, where there are revenues, there are also expenses. 😰
For L2s, their expenses come from paying gas fees to Ethereum to settle the bundled up transactions that occurred on the L2.
And here are the cumulative expenses…
You can think of L2s as a “reseller” of Ethereum blockspace, albeit in a more gas efficient and faster form.
As a result, as L2s sell Ethereum blockspace, they skim off the top for their own profit. 💸
You can see below that Optimism and Arbitrum are generating more than $200k in profit per week.
Base is higher, but that’s likely just because of a hyped up launch, I’m not sure it will sustain these numbers in the medium to long-term.
That said, you can see that both Arbitrum and Optimism profits are growing as of late. As more users enter web3 and more transactions occur, these revenues will go exponential.
For context, here are the cumulative profit numbers for each chain.
You may have noticed that I haven’t included Polygon in the expenses or profit charts above.
That’s because Polygon is not yet an L2, so it doesn’t pay Ethereum to settle its transactions.
Polygon has to pay to secure its own blockspace and settle transactions on Polygon instead.
As we’ve taught previously, securing blockspace is not cheap! 😅
Here’s what Polygon pays for its expenses, which it affords through its fee revenue and inflating its currency, $MATIC.
Yes, you’re seeing that correctly, Polygon paid $5.8 Million last week to secure its blockspace.
In terms of profit, there is none. Polygon is bleeding out millions of dollars per week in value just to secure its blockspace.
Polygon is almost 1 Billion dollars in the negative in cumulative “profit” since launching in 2020.
Compare those expenses and profits with those of an L2, generating 10s of millions of dollars in less than 2 years and you can see why the L1 + L2 model is so successful and sustainable vs the L1 only model.
It’s something tha even Polygon understands, hence why they’re transitioning to becoming an L2.
This is the sole reason why I am not overly bullish on any L1 (outside of Ethereum) and why I believe L2’s have plenty of potential into the future.
Profitable business models are exactly what this industry needs to remain relevant and L2s do exactly that. 🔥
Before we move on, there’s one more very interesting aspect of economics of L2s specifically for Arbitrum and Optimism.
Both have built a product called “L2s-as-a-service, which is essentially sharing their tech and resources for other companies to create their own L2.
Arbitrum’s product is called Arbitrum Orbit and Optimism’s goes by the OP Stack.
The revenues and product market fit is still unknown seeing as this is such a new service, but the best example we can take from this currently, is Base.
Base is a Layer 2 built on top of the OP stack, which means they are using Optimism's code and also using the Optimism team to support their tech.
In return, Base pays 10% of its profits to the OP Collective – you can think of this as the treasury of the Optimism community (more on this later).
So now, Optimism has revenues from their own chain (as shown above), but also additional revenues from other L2s using the OP stack.
Base has already generated $2.5 Million in profit since launching 2 weeks ago, which means that Optimism has generated $250k in 2 weeks, very impressive! 😲
Here’s an image showing some L2s already using the OP Stack, though there could be many more.
One important thing to note is that not every L2 using OP code is paying 10% to Optimism, some companies simply forked the OP code and built their own L2, thus no need to pay any fees to Optimism.
Whereas those who build on top of the OP stack, rather than fork it, do pay fees to Optimism. So why would a company choose to build on rather than just fork? It all comes down to network effects and the long-term vision.
Optimism is working to build a “Superchain”, which aims to connect the L2s in a seamless way to create the best L2 infrastructure available. This superchain looks something like this:
Without going into technical detail, Arbitrum is doing something similar, however with a structure of L3s on top of Arbitrum L2s to make up their “superchain”. That looks more similar to this:
This is still very early days for this so nobody knows which solution will win, if the rev share will continue or what else will happen…
But at the moment, it looks like this may be an excellent revenue generator for both Optimism and Arbitrum. 🤑
Now that we can see the profit being generated from L2s and their business models, let’s look into if any of that value can or will actually accrue to the token holders.
If it doesn’t, then what are we even investing in?
Before we look at the tokenomics, it’s important to understand the value accrual to these tokens, if any. 🤷
Value accrual simply means: How does the created value for the blockchain make its way back to the token holders?
In traditional equities, when you purchase shares of a company, you are purchasing ownership over that company.
In the event that that company is bought out, your shares would be sold to the buyer. In web3 however, most tokens don’t actually represent ownership of a company or protocol.
The best example of a token that has real value accrual is $ETH.
Firstly, when $ETH is burned during every transaction on Ethereum, that accrues value to ETH holders as it means the tokens you hold have become more scarce.
Secondly, if you stake your $ETH, you earn between 4-7% on that ETH from people transacting on the Ethereum network.
Both of these examples are direct value accruals as a token holder. Most tokens in crypto do not have this, even if the protocol or application is generating plenty of revenue.
In the case of $OP, there is no direct value accrual via fees, burning or otherwise (yet). However, Optimism has created something fairly unique with their token to incentivize growth of the network and potential value accrual.
Optimism has created a community treasury called the OP Collective, which is governed in combination with $OP holders and the OP Citizens House (a group of individuals who have been working on and dedicated to Optimism for an extended period).
After an initial airdrop to the collective when the OP token first launched, Optimism is now taking its profits from blockspace transactions and giving that to the OP collective.
The profits from Base and other L2s is also put into this OP collective, which then uses this capital to fund public goods.
What this means is that the revenues of Optimism go to a community treasury and then are distributed to teams and developers building on Optimism, which then drives more demand for Optimism blockspace, creating more fees and generating more revenue.
It works in a cycle to create growth within the Optimism network.
Additionally, this treasury is also used to pay users for creating activity and value on Optimism through Airdrops.
While this is not direct value accrual to OP holders, it’s value accrual to those building and using the blockchain, which I believe is an extremely smart way to incentivize growth to the network and form a moat around your technology.
In the future, Optimism could create new utility to the $OP token to provide direct value accrual to holders via dividends, staking, etc.
I will discuss how some L2s are already doing this in next week's report. 👀
As a quick note, Optimism is still very new and profits are limited (only $9 Million since launching).
It doesn’t make sense to pay dividends or give direct value to token holders this early in their development.
Instead, using the profits to incentivize growth right now is extremely smart in my opinion, and something very common for any business.
On the Arbitrum side, there is also no value accrual to the $ARB token in its current state.
The $ARB token is strictly meant for governance, as a part of the Arbitrum DAO which has 3 responsibilities: electing members of the Security Council, making decisions regarding upgrades to Arbitrum's core contracts, and authorizing the creation of new L2 chains.
It’s also important to note that $OP has a similar utility in terms of governing the technology and its upgrades.
Outside of governance, there is very little public information regarding what Arbitrum is doing with their profits, how they are funding growth or if there is any value moving back into the hands of $ARB holders.
While that may seem like a red flag to some investors, let’s remember that $ARB was only launched in March of 2023, so it’s still extremely new and there’s plenty of work to be done within the Arbitrum ecosystem before this sort of information is necessary.
Sorry that this section couldn’t be a bit more exciting, but don’t worry, read until the end and I’ll give you my strategy and thesis on these two tokens as an investment.
Now that we understand the current state of value accrual for both $OP and $ARB let’s move onto the tokenomics.
The tokenomics of $OP and $ARB are very similar. To start, let’s look at their current valuation.
The market cap of $ARB currently sits at $1.2 Billion (FDV at $9.6 Billion)
The market cap of $OP currently sits at $1.1 Billion (FDV at $6.6 Billion)
Their valuations are extremely high vs. their yearly profit, but investing on current numbers is never a good idea.
Instead, we need to think about potential future profits and utility around the token.
And if you compare them to other big names like Solana, which has a market value of $8.2 Billion (and even hit $77 Billion before), or Polygon, valued at $5.02 Billion (and had reached $20 Billion), it looks like these newer tokens might have some room to grow.
In terms of the initial distribution and allocation, Optimism and Arbitrum distributed their tokens similarly to investors, core team, community and users.
Even the timeframe and unlocks are almost the same, as you will see below.
Here is the allocation and future unlocks for each group for Arbitrum...
And here it is for Optimism…
(You can explore these yourself on Token Unlocks for Optimism here and Arbitrum here).
Overall it’s pretty standard stuff, the only thing to note here is that Optimism is farther along in their timeframe vs. Arbitrum.
As you can see, $OP distribution to investors and the core team is already being unlocked, whereas Arbitrum has not yet reached that cliff.
This is important as investors and core team are likely to be selling these tokens, adding some sell pressure to the token, however it’s tough to know what percent is being sold and when.
The final piece of the tokenomic puzzle for $ARB and $OP is inflation. Both companies have decided to add a 2% inflation rate to their token to be used for ongoing funding for growth of the network.
The OP collective and The Arbitrum DAO have governance power to alter this inflation rate (through voting) at any point in the future. At current, Optimism has not started their 2% yearly inflation, whereas Arbitrum has.
Of course, we don’t love seeing tokenomics with inflation to currencies, unless they have other mechanisms to balance this out via burning or locking in some way, which neither Arbitrum or Optimism have.
We’ve written about tokens which have inflation but have found ways to balance them out:
And potentially $RPL with utility staking.
Either of these options could be implemented in the future for $ARB and $OP too.
In conclusion, in terms of tokenomics – for both $ARB and $OP – the analysis doesn’t look great.
They are governance tokens with an inflating supply and a few years worth of token unlocks to investors and the core team.
Fundamentally speaking, this means there's a lot of structural sell pressure and not much, if any, structural demand.
Of course, like we often see in crypto, this doesn’t mean these tokens won’t go up in price.
In fact, I am a holder of both tokens and I believe both have potential to see incredible upside over the coming years.
Narratives, speculative demand, future potential utility and value accrual can also play a big role in the supply/demand dynamics of tokens.
The key takeaway here on tokenomics is that both of these tokens are new and they will take time to adapt into a structure with sustainable tokenomics that can create real utility (demand) and accrue value back to its holders.
I’ll explain my thoughts below on how I think through this, however I would love any additional comments below this post or in Discord.
Layer 2s play a critical role in blockchain infrastructure: Optimism and Arbitrum are at the cutting edge of this sector as well as have the most experienced and well-funded teams.
Exponential growth: Optimism and Arbitrum, as well as L2s using their tech stack will likely see exponential growth over the coming years in terms of onchain activity.
Profitable business models: The business model for Optimism and Arbitrum as an L2 and as a provider for L2s-as-a-service is extremely profitable and will grow exponentially as activity across these chains grow in the coming years.
L2s are a network-based technology: This is similar to that of Ethereum, and thus they will benefit from the network effects of more users, developers, applications and other chains on its chain.
Technologies deeper in the tech stack that can find a way to create a profitable business model are much easier to invest in vs. trying to choose the specific application that will succeed, be profitable and have favorable tokenomics long-term.
Future improvements to the tokenomics: While the tokenomics and the value accrual in its current form are not favorable, it’s very easy to imagine a world where both of those flip in the favor of the token holder.
Not only has that playbook already been written with $ETH, but it’s also in the best interest of the Arbitrum and Optimism ecosystem and their long-term strategies.
If they want to use their native tokens as a means of funding (which they do), they need that token to retain or appreciate in value.
The more it appreciates, the more funding they have to incentivize further growth.
Key considerations: When “speculating” on tokens that don’t yet have real utility or value accrual, the key things to think about are:
Do they have product market fit? ✅
Do they have a means to generate profit? ✅
Do they have a real need to focus on tokenomics or is it just a nice to have (aka does the token matter to the longevity of their business)? ✅
Do they have staying power? 🤔 This is the only one I’m uncertain of, however the L2-as-a-service model I think really helps their case.
The narrative: My last thought on this in terms of timing of an investment is its narrative. In the crypto world, narratives drive price more than any fundamental analysis.
L2s are all the rage right now, especially with Base launching just a few weeks ago.
In Q4 2023 or more likely Q1 2024, EIP 4844 will launch, which will lower the gas fees of L2s by an order of magnitude (10x).
This is likely going to be a very big catalyst for the use cases of L2s as well as an increase in their profits (as it lowers expenses) and thus will likely drive a large narrative for L2s. $OP and $ARB are likely to do really well during this time.
If you've been a PRO member for a while or you’ve taken the Profit From The Future: A Web3 Investing Masterclass, then you know that 80%-100% of your portfolio should be in long-term sustainable assets.
Neither $ARB nor $OP fits that category currently.
That said, I believe both of these tokens have potential to grow significantly with the coming upgrade to Ethereum (EIP-4844) and the expected influx of activity during the coming bull run.
While I currently hold both $OP and $ARB (I received an airdrop from both and only sold half of it), I’m currently leaning towards $OP as the better investment.
Why? Because it’s currently valued less, yet it’s gaining in activity and fees faster than Arbitrum.
Plus, it's teaming up with big players like Base and other apps that could make a lot of money in the future, such as Sound, Worldcoin, and Farcaster.
After the current beating on crypto assets over the last week, I also believe that now is a great time to start accumulating tokens with fundamentally strong business models. While $ETH is still my main investment every month, $OP and $ARB may be a great addition to your portfolio.
Next week we’re going to cover $IMX, the token for Immutable and $POL, the new token for Polygon and look into how these companies have managed to create additional utility for their tokens as well as drive value to token holders.
Both $IMX and $POL ($MATIC) are farther along in their tokenomic journeys than $OP or $ARB so this may be a look into the future of how the Arbtitrum and Optimism community manage their tokens.
See you in the next one! ✌️
Kyle Reidhead
Founder of Web3 Academy and Impact3
Find him on Twitter
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Disclaimer: This article is for informational purposes only and not financial advice. Conduct your own research and consult a financial advisor before making investment decisions or taking any action based on the content.
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