Written by: James Ho
Compiled by: TechFlow
Investing in L2 vs ETH
Layer 2 (L2) solutions on Ethereum have made significant progress in the past few years. Currently, the total locked value (TVL) of Ethereum L2 exceeds $40 billion, compared to only $10 billion a year ago. On @l2beat, you will find more than 50 L2 projects, but the top 5-10 projects account for more than 90% of the TVL.
After the implementation of the EIP-4844 proposal, transaction fees were significantly reduced, and transaction fees on platforms such as Base and Arbitrum were even less than US$0.01.
Despite the huge progress L2 has made in technology and usage, L2 tokens have generally performed poorly as liquidity investments (although as venture investments they have performed very well). You can find many jokes and memes about the poor performance of L2 tokens relative to ETH.
We reviewed the valuations of major L2s relative to ETH. One notable observation is that despite the increase in the number of listed L2s, their total fully diluted valuation (FDV) as a percentage of ETH has remained constant.
Two years ago, the only listed L2s were Optimism and Polygon, with 8% of ETH’s FDV. Today, we have L2 projects like Arbitrum, Starkware, zkSync, etc., with 9% of ETH’s FDV.
Every new L2 token listed actually dilutes the valuation of previously listed L2 tokens.
The result of investing in L2 tokens is significant underperformance relative to ETH. The returns over the past 12 months are as follows:
- ETH: +105%
- OP: +77%
- MATIC: -3%
- ARB: -12%
For a long time, the FDV of the main L2 tokens has been around $10 billion. To some extent, this is quite arbitrary, and market participants have not had a strong reason to explain why it is $1 billion instead of $2 billion or $300 million. Ultimately, there is significant supply pressure due to demand for liquidity and/or large unlocking.
The aforementioned L2 generates $20-30 million in fees per month. Since the implementation of EIP-4844, fees have dropped to $3-4 million per month, with an annualized fee of about $40-50 million.
Includes: ptimism, arbitrum, polygon, starkware, zksync
Currently, the total FDV of major L2 tokens is approximately $40 billion, with annualized fees of $40 million and a valuation multiple of approximately 1,000x.
This is in stark contrast to large DeFi protocols, which typically trade at valuation multiples between 15-60x (based on last month’s annualized fees):
- DYDX: 60x
- SNX: 50x
- PENDLE: 50x
- LDO: 40 times
- AAVE: 20x
- MKR: 15x
- GMX: 15x
As more L2 projects come to market, the FDV of L2 tokens may continue to be pressured and diluted. There is too much supply in the market for the liquid market to easily support.
Conclusion
In the long term, L2 is likely to generate significant fee income. L2 generates $150 million in fees per year (including Base, Blast, Scroll), and this number is likely to grow significantly as L2 activity increases.
The above is not specific to a particular L2 project, but rather a broad observation about the category as a whole. It seems difficult to buy a basket of L2 tokens with ~$40B FDV and ~$40M in fees (1000x) and expect them to outperform ETH in the long term.
Clearly, there is no shortage of blockspace between L2, high throughput chains like Solana, Sui, Aptos, etc. The limiting factor is the applications that use that blockspace. I expect more focus to be placed on the application layer in the future, and that liquidity markets will reward the application layer over the infrastructure layer in the next few years.
In the last cycle, it was more common for projects to be listed significantly early. MATIC was listed on the liquid market with a FDV of less than $50 million, and now it is over $5 billion, an increase of more than 100 times. However, this is not the case recently for $OP, $ARB, $STRK, $ZK, and most other L2 tokens that may eventually be listed.
