Erik Weijers, 8 months ago

The success of Layer 2's, bearish for Ethereum?

As Ethereum is at least a year away from significant scaling upgrades, Layer 2 solutions like Matic have benefited and might continue benefiting. If the 'economic activity' happens on Layer 2 chains, then the token of that network will benefit.

The price of Ether correlates with the amount of activity on the Ethereum blockchain, aka the number of transactions. That's why we've seen a decline in the ETH price since basically May 2021: Ethereum became clogged and activity moved elsewhere. Not just to competitors like Solana and Avalanche but also to so-called Layer 2 solutions. Surely, the latter would still benefit Ethereum, right? As these Layer 2's are still founded on Ethereum? Not so fast. The transition from a single chain to Layer 2's has big implications for the ETH valuation.

About Layer 2 solutions

Layer 2 solutions handle transactions off the Ethereum Mainnet to achieve scalability. They are like roads exiting and entering Ethereum's highway. They offload traffic so that Ethereum won't get too clogged. In return, users have to put up with a slight bit of extra risk: after all, every move in traffic is a source of a potential accident.

Polygon (MATIC) is the most widely adopted layer 2 solution for Ethereum. By far. It can process 500 times more transactions per second than Ethereum. Other popular layer 2's are Arbitrum and Loopring. Arbitrum has gained a lot of traction since its launch in May 2021. Unlike most Layer 2's, Arbitrum doesn't have its own token. Loopring uses zero-knowledge (ZK) rollups: a way of compressing Ethereum transanction data and feeding them back to the Ethereum chain, to achieve higher throughput.

The potential of Layer 2 solutions

So what is Ethereum's 'business model' in relation to L2s? Ethereum provides a checkpointing system: it still needs to be 'consulted' to approve the batched transactions of the rollups. These are costly transactions in terms of gas fees. But if you realize that thousands of Layer 2 transactions fit in one batch, the higher gas fees won't make up for the lost demand of Ethereum blockspace. So the advent of Layer 2's is one reason that Ether hasn't performed so well in the past year, at least in terms of price of the token.

This all is of course good for the ecosystem and for Layer 2s, but not necessarily for the price of Ether. That's because the ethereum ecosystem fees would be split across major L2s. Every decentralized App (like Uniswap) that would migrate from Ethereum to L2's strengthens the business case for the token of the L2instead of Ether.


The hypothesis that the price of Ether might not benefit from scaling is still that: a hypothesis. In the coming months and years we'll have to see how it all plays out. It will also be interesting to watch how big the imporance of Layer 2s will be after Ethereum will have scaled with the shard chains. As mentioned, this won't happen the coming 12 months at least (the Ethereum Merge won't improve scalability).

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