Layer 2 Token Speculation: Economic Models, Distribution Timing, Incentives.

Original: Layer 2 Tokens Are Coming - Bankless

Original Authors: John Wang, RyanSAdams

Translator: @gm365

Introduction

Layer 2 tokens are coming.

Arbitrum, Optimism, zkSync, Starkware ------ all these currently popular Layer 2 networks do not have tokens yet!
But these Layer 2 networks are growing rapidly, currently locking in billions of dollars in TVL and attracting more on-chain activity every day. The future of Ethereum lies in the hands of Layer 2 networks.

The question arises, "When will they issue tokens¹?"

/zkSync/ has confirmed that it will be "community-owned."
/Arbitrum/ and /Starkware/ have not yet responded.
/Optimism/ stated in a Bankless podcast that they have no plans to issue tokens in the near future.

Whether they publicly confirm their token issuance plans is actually not important. They all have equity structures² filled with investors and team members. They also need to stimulate growth and increase liquidity.

In the words of Charlie Munger: "Whoever gives me bread to eat, I will sing for them."

Now the bread is there, and the outcome seems clear.

To seize the gold rush of L2, we need to answer the following questions:

• What does L2 token economics look like?
• What incentives will be in place at the time of token issuance?
• What will they govern?
• How will the tokens be distributed?
• What are they waiting for?
• Will rollup Layer 2 tokens be parasitic on ETH?

We have invited someone who helped launch the IMX token to share his views on all these questions.

Let’s get ready for the L2 gold rush.

------ RSA

Rollup Tokens Are Coming

Author: John Wang, Independent Analyst and Builder

This article is based on a Twitter thread by John Wang.
Image credit: Logan Craig

Layer 2 (L2) tokens are about to arrive and will soon see a major explosion, but there is little information on L2 token economics, and more importantly, "When will they issue tokens?"

This article intends to delve into this topic.

A bit of background: I facilitated the issuance of IMX and GODS on the Immutable chain, as well as GOG on the StarkEx chain. Given this, I plan to share my experiences in this emerging field of cryptocurrency.

Although I work with the Starkware team, I have no insider information about these L2 tokens. The following content is mainly based on what I believe good rollup token economics should look like and how they will be distributed. All of this is just some well-reasoned speculation.

Topics

1. Aggressive airdrops or incentive strategies to vampire attack other L1 networks
2. Token staking economics and governance systems
3. Rollup cost subsidies
4. Token distribution
5. Cross-chain bridges, fiat on-ramps, and /Tokemak/ collaborations
6. EVM compatibility
7. MEV acquisition or prevention
8. Will rollup tokens be parasitic on ETH?

Rollup Overview

If you know little about Rollups, please refer to this DCBuilder's great article for a wealth of information.

The four giants of Rollups: Arbitrum, Optimism, zkSync, and StarkNet have currently opened whitelists for dApps, while having centralized sequencers and validators, but plan to build decentralized sequencers in 2022 and promote permissionless access. Notably, Arbitrum recently experienced a ten-hour outage due to issues with its centralized sequencer³.

The TVL locked in these Layer 2 networks is continuously growing, and they especially need decentralization. A logical solution is to issue tokens. Image credit: L2Beat

So When Will They Issue Tokens?

I believe rollup tokens will be launched in the following order from late 2022 to early 2023: zkSync (/confirmed/) → StarkNet (/no news/) → Arbitrum (/no news/) → Optimism (/publicly denied/). Source: Bankless Interview with Optimism

That is to say, any project—including Layer 2 networks—should only issue tokens when they reach "product-market fit⁴." I believe rollups can only achieve product-market fit after solving the following issues:

• Decentralized sequencers
• Cross-chain bridges/on-ramps
• EVM compatibility/equivalence

Incentive programs are part of marketing expenses and can be very costly. You always need to prove that users like your product first; otherwise, you are wasting your marketing budget.
------ @QiaoWang

We will revisit these issues later.

Aggressive Incentives

Are you ready to witness the largest vampire attack⁵ in history?
Compared to this, SushiSwap's vampire attack on Uniswap is merely a small-scale event. To compete with other L1 public chains⁶, rollup tokens should aggressively promote user migration to L2 through airdrops, staking, liquidity mining, and ecosystem funds. Cross-chain bridges between L2 networks will allow the rollup ecosystem to surpass other centralized L1 public chains.

Rollups should strategically airdrop to early rollup testers or ETH users, as well as active users from other L1 public chains, while filtering out those cross-chain yield farmers. Incentives for developers can also be proportionally quantified based on their active use of deployed contracts. Rollups can also collaborate with DeFi 2.0 protocols like Olympus Pro to create liquidity incentive pools or L2 bond pools.

However, to attract more TVL, the industry needs better cross-chain bridge infrastructure between L1 and L2. Rollup team⁷ members understand this, and they may only issue tokens at that time.

But what will the token economics⁸ look like?

L2 Token Staking Mechanism

Incentives can be balanced against the following forfeitable staking mechanism requirements:

• Sequencers and provers of zkRollups (hinted)
• Initiators and validators of fraud proofs for Optimistic Rollups (hinted)
• Data availability committee members for Validiums/zkPorter
• Data availability guardians for zkPorter (officially announced)
• $METIS model: incentives for Rangers (validators) to challenge sequencers for fraud (the winning side retains the forfeited $METIS)

As a reference, Immutable's IMX allocates a certain percentage of transaction fees to a staking reward pool, a model that can be emulated by other rollup tokens.
Once tokens participate in staking, they lose liquidity (i.e., they cannot be bought on the market), so the staking mechanism itself can greatly enhance the security of rollups. Matter Labs has stated, "To make data unavailable in zkPorter, an attacker needs to raise 2/3 of the total market value of all staked tokens."

METIS is a forked token of the Optimism mechanism, featuring a dynamic Bond threshold staking mechanism. For sequencers, if the value of their staked tokens is lower than the value of the block they are about to order, they will not be able to participate in ordering that block. Until a qualified sequencer is found, transactions cannot be packed, thus limiting the size of transaction values.

Cost Subsidies

ZK Rollup systems should pursue a user growth strategy through loss-leading cost subsidies for early users.

According to Polynya's model predictions, as TPS increases, transaction fees can break even at around 3.33 TPS and continue to decline. Matter Labs agrees, stating, "Current service operations are very close to breaking even and have remained so until decentralization is achieved."

This can be achieved through marketing budget expenditures or token inflation. Compared to networks like Aurora, which spends tens of millions of dollars daily to secure SOL, DOT, AVAX, and NEAR, a few thousand dollars in subsidy costs are negligible.

For reference, Solana spends $18 million daily on security costs but only sells $225,000 worth of transaction-packed blocks. On Immutable, we directly subsidize transaction gas fees (i.e., no gas fees for sending transactions), hoping that transaction fees can be partially covered.

In contrast, Optimism Rollups…

ORs (i.e., Optimism Rollups) follow another method to reduce transaction fees: compressing calldata. Their packing processing costs are already low enough, although I know some ORs still have some optimization space.
------ @polynya

Governance Design

Currently, all rollups have multi-signature smart contracts deployed on L1.

Rollups are a new phenomenon, so early upgrades and bug fixes need to occur on the L1 side. What is currently important is that we have detailed transparency reports and emergency exit mechanisms like escape hatches.

The current Rollup escape mechanism is not very useful. You need to have the ability to produce new blocks to withdraw your funds from a Layer 2 smart contract, but most users do not have that capability.
------ @JohnWang

As DAOs mature, the smart contracts of Rollups on L1 should be voted on by governance tokens and eventually become immutable. For now, multi-signature smart contracts on L1 absolutely mean a trusted initial setup, but due to the existence of time locks, you can withdraw your funds at any time, so it does not pose a substantial security risk.

Other governance issues include designing mechanisms to reduce MEV for sequencers, fee models, implementing fraud proofs on Optimism, treasury expenditures for ecosystem funds and DAO partnerships, data availability layers, and funding public goods through MEV auctions.

As you can see, there are plenty of topics for L2 DAOs to vote on.

While there are many innovative solutions, the first step towards achieving a decentralized sequencing mechanism should be for the rollup teams to designate a few high-reputation teams around the world and rotate among them. A better solution would be to have a governance token and decide through governance voting (Lido?)
------ @polynya

Token Distribution

I am impressed by zkSync's public claim that they will allocate 67% of tokens to the community. This sets a competitive baseline for others to follow.

Some existing L2 dApp protocol tokens have an FDV⁹ of over a hundred billion dollars, while the rollup tokens for L2 smart contracts will be at least ten times that, easily placing them in the TOP 30 by market cap.

Furthermore, IMX and DYDX have an FDV of $9 billion, and the tokens for StarkNet and zkSync will only be higher. At an 8% inflation rate, it is sufficient to subsidize gas fees to $0.01 at 500 TPS. If the inflation rate is as high as SOL, it is possible to maintain a gas fee price of over $0.01 at TPS greater than 5000 (i.e., maintaining a gas fee price of $0.01).
------ @polynya

Starkware recently raised funds at a valuation of $2 billion, while zkSync raised at $1.25 billion.

If we extrapolate the token distribution plan based on Cooper's data, where 35% is reserved for the team or insiders, and reverse-engineer the super low discounts for early VCs, the initial market value of these tokens would be at least $7 billion.

Private investors
Allocated to those early equity purchasers who later convert to tokens or directly purchase tokens.
There will also be a lock-up period, generally consistent with team members. The allocation for investors has been on a declining trend—from about 25% in 2013 to 15% in 2021.
[image:9EBB32A3-9E1E-4659-9437-998B038AB397-60073-00000E5152EA628D/FISKPmAVcAQovOK.png]
------ @Coopahtroopa.eth

Compared to L1, a major disadvantage of L2 tokens is the lack of a token distribution phase. Even if airdrops and incentive programs work well, the tokens of other L1 public chains have a time advantage due to their poor performance in recent years. If L2 tokens perform strongly in the early stages, they may be further accumulated by whales.

We can address this issue by subsidizing transaction fees through continuously inflating L2 token rewards (like Bitcoin), attracting users and ensuring broader distribution to maintain long-term security.

Obstacles to Issuing L2 Tokens

Cross-Chain Bridges

Cross-chain bridges for L2 and fiat on-ramps are crucial for attracting TVL and addressing liquidity fragmentation issues.

Some cross-chain bridges have already shortened the 7-day withdrawal period for Optimistic Rollups, such as Hop Protocol, Connext Network, Argent, Celer Network, Maker, PolyNetwork, Layerswap, MultiChain, etc.

Currently, the TVL of native L2 cross-chain bridges accounts for only 17.7% of the total TVL of all cross-chain bridges on Ethereum. Compared to other L1 chains, ZKRs cross-chain bridges have unparalleled advantages because you can verify state transitions on the L1 target chain through minimally trusted cross-chain bridges. In the long run, even executing across multiple shards or external DA sources, rollups will still have the best composable execution layer.

Celestia founder Mustafa Al-Bassam pointed out, "For trust-based cross-chain bridges, the operators of the bridges can steal your funds. This is because these chains do not verify each other's state transitions, relying only on a committee of validators to sign transactions. For example, the Eth-Polygon cross-chain bridge or the Eth-Solana Wormhole cross-chain bridge."

Starkware and Loopring have collaborated to develop dAMM, a cross-ZKL2 AMM that allows asynchronous sharing of liquidity with liquidity pools on other L2s and L1s (e.g., Uniswap).

Layer 2 network technology requires a lot of manual integration from existing infrastructure. Centralized exchanges, CoinList, Chainlink oracles, and data indexing services like Graph Protocol must all undergo custom integration. As far as I know, BitGo/institutional custodians do not even have specific plans in this regard, limiting institutional access to L2.

Incentivizing liquidity through inflation or centralized market makers within cross-chain bridges will make the L2 ecosystem fragile due to the highly volatile nature of hot money or reliance on centralization. To incentivize liquidity within the pools, the Hop project and Polygon jointly launched a liquidity mining program, distributing MATIC rewards to liquidity providers. As expected, once the liquidity mining program ended, liquidity in those pools sharply declined.

It is evident that there is still much work to be done in cross-chain bridges.

EVM Compatibility/Equivalence

The composability of software is crucial.

In the coming months, EVM compatibility/equivalence will appear across all four major Layer 2 networks¹⁰.

For true composability, EVM equivalence is important, not just EVM compatibility.

Metis DAO and Optimism have EVM equivalence. Optimism 2.0 integrates the EVM interpreter into its Geth client without needing to re-implement the on-chain EVM. This provides future security guarantees for future EVM upgrades.

Developer tools like DappTools (smart contract libraries, command-line tools, formatting verification, symbolic execution, project management, etc.), Hardhat, Solidity, Vyper, and all other tools will operate seamlessly on the native OVM 2.0, and the developers of these tools do not have to worry about supporting fragmented codebases.

In contrast, Arbitrum One (formerly Nitro), zkSync 2.0, and StarkNet are merely EVM compatible. The simple syntax differences between Cairo and Solidity hinder code interoperability. Consequently, zkSync admits that they are not yet fully compatible with EVM.

Only minor changes to the code are needed, and the prepared Solidity contract ABI can be deployed on-chain. However, seamless cross-L2 message communication or smart contract calls are currently not achievable.

zkEVMs are extremely complex, and developers are still working tirelessly to resolve issues such as denial-of-service attacks caused by validators being unable to handle fallback transactions.

Are Rollup Tokens Parasitic on ETH?

Layer 2 rollups validate and execute contracts, while L1 is dedicated to storing immutable transaction data. In the current situation, L1 chain tokens capture almost no value. One can look at the cases of Solana and Avalanche.

Value capture mainly occurs at the protocol layer. This also means that the settlement layer, execution layer, and consensus layer are competing for MEV¹¹ and the value storage of currency.

In fact, according to this Flashbots paper, in Eth 2.0, "MEV can increase validator rewards by 75.3%!"

As more liquidity flows into Layer 2 networks, L2 tokens are essentially parasitic on the MEV value capture of L1 tokens. L2 transfers the miner income that provides security for L1, reducing the security budget and thus lowering the cost of launching a 51% attack.

This is a serious issue that the ETH community has not yet taken seriously.

Why Does L2 Capture MEV?

Layer 2 networks may see more complex MEV and coordination mechanisms between sequencers and miners. Compared to current PoW miners, the backgrounds of those running PoS validators are closer to those who truly understand MEV.

Under the interaction of different ordering mechanisms, cross-rollups will facilitate an explosion effect of MEV combinations. Flashbots has a great paper suggesting that sequencers "accumulate votes on the chain with the highest MEV value… thereby reducing their cross-domain MEV costs," and "mechanisms like Flashbots or SGX-based DAOs can lower the costs of cross-chain collusion."

However, as Flashbots founder Stephane Gosselin said, "Settling rollups on the mainnet doesn't yield much MEV—miners can only delay the settlement of a few blocks, but this doesn't really affect the rollup experience, and the costs are quite high."

Ethereum's Net Gains

While Layer 2 networks may be parasitic on ETH in the short term, the long-term relationship between the two is a positive-sum game¹². Indeed, as more activity gradually migrates to Layer 2 networks, they will capture more MEV than L1. Meanwhile, this may create downward pressure on profits in the short term compared to a world without rollups.

Because rollups batch thousands of transactions at once to submit to the L1 chain, the transaction fees of rollups scale logarithmically. This is almost like the dilemma in sales of "thin profit, high sales" versus "thick profit, low sales." From the scale of providing data availability, L1 transactions from rollups will pay higher transaction fees than ordinary transactions.

Another tricky issue is that miners may leave the network, reducing L1's security. Worse, more L2 transactions will lead to more state bloat and higher storage requirements for full nodes, thus reducing decentralization.

Ultimately, we should ask: Would ETH's price rise higher without rollups?

Due to block capacity limits and high gas fees driving away most users, interactions occurring directly on Ethereum L1 will have a demand ceiling. In a world with rollups, recursion, and layered L3, the potential user scale¹³ will be in the billions.

In the same fixed L1 block space, rollups pack in greater network effects.

Ethereum's expansion to global utility means that L1 block space will always be occupied. L2 sequencers earn L2 transaction fees while paying their fees on L1, profiting from the difference, and everyone is happy.

Moreover, I do not believe that MEV and transaction fees are the driving factors of ETH's value. Solana's transaction fee revenue is extremely low, yet it still has an $80 billion market cap.

ETH's value should be calculated through a blend of commodity pricing and monetary quantity theory (Ethereum is a country, and ETH is its currency). The value capture of the security layer comes from the economic activities occurring on it, as well as ETH's "monetary nature." While L2 has higher TPS and lower transaction fees, it still significantly increases the velocity of currency circulation.

Many skeptics argue that L2 reduces ETH's "moneyness." @TaschaLabs claims:

You can directly buy it on a centralized exchange, say /ZKTOKEN/, transfer it to your ZK wallet, and then spend your /ZKTOKEN/ on ZK's L2 without needing ETH at all.

The reality is that ETH's "moneyness" has not been weakened at all. Compared to the tx demand fluctuations caused by unstable demand for specific dApps or use cases on a particular L2, the total tx demand across all rollups will be more stable. In a rollup world, ETH will become a universal currency.

People buy ETH not only to pay gas fees but also because many things are priced in ETH. ETH will become the primary utility token for paying gas fees (even on rollups). NFTs are priced in ETH. The largest liquidity pools on Uniswap are paired with ETH.

ETH is a reliable collateral and the preferred payment method.

ETH has a first-mover advantage in the widely distributed "moneyness" network effect.

Deflationary token economics help the narrative of currency. As @epolynya said, "Rollups have a significant advantage in that they have almost no expenditure in inflationary budgets, or only a small portion compared to other competitive L1s."

L2 Tokens Are Coming

The rollup tokens are exciting. However, there is still much preparation to be done before they are launched. I expect most rollup tokens to be issued by the end of this year or even in 2023.

But I believe it is unstoppable. Layer 2 networks need tokens to compete with other competitive L1s. By launching native tokens and implementing a complete set of incentive programs and airdrop measures, this technology will fulfill its original prophecy: to scale Ethereum.

Once they issue tokens, it will cause a stir.

Stay tuned.