# ETH or L2s? _A data-driven framework for portfolio construction_ June 26, 2024 • Michael Nadeau --- # ETH or L2s? ## A data-driven framework for portfolio construction Michael Nadeau June 26, 2024 Hello readers, Ethereum is executing on its roadmap. The network is scaling via layer 2. We should have an ETF trading sometime this summer. Larry Fink won’t stop talking about tokenization. And we’re on the cusp of rate cuts from the Fed. It’s a good time to be bullish on Ethereum. But should you own ETH? A basket of L2s? Or both? In this week’s report, we provide a data-driven framework for portfolio construction. Topics covered: - [L2 Data vs Ethereum](#l-2-data-vs-ethereum) - [L2 Token Utility/Demand vs ETH](#l-2-token-utility-demand-vs-eth) - [L2 Token Value Accrual vs ETH](#l-2-token-value-accrual-vs-eth) - [L2 Token Unlocks vs ETH](#token-unlocks) - [Execution (L2s) vs Settlement (ETH)](#execution-l-2-s-vs-settlement-eth) - [L2 Margins vs ETH](#l-2-margins-vs-eth) - [L2 Correlations to ETH](#l-2-correlations-with-eth) - [L2 Catalysts vs ETH](#l-2-catalysts-vs-eth) - [Price Forecasts](#forecasting-price) - [Conclusion](#conclusion) ***Disclaimer:**** Views expressed are the author’s personal views and should not be relied upon as investment, legal, tax, business, or any other advice. * Let’s go. ## L2 Data vs Ethereum We’re kicking off the analysis with some high-level data comparing the top L2s to ETH across multiple KPIs. We also examine the leaders amongst L2s across each metric. ##### Total Value Locked: Data: Token Terminal as of 6.23.24 The top 12 L2s combine for 15% of the value locked on Ethereum today. Here’s the TVL leaderboard amongst the L2s: Data: Token Terminal as of 6.23.24 Arbitrum sits in the #1 spot with the top 5 drivers as follows: - Aave - $790m - Pendle - $659m - GMX - $612m - Renzo - $371m - Uniswap - $306m It’s noteworthy to see Blast sneak into the #2 spot by offering yield on Ethereum (via staking) and stablecoins (via MakerDAO, T-Bills). We’ll be keeping an eye on this to see how sticky it is post-token drop. ##### Daily Active Addresses: Data: Token Terminal 6.23.24 The top L2s combine for 4.7x the number of daily active addresses on Ethereum today. Here’s the leaderboard amongst the L2s: Data: Token Terminal 6.23.24 Arbitrum occupies the #1 spot once again and is the first L2 to have sustained daily users in excess of Ethereum L1. ##### 90-Day Fees: Data: Token Terminal 6.23.24 The top 11 L2s did 15% of the fees that Ethereum captured over the last 90 days. Let’s take a quick peek at the L2 leaderboard: Data: Token Terminal 6.23.24 Base did more than 2x the fees of Scroll in the number 2 spot and 6% of Ethereum’s total fees over the last 90 days. ##### 90-Day Transactions: Data: Token Terminal 6.23.24 On average, the top L2s are now processing 6.7x the number of transactions per day when compared to Ethereum L1. Here’s the breakdown across the L2s: Data: Token Terminal 6.23.24 Base has about 66% of the average daily users that Arbitrum does. However, Base users are transacting 6.9x/day on vs just 2.5x on Arbitrum. ##### Cost/Transaction: Data: Token Terminal 6.23.24 Avg. cost/transaction reveals why Arbitrum was in the middle of the pack for fees despite being #2 in terms of transactions: it costs $.02 to transact on Arbitrum vs $.15 on Base. For reference, the average transaction fee on Ethereum over the same period was $5.30. ##### Developers: Data: Token Terminal 6.23.24 The top L2s now have about 2x the active core developers today. *Token Terminal defines a core developer as the number of distinct Github users that made 1+ commit to the project’s public repositories over the last 30 days. These figures do not include ecosystem/application developers. Let’s see how the L2s stack up against each other: Data: Token Terminal 6.23.24 Here we have Optimism making its first appearance in the #1 spot with more than double the active devs on Arbitrum today. It’s also noteworthy to see Base in the middle of the pack — a sign that they are getting more out of their developers than their competitors given the applications, users, and onchain fees. ##### But what are market participants holding? ETH or L2 tokens? Data: Token Terminal 6.23.24 The L2s combine for just 2% of the token holders that Ethereum has today (please note that 4 of the top projects do not have tokens just yet: Base, Blast, Linea, and Scroll). Here’s the breakdown across the 8 leaders with tokens in the market: Data: Token Terminal 6.23.24 Optimism and Arbitrum have 80% of the market when it comes to token holders/investor mind share in L2s, but just 1% of Ethereum L1. ##### Finally, let’s wrap up with valuations: Data: Token Terminal 6.23.24 As noted above, the top L2s have: - 15% of Ethereum’s TVL - 15% of Ethereum’s fees - 4.7x the number of active addresses - 6.7x the number of daily transactions - 2x the number of developers But just… - 2.4% of the token holders - 9% of the fully diluted market cap of Ethereum - and 2.7% of the circulating market cap of Ethereum ##### Here’s the fully diluted market cap of the top L2s: Data: Token Terminal On a fully diluted basis, Arbitrum and Optimism make up 40% of the top 10, and 3.7% of Ethereum’s market cap (1.06% of the circulating market cap). [](https://tokenterminal.com/terminal/auth?utm_source=newsletter&utm_campaign=tdr) *The DeFi Report is powered by Token Terminal — the leading onchain data & analytics platform for institutional investors. If you’re interested, you can sign up for a free account at the link here: **[FREE ACCOUNT](https://tokenterminal.com/terminal/auth?utm_source=newsletter&utm_campaign=tdr)* ## L2 Token Utility/Demand vs ETH Now that we’ve level set with some data, let’s examine the utility and demand for the ETH token vs L2 tokens. ##### ETH Today, ETH is used for the following: - Pay for gas on the Ethereum Network (including on L2s!). If you want to transfer a stablecoin, transact on a DEX, mint an NFT, play a game onchain, get a loan, etc, *you need some ETH. * - Collateral to access yield. Want to capture the yield coming off of the Ethereum Network? *You’ll need some ETH to do that. * - Collateral for loans. Over 1% (2.3 million) of the circulating supply of ETH is currently locked within MakerDAO smart contracts, serving as collateral for onchain loans. - Medium of exchange. Want to purchase your favorite NFT on OpenSea? *You’ll need some ETH. * - Real-world assets. Want to tokenize an asset so that it can transact freely and globally? *You’ll need some ETH. * - Deployment of smart contracts. Want to build something on Ethereum? *You’ll need some ETH. * - Re-staking. ETH can be used as collateral to access fees directly from Ethereum but also from apps and protocols within the Ethereum ecosystem. This is done with “re-staked” ETH. To capture this yield* you’ll need some ETH.* As we can see, ETH has abundant utility within the Ethereum ecosystem. This utility drives demand for the asset in a similar way that the utility of oil drives demand for the asset/commodity. For these reasons, we believe ETH has more utility than any other asset in crypto today. ##### Layer 2 Tokens Layer 2 tokens are used today for….governance. That’s really it. A few networks will allow users to pay for gas with the L2 token but for the most part, these fees are being paid with ETH. Furthermore, L2s must pay for block space on Ethereum (where transactions settle) in ETH. *Key Takeaway:* L2s do not have utility or an incentive structure that drives demand for the token today. ETH does. ## L2 Token Value Accrual vs ETH How does value accrue to ETH? Via real yield generated from staking (and re-staking). How does value accrue to L2 tokens? There is no such value accrual mechanism today as user fees are paid to the L2 sequencer, rather than a distributed network of validators. ## Execution (L2s) vs Settlement (ETH) What’s more valuable? Execution? Or settlement? First, let’s level-set the difference between the two: - Execution: a useful analogy might be to think of execution as ordering a meal at a restaurant. You select what you want. Communicate it to the waiter. And the waiter confirms your order. - Settlement: settlement could be thought of as paying the bill, receiving a receipt, and accounting for the transaction. The relationship between L1 and L2 today is such that the user executes their transaction on L2, and L2 settles the transaction on L1 (paying fees to do so). So, what’s more valuable? ##### A few thoughts from the “L2/execution” camp: - In traditional finance, the vast majority of value accrues to the execution layer of the tech stack — brokers, market makers, and high-frequency traders. Less value accrues to settlement — which can be thought of as clearing/accounting (DTCC). - It’s possible that transaction fees across all blockchains eventually collapse to zero (or close to it). If this is the case, then MEV will be the way in which these networks are monetized in the future. Now. If all of the execution occurs on L2s, then that is where we should expect MEV to come from — *as execution includes the batching and ordering of transactions. * ##### A few thoughts from the Ethereum L1/settlement camp: - In the case of the Ethereum ecosystem, there is only 1 settlement layer. Everything on top ultimately settles down to Ethereum, paying fees in ETH to do so. - L2s inherit their security & decentralization from Ethereum. - The utility of the token (and the ensuing network effect) could ultimately be the only thing that matters. For example, Ethereum could potentially lose most of its fees at the L1 level but still capture cash flows from other apps and protocols that “rent” Ethereum’s security (including L2s that do not have a token such as Base). ## L2 Margins vs ETH Margins for Ethereum are essentially 100% and will not change in the future. Here are current L2 margins, which have increased significantly since EIP4844: Data: Token Terminal - Base has lower margins due to paying 15% of its top-line revenue to Optimism. - Blast margins are low due to a delay in upgrading the network to support upgrades related to EIP4844. Since upgrading on May 27, Blast margins have improved to 91%. ## L2 Correlations with ETH ##### ARB & OP Price to ETH Data: Token Terminal ARB has an all-time price correlation coefficient of .71 to ETH (highly correlated). Interestingly, Optimism is less correlated to ETH with an all-time correlation coefficient of .61 (moderately correlated with periods where it’s been completely uncorrelated to ETH). **ARB Price to Users**  Data: Token Terminal Arbitrum has an all-time correlation coefficient of -.009 (negative correlation). That’s not a typo. How can user activity be so negatively correlated to price? Token unlocks. Which are largely a result of a lack of regulation on the part of the SEC and Congress. Stay tuned as we cover unlocks in an upcoming section. ##### ARB Price to Fees Data: Token Terminal Not surprisingly, price is also negatively correlated to fees (-.004 all-time correlation coefficient). You can’t make it up. ## L2 Catalysts vs ETH ##### ETH Catalysts The biggest catalyst for ETH over the next year is the ETF — which should be trading sometime this summer. Additional catalysts include re-staking (additional yield for ETH holders), tokenization of real-world assets, enterprise adoption, and maturation of DeFi and NFT use cases. With the approval of the ETF, we expect Wall Street to start to do some real due diligence on the network, and the asset. We ultimately believe that Ethereum has a larger addressable market than BTC, so it will be interesting to see if large institutions ultimately come to the same conclusion. ##### L2 Catalysts We think there are two potential catalysts for L2s over the next year. - ETH price. If ETH outperforms post ETF approval, we could see some investors jump right to the L2s — looking to allocate to projects with smaller market caps. - A re-rating of L2s in relation to ETH. Currently, the top L2s represent just 2.7% of Ethereum’s market cap (9% on a fully diluted basis). If the market thinks this should be closer to 10%, the L2s could potentially outperform. ## Token Unlocks *This might be the most important section of this report.* Ethereum does not have any “token unlocks” as the supply is fully circulating. Furthermore, Ethereum whales that received large allocations via the initial ICO have now had two bull markets to sell/recycle their tokens back into the market/new hands. With that said, Ethereum’s supply can increase during periods when onchain activity slows, and “fee burns” are not enough to offset new issuance/consensus rewards paid to incentivize validators to provide services. For reference, Ethereum was deflationary in 2023 (-.28%) and has been deflationary so far in 2024 (-.02%). Below is Ethereum’s inflation rate since inception: Data: Etherscan It’s important to note that with fees dropping on L2 as a result of EIP4844 (network upgrade), we are observing a slowing rate of “fee burns.” In fact, Ethereum has seen an increase in ETH issuance of 75,951, or about 767 new ETH per day since March 13 (EIP 4844 implementation). For the year, the network has still experienced a reduction in supply of 23.3k ETH. But if we do not see onchain activity increase in the second part of the year, the network could become slightly inflationary for the year. ##### L2s are different across the following factors: - L2s have token allocations made to investors, advisors, and contributors that vest typically over 4-year periods. - There is no “buyback” or “burn” mechanism for the vast majority of L2 tokens today - particularly the majors. - There is almost zero utility to L2 tokens and therefore no structural buying support. As noted, we are forecasting Ethereum to be slightly deflationary this year. We can contrast this with known information related to L2 token unlocks. For example, Arbitrum will unlock 1.15 billion tokens over the next year (36% inflation on the existing supply). And over the next three years, Arbitrum will unlock 3.2 billion tokens. The majority of these tokens are allocated to investors and contributors who are sitting on large unrealized gains. We should expect them to sell when their vesting periods end — increasing the supply of tokens in the market. We can see the impact of the token unlocks in the below chart. For example, Arbitrum’s unlocks began in March and we can see the impact on price below. This is offsetting what is otherwise fantastic growth in Arbitrum’s fundamentals (pink represents active user growth). Data: Token Terminal Given that Arbitrum is unlocking 1.15 billion tokens over the next year, *nearly $1b of new money must come into the asset for its price to remain at $.82 — all else equal* (ARB price at the time of writing). *Key Takeaway:* In a bear-case scenario, Ethereum could see slight inflation this year (less than 1%). Leading L2s such as Arbitrum and Optimism have inflation rates of 36% over the next year. zkSync and Starknet have even higher inflation rates over the next few years. *Remember, as the price rises, the amount of new money that must come into the asset to offset unlock sales rises as well. ## Forecasting Price Please keep in mind that nobody can forecast price, no matter how much data, foresight, or luck we have. In this section, we’re simply sharing some high-level projections so that we can back into reasonable price targets. Data: Token Terminal *The above forecast assumes the circulating token supply for ETH stays constant. BTC supply is known. Therefore, actuals were used with 1 year of inflation added. Additionally, “BTC dominance” and “ETH % of BTC MC” were taken from the cycle peak. We use our forecast for ETH to back into potential valuations for the top 2 Layer 2s: Arbitrum and Optimism. Data: Token Terminal The above data table assumes the following: - Arbitrum captures .62% of ETH’s projected market cap (as is the case today) in its base and bear case. - Arbitrum captures 1.24% of ETH’s market cap in its bull case (2x current). - Optimism captures .46% of ETH’s projected market cap (as is the case today) in its base and bear case. - Optimism captures .92% of ETH’s projected market cap in its bull case (2x current). - Token unlocks for 1 year are factored into the price/token for each asset. - A bet on Ethereum L2s is inherently a bet on ETH. This is why our projections start with a high-level forecast for ETH. ## Conclusion - If you’re bullish on the Ethereum ecosystem, we believe you need to emphasize ETH as part of a portfolio. Why? Because betting too much on any one L2 could yield negative returns — even if the thesis is correct on Ethereum. We believe a minimum of 50% of the Ethereum portion of a liquid portfolio should be in ETH for this reason. Note that this figure depends on risk tolerance, goals, investing timeline, etc. - Token unlocks are real. And they clearly impact forecasted returns. For example, Arbitrum’s base case projects a 315% increase in market cap over the next year but only a 210% increase in price/token. It is for this reason that ETH outperforms the L2s in the base and bear scenarios. - For the top L2s to outperform ETH, the market needs to re-price them in terms of their % of Ethereum’s market cap. We saw this play out over the last year with Solana — which had just 2.5% of Ethereum’s market cap in December of ‘22. This was clearly wrong. The market has since re-rated Solana to 15% of Ethereum. - On a fully diluted basis, ARB and OP have 3.7% of Ethereum’s market cap. If you believe the top L2s should have closer to 10% of Ethereum’s market cap, this could change your portfolio allocation. Given the lack of utility of the token, the unlocks, and the competition, we do not see this playing out over the next year but could see a re-rating over the longer term. We hope you enjoyed the report. As always, please do your own research. Take a Report. And Stay Curious. ***Disclaimer****: Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment advisor and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.*