Optimism vs. Arbitrum: A Comparative Analysis of Ethereum’s Layer 2 Solutions
Introduction
Ethereum is set to receive some serious traction over the coming weeks. With the end of May marking the final deadline for a bunch of the Ethereum spot ETF applications, it seems the market hasn’t fully priced in the potential approval yet. The only date that matters is May 23rd, which is VanEck US’s final deadline date. I’m leaning towards it being denied, but you never know! We might see a run-up in price in the lead-up toward May 23.
Additionally, the Ethereum Dencun upgrade successfully went live on the Ethereum mainchain on March 13. This improved the scalability and gas fees for Ethereum Layer 2 solutions tremendously.
In this article we’re diving into two of the most promising Ethereum Layer 2 solutions, Arbitrum and Optimism, comparing them with a comparative fundamental analysis and technical analysis.
Why Does Ethereum Need Layer 2 Solutions?
Public cryptocurrencies face a well-known challenge known as the blockchain trilemma. Blockchains cannot achieve scalability, decentralization, and security all at the same time. In most cases, Layer 1 blockchains like Ethereum prioritize decentralization and security, which is why Ethereum has low transaction throughput and high gas fees.
That’s where Layer 2s come in. In the future, no one will transact or use the Ethereum Layer 1 anymore. The Ethereum main chain will just be used for its security, decentralization, and block space. Essentially, every transaction, from buying a coffee to playing video games, is expected to occur on a Layer 2 scaling solution, or possibly even a Layer 3 for specific applications like gaming such as Xai.
Layer 2 chains enable Ethereum to scale by executing transactions off-chain, thereby allowing more transactions per second for lower fees in the entire network. These L2 chains “roll up” several off-chain transactions into single batches, which are published on the Ethereum L1 chain. As a result of this batching process, Layer 2s can offer users significantly greater throughput and lower costs than transactions executed on the main chain, while still leveraging the strength of Ethereum and its network security.
What Is the Dencun Upgrade?
The ‘Dencun’ upgrade is a major hard fork upgrade, which is intended to enhance the Ethereum network’s scalability, security, and usability. It’s part of ‘The Surge’ on Ethereum’s roadmap, a series of updates aimed at increasing the network’s capacity to handle up to 100,000 transactions per second.
Without getting too technical, the Dencun upgrade implemented nine Ethereum Improvement Proposals (EIPs), with EIP-4844 being the most anticipated. EIP-4844, also known as proto-danksharding, introduces a new type of transaction called blob-carrying transactions.
This long-awaited upgrade is forecast to cut costs for Ethereum’s L2s by a hundredfold, making Ethereum more scalable and efficient for users. This will be the biggest reduction of L2 gas fees we’ve ever seen.
The core objective of this upgrade is to significantly reduce gas fees on Layer 2 networks without compromising on decentralization. This reduction will be a major catalyst for the entire Ethereum ecosystem, encompassing everything from DeFi applications to gaming and on-chain trading. As a result, Layer 2 solutions, and thereby Ethereum, will become increasingly attractive compared to alternative smart contract platforms, such as Solana, offering users both enhanced performance and lower costs.
While all Ethereum Layer-2s stand to gain from the Dencun upgrade, I’d like to isolate two specific L2s which possess compelling specific ecosystem catalysts, alongside the benefit that EIP-4844 will present.
Arbitrum
Leading the list is Arbitrum. Developed by Offchain Labs, a New York-based company founded in 2019 by former Princeton University researchers Ed Felten, Steven Goldfeder, and Harry Kalodner.
Arbitrum uses the optimistic rollup scaling solution. A specific technique for rolling up transactions designed to increase throughput and reduce fees for Ethereum transactions.
After a soft launch in May 2021, initially available only to developers, Arbitrum quickly demonstrated its potential. By July 2021, Arbitrum already had around 300 active dapps deployed & over $1 billion in TVL. The official launch of its mainnet, Arbitrum One, on August 31, 2021, marked a significant milestone in its development. Moving forward to March 2023, Arbitrum released its native governance token, $ARB, rewarding early network users with an initial airdrop.
One of Arbitrum’s key features is the Nitro tech stack, which enables developers to create orbit chains. These are effectively Layer 3 solutions, with a notable example being the gaming platform Xai.
Another key feature is arbitrum Nova which is itself an orbit chain that leverages AnyTrust technology as its scaling solution. Arbitrum Nova is faster cheaper and more scalable than Arbitrum One with the tradeoff of it being more centralized and therefore less secure.
OPTIMISM
Arbitrum’s main competitor, Optimism, is another optimistic rollup solution with technology similar to Arbitrum.
Optimism was founded in 2019 by Karl Floersch, a former Ethereum Foundation researcher, Jinglan Wang, a key contributor to the optimistic rollup solution, and Kevin Ho, a computer science engineer.
The main technical difference is that Arbitrum uses a multi-round fraud proof system to authenticate transactions and Optimism only uses a single round. This makes Optimism inherently faster. Arbitrum’s fraud proof system takes transactions away from Layer 1 to be processed, whereas Optimism only makes transactions faster on Ethereum. This means that although transaction finality is improved, it doesn’t have any impact on gas fees. Put differently, Optimism is faster but more expensive, whereas Arbitrum is slower but more cost-effective.
The OP token was launched in June of 2022. $OP is used as a governance token that its holders have the right to participate in network’s governance using Optimism Collective.
Worthless Governance Tokens?
This raises an important question: Do these Ethereum Layer 2 tokens have value? Or are they just worthless governance tokens? Contrary to any dismissive views, Layer 2 tokens are remarkably well positioned for significant value accrual. In fact, Layer 2 scaling solutions are among the cryptocurrency space’s most concrete, most tangible, sources of real-world value.
Layer 2s have the capability to purchase block space from any Layer 1 chain and resell it at a profit. This unique ability to generate revenue from block space sales — after accounting for the cost of issuance — acts as a solid metric for value creation. Essentially, Layer 2s can achieve long-term profitability as long as their income surpasses their operational costs. Their primary expense is the security fee paid to their parent Layer 1 chain. But unlike Layer 1 chains, Layer 2s aren’t burdened with security costs through token issuance; they operate as value-added resellers of Layer 1 and Data Availability block space.
The valuation of Layer 2 tokens can thus be compared to that of equities, based on cash flows, growth potential, and discounted cash flow analysis over time. Looking ahead, they will probably become more like a network type equity. So long as they can attract users and capital to their execution environments, they will be very successful.
Comparative Analysis: Arbitrum Vs. Optimism
Technical Differences
The main technical difference between Optimism and Arbitrum is that Optimism simplifies the transaction validation process by implementing a single-round fraud proof system, which offers a faster way to confirm transaction legitimacy but has higher gas fees. And Arbitrum utilizes multi-round fraud proofs to bolster security. A method that might afford users savings on gas fees but may lead to longer transaction finality times. Put differently, Optimism is faster but more expensive, whereas Arbitrum is slower but more cost-effective.
Fundamental growth metrics
In terms of fundamental growth metrics when we examine the activity within both ecosystems. It becomes evident that Arbitrum takes the lead in multiple key metrics. It boasts a significantly higher TVL, has more daily active users, processes more transactions, has more protocols, more stables, and most importantly, significantly outperforms in terms of on-chain profits.
In terms of a potential investment decision $ARB looks clearly the favorite. But try to stay cautious here because of its big FDV and massive token unlock starting on March 16.
Technical Analysis
Arbitrum
$ARB is looking bullish, with higher highs and higher lows, indicating bullish market structure. Currently, we are trading in a daily re-accumulation range that will send us to new highs. Anything within this current range is a solid long-term spot buy but aim for buys at the lows. A beautiful entry would be a sweep of these lows.
Optimism
$OP was trading within this daily range, similar to $ARB, but have already broken towards the upside. A very good entry point to buy some $OP would be within the previous sideways price action range, or even a sweep of the previous lows of that sideways price action.
Targets: Use the Fibonacci levels to identify your target when something is in price discovery.
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