Analyzing On-chain Financial Statements: Part 2, Layer 2 blockchains.
By Daniel Gardeñes, marketing responsible at Vottun.
In this second part of the “Analyzing On-chain Financial Statements” article series, we will analyze, using traditional business valuation techniques, two layer 2 blockchains: Optimism and Base.
We could analyze others such as Arbitrum, Mantle, or Zk-Sync, but in the case of Ethereum layer 2 blockchains, they are all quite similar in terms of their business model, and doing so would be redundant.
It is advisable to read the first part of this article before proceeding further, where I provide context on why I conduct this type of analysis, which can help you better understand this content.
We will begin by examining the main differences between a layer 1 blockchain and a layer 2 blockchain, and why, from my perspective, a layer 2 blockchain has a much easier time being economically sustainable and highly profitable in the medium to long term.
Differences between a layer 1 blockchain and a layer 2 blockchain
Let’s look at the differences between layer 1 and layer 2 blockchains. A layer 1 blockchain is one that has its own consensus mechanism, such as Bitcoin, Ethereum, or Solana. These blockchains are characterized by issuing a native token with which they pay their miners or validators to secure and maintain the network.
The reality is that as of today, the only economically sustainable layer 1 blockchain is Ethereum. I consider a blockchain economically sustainable when the “revenues” it generates through user fees are enough to pay its miners/validators, or when this issuance is offset by a burning mechanism derived from the fees these users pay.
On the contrary, a layer 2 blockchain is one that does not have its own consensus mechanism, and instead utilizes another blockchain such as Ethereum. Therefore, these types of networks benefit from the cryptoeconomic security provided by the layer 1 blockchain to which they are anchored, utilizing its cryptographic proofs and data availability, which are paid for through a portion of the revenues generated from user transaction fees on their network.
Note: Some Layer 2 solutions like Optimums and Validiums only use Ethereum for cryptographic proofs, not for data availability.
The amount that a layer 2 blockchain must pay to the layer 1 blockchain for using its consensus mechanism and data availability is insignificant compared to the economic cost incurred by a layer 1 blockchain to maintain its structure, and even more so after EIP-4844.
Thus, layer 2 blockchains have a much easier time being profitable and economically sustainable in the long term than a layer 1 blockchain.
EIP-4844 and the massive reduction on Layer 2 data availability costs.
In this section, we will examine the impact of Ethereum’s latest update, EIP-4884 or “proto-danksharding,” on the business model of Layer 2 blockchains that utilize Ethereum as a data availability layer.
In this image, you can see the fees that Arbitrum (light blue), Optimism (red), and Base (blue) pay to Ethereum for uploading their cryptographic proofs and data availability.
As you can see, starting from March 13th, when the update occurred, the costs incurred by Arbitrum, Optimism, and Base to use Ethereum as a data availability layer plummeted. In fact, they have decreased from an average of $400k in Ether per day to around $1000, a reduction of 99.75%.
In the following sections, we will examine the impact of this change on the income statements of Optimism and Base.
How does a Layer 2 blockchain generate revenue?
In the architecture of Layer 2 blockchains, we have a fundamental component known as the transaction sequencer or sequencers. These highly powerful nodes are responsible for ordering and processing transactions, and they charge fees to users for this service.
As of today, these fees generated by the sequencer go to its owner, in the case of Arbitrum, Optimism, and Base, the teams managing the Layer 2 blockchains, and thus represent income for the protocol.
In the near future, it is highly likely that the ability to have a sequencer on these networks will be decentralized, and therefore this revenue will flow to a location other than the founding teams of these protocols. For this analysis, we will not take into account this feature as we currently do not know exactly how it works, but it is important to be aware of it.
Optimism income statement analysis
It’s time to analyze Optimism’s basic income statement, one of the leading Layer 2 blockchains of the moment and promoters of the “Superchain,” currently composed of OP Mainnet, Base, and Mode Network, among others. It’s important to differentiate OP Mainnet (Optimism Mainnet), which is the original blockchain created by Optimism, from Optimism in general, which not only includes OP Mainnet but also part of the governance and fees produced by all the blockchains within the Superchain.
Fees: Total transaction fees paid by users on the OP Mainnet + fee split with Base’s and other superchain participants’ sequencers. In the case of Base, it gives 15% of its sequencer revenue to Optimism.
Supply side fees: In this case, as it’s not a Layer 1 blockchain and transaction sequencers owned by Optimism are used, they don’t share the fees collected with any third party.
Revenue: Therefore, revenue equals the fees collected by Optimism’s transaction sequencer plus a percentage of the revenue from the sequencers of other blockchains in the superchain.
Expenses: Total on-chain expenses for the protocol (Ethereum settlement costs + token incentives).
Cost of revenue: Total Ethereum L1 settlement costs.
Token incentives: USD value of the protocol’s governance token $OP that has been distributed to protocols building on Optimism with airdrops and retroactive public goods funding initiative.
Gross Profit: Revenue minus cost of revenue.
Earnings: Revenue minus token incentives and L1 settlement fees.
As we can see, there’s quite a bit to analyze. On one hand, Optimism generates revenue through the fees paid by users on the OP mainnet, as well as a percentage of fees that other blockchains forming part of the superchain give to Optimism. During April, these amounted to $3.96 million in Ethereum.
Regarding expenses, we have the cost that Optimism pays to Ethereum for using it to upload its cryptographic proofs and as a data availability layer for the OP Mainnet, which we account for as “cost of revenue.”
In April, with EIP-4844 implemented, this expense was only $138k in Ether, whereas in February, when calldata was still used to upload data availability, the cost was $5.7 million in Ether, 41 times higher.
On the other hand, we have the token incentives that Optimism provided during April for initiatives such as airdrops and retroactive public goods funding. From an accounting standpoint, we assume this to be an expense, as this “issuance” of OP tokens increases its supply and thus potentially dilutes its value. The average USD value of OP tokens distributed during April amounted to $812k.
Therefore, we have a gross profit of $3.82 million during April. Remember that gross profit is the difference between a company’s total revenue and its direct costs, so we do not take into account the expense of token incentives in $OP, which would be an indirect expense.
Finally, the earnings (revenue — total expenses) amounted to $3.01 million in Ether during April.
Since the issuance of $OP is relatively arbitrary and varies significantly from month to month, I believe it’s more reasonable to compare gross profit rather than earnings between months. During February, before EIP-4844, the cost of revenue, or what Optimism had to pay Ethereum for its security, consumed almost all the revenue of the blockchain (specifically 97.4%), leaving it with a gross profit of only $147k in Ether.
In contrast, in April (when proto-danksharing was already implemented), the gross profit was $3.82 million in Ether, where the cost of revenue only represented 3.4% of the total revenue.
In other words, since the costs of uploading data availability to Ethereum have been massively reduced, Optimism’s business model has become quite interesting.
If we take April’s earnings as a reference and the current fully diluted market cap of the $OP token (10 billion dollars), it gives us a P/E ratio of 218.15. So, either the $OP token is overvalued today, or it has enormous growth expectations from investors.
Nevertheless, personally, I believe that in this case, as it’s an emerging technology, the important thing is that the business model works and is highly scalable, so this very high P/E ratio is not something to particularly consider.
Base income statement analysis
Now it’s time to analyze Base, another layer 2 solution of Ethereum that is part of Optimism’s superchain.
Fees: Total transaction fees paid by users.
Supply side fees: Similar to Optimism, Base is not a Layer 1 blockchain, and the transaction sequencers are owned by Base itself, so they collect all the fees paid by users.
Revenue: Share of fees that goes to the protocol (before paying 15% of them to Optimism).
Expenses: Total on-chain expenses for the protocol (Ethereum settlement costs + token incentives).
Cost of revenue: Total Ethereum L1 settlement costs plus 15% fee share with Optimism.
Token incentives: USD value of the protocol’s governance tokens that have been distributed to users. Since Base does not possess or distribute a governance token, this cost is 0.
Gross profit: Revenue minus cost of revenue.
Earnings: Revenue minus all expenses (Ethereum L1 settlement costs plus 15% fee share with Optimism).
The analysis we can conduct on Base is very similar to what I’ve done with Optimism but with some slight changes, which I’ll discuss below.
Firstly, unlike Optimism, which receives a percentage of fees from all blockchains forming part of the superchain, Base’s revenue, which amounts to $12.58 million in Ether, comes exclusively from the fees paid by users on the Base mainnet.
Similarly, Base has an additional cost that Optimism does not have, which is this 15% of revenue in user fees paid by Base that it pays to Optimism. Therefore, Base’s cost of revenue is not only the cost of using Ethereum as a settlement layer and data availability layer, but also the payment to Optimism for being part of the superchain.
It’s also worth noting that Base’s token incentives cost is 0, as this blockchain does not have a governance token (at least not as of today). It’s remarkable how, without the advantage of being able to provide incentives in tokens, Base is one of the layer 2 blockchains that has grown the most in recent months.
Finally, since there are no indirect costs, the gross profit and earnings are the same, totaling $10.49 million in Ether during April, which is quite impressive!
In this case, we cannot directly calculate a P/E ratio for Base since this blockchain does not have a governance token, and as of today, it is one of the many businesses of Coinbase Inc.
Conclusions
As we have seen throughout this article, due to their architecture and not having to maintain their own consensus mechanism, layer 2 blockchains are much more likely to be profitable as a business than layer 1 blockchains, where as we saw in the previous article, practically the only one that is economically sustainable is Ethereum.
This would imply that, as long as at some point a mechanism is established through which this value is distributed among token holders (for example, distributing dividends or burning token supply with profits), tokens of these layer 2 blockchains would be interesting as an investment from a fundamental standpoint and with traditional analysis.
However, if we take into account other elements such as network effect and monetary premium, layer 2 tokens are light years away from Ether, the native token of layer 1. Thus, although it is likely that in the future layer 2 will capture more value directly than layer 1, this does not imply that their associated tokens necessarily have to be better valued by the market.
The argument I consider to have the most weight in favor of this thesis is that the money (medium of exchange and primary collateral in DEFI) used in these layer 2 blockchains is Ether, even in those that are not used as gas tokens, such as Mantle Network or Starknet.
In the next article and the last of this series of “Analyzing On-chain Financial Statements”, we will perform a basic business valuation analysis of various DEFI applications, such as Aave and Lido Finance, and provide some final conclusions.
Disclaimer
This article is for informational and educational purposes only. None of the opinions expressed in this article should be construed as investment advice. Neither Vottun nor Daniel Gardeñes offer investment advice, and any investment decision made based on the information provided in this article is the sole responsibility of the reader.
