Gearing Up for Arbitrum
By Daniel Dal Bello, Director.
June 8, 2021–11 min read.
Polygon has been around for a long time, but really only captured mindshare over the past couple of months with the launch of established platforms like Aave, Curve and SushiSwap on Polygon (previously called Matic, token remains as MATIC).
This was all achieved despite the widespread criticisms calling on its systemic risks due to centralization. There are many arguments suggesting that Polygon is not a layer-2, rather it is a sidechain.
Whatever the case, there is an argument to be made that capital will flow from Polygon to another layer-2 like Arbitrum or Optimism. The relative underperformance of a sidechain like xDai (in terms of adoption and TVL) also helps lend credence to the competitive forces in the space. The industry is not quite big enough for multi-sidechains/layer-2s to thrive equally.
Arbitrum’s developer mainnet has launched as of 28 May this year. This does not mean that it’s fully live. Rather, developers and projects will be given access to begin building infrastructure and conduct testing upon request. Once they’ve deemed there to be sufficient activity and live projects, Arbitrum will be open to all end-users, and so begins the great capital migration.
If you indeed believe that there will be a significant inflow of capital into Arbitrum, what should you know to be positioned appropriately?
In this post, we’ll explore the bigger picture behind Arbitrum and the potential opportunities, rather than dive deep into its underlying tech.
What is Arbitrum and How Does It Work?
In a bid to scale Ethereum, various solutions are being developed or have been developed, ranging from ETH 2.0’s sharding, side-chains like Matic/Polygon and Layer-2s (“L2”). Rollups are the main L2s currently in development, with 2 sub-categories: Optimistic rollups and ZK-rollups. Arbitrum, along with OptimismBPC, falls into the former. The key concept behind L2s is that its security should still be dependent on Ethereum’s main chain. This means that all transactions should be stored on layer-1 (“L1”).
Optimistic rollups settle things optimistically — innocent until proven guilty (h/t Mechanism). Transactions are initially assumed to be legitimate, but may be rejected/disputed by any network participant within the 1–2 week settlement period.
Conversely, ZK-rollups post all transactions to Ethereum paired with cryptographic proof (SNARKs) and are only settled once these proofs can be validated — guilty until proven innocent.
Thus, ZK-rollups have been suggested to be far more secure than Optimistic rollups. Still, at the cost of EVM compatibility — dApps moved to ZK-rollups are not quite plug-and-play, instead requiring heavy modification to incorporate validity proofs, unlike Optimistic rollups that require little alteration. The differences run far deeper, and you can read more about it in Mechanism’s article on Deribit.
Arbitrum vs Optimism is a rather complex topic and could be an article on its own. Summarizing it here would also be an injustice to the argument. Instead, you can read a good thread on it here.
What’s the Play Here?
When it comes to exploring cross-chain, DEXs are typically the first place to start. The same likely holds true even for an L2 like Arbitrum as it does for a sidechain like Polygon. A good parallel might be PancakeSwap on Binance Smart Chain (“BSC”) that initially flew under the radar, but has since emerged as BSC’s winner despite other new and incumbent DEXs going live (e.g. SushiSwap).
QuickSwap was an exceptional play because it was around the earliest and managed to gain the most traction. This meant that its native farmed token QUICK performed very well, with a recorded low of around $31.76 on 15/02/21 and a recorded high of $1,590.57 on 30/04/21.
Since going live, SushiSwap has managed to capture significant volume share from QuickSwap, but has been unable to replace it due to QuickSwap’s first-mover advantage.
The same can’t be said about SUSHI’s price performance, which is not unexpected given that it enjoyed the majority of its growth while on L1 Ethereum. Something to note is that Sushi’s TVL has closed the gap with QuickSwap with $883m vs $924m as of 30/05/21.
Will the same trend play out for DEXs on Arbitrum (that aren’t already incumbents on L1 Ethereum)? It’s hard to say, but I’m leaning on “no”. Multiple DEXs have already indicated their move to Arbitrum: Curve, SushiSwap, Uniswap (+MCDEX Perps). All of them will likely be live-ready once the mainnet opens up to all end users. Even if Arbitrum-native DEX s spring up, it won’t have the first-mover advantage enjoyed by QuickSwap or PancakeSwap.
One caveat is that it may be able to capture volume and TVL in the short term if the APY for its farmed token is attractive enough compared to its peers. SushiSwap is likely one of its key competitors due to their Omakase Bar that will likely provide relatively attractive incentivized yields.
What sort of Arbitrum-native platforms may arise? We’re sure to see clones of incumbents, but ultimately, they may not last long. Should you choose to participate in new platforms + farms, be extremely mindful of Pool 1 vs Pool 2 games.
Anything that could thrive in a low-fee environment could be fair game here. Some examples might be new yield aggregators that could compound far more frequently than possible on Ethereum due to capital efficiency. With higher compounded yields and an expected vault token, these might be very lucrative. In the short term, they could be far more nimble than an aggregator like Yearn that may create strategies for Arbitrum.
Uniswap v3 active LP strategies will also benefit from this low-fee environment. This is discussed in a later section, “Uniswap on Arbitrum”.
The real questions are if Arbitrum will be able to (1) pull significant TVL away from Polygon and (2) if it can pull significant TVL at all. Arbitrum will not be creating its own native token, rather will use ETH as its native asset. You can read about this in their blog post here. Utilizing ETH as its underlying asset is a highly welcome decision but has negative implications.
Like many assets and platforms in crypto, prices, TVL, and volume are both reflexive upwards and downwards. Higher prices push APY upwards, which then attracts more yield-seeking capital. Prices then rise again, and the cycle continues until no longer sustainable, and capital begins to look for the exit. Prices crash, sending APY down, and the reverse now occurs in a downward spiral.
This trend has likely benefited Polygon tremendously, with additional rewards across multiple platforms (Aave, Curve, SushiSwap, Bancor) being given out in MATIC. At the same time, MATIC has continued to skyrocket despite the overall market being down significantly. Perhaps we have yet to see the end of Polygon’s growth cycle.
Incumbent platforms launching on Arbitrum will likely find it challenging to provide additional incentives for liquidity without any native asset — unlike MATIC, they can’t just give out ETH. It’s also unlikely that they will be able to give out inflationary rewards to the same degree as any new DeFi project (on any platform).
Another thing to note is that for trading activity on Arbitrum to really take off, users must want to take liquidity (trade) from L2 DEXs vs on L1. With insufficient liquidity, it may not make sense due to slippage. The only trading activity will likely be arbitrage between L1 and L2. It might be a bit of a chicken and egg issue that incentivsation typically reduces.
Thus, despite the hype, it’s uncertain if there will be explosive growth in the short term simply due to a lack of inflationary rewards from incumbents. This is not necessarily a bad thing. Capital that moves into Arbitrum might simply be more sticky — in the medium to long term, and there is a good opportunity for Arbitrum to grow.
Uniswap on Arbitrum
Luckily, it’s not all about incentives. Uniswap v3 coming to Arbitrum following the governance vote is an interesting development. In fact, they’re already deployed!
They were initially set on extending their v3 launch to Optimism once it went live. However, given the delay, things have obviously changed.
v3 on Ethereum has been criticised for its heavy gas usage compared to v2. It’s not unexpected, given the additional complexity of the contracts. v3 LPs exist as NFTs, and these are typically more expensive to work with. v3 might have thrived on Polygon, they just probably just weren’t optimistic enough.
Visor Finance has already given us a taste of the additional yield possible from active strategies. Deployment on Arbitrum will potentially allow users to fully realise the true potential of v3 with more active LP strategies, made possible by capital efficiency from low fees. More sophisticated strategies could also be created to take advantage of these low fees, likely attracting significant TVL (and some competitors).
This also means that being an early user on upcoming active LP strategy platforms may be an exceptional play, yielding both platform tokens and higher (potentially defensible) yields from strategies.
MCDEX
MCDEX was the first project that began building on Arbitrum (despite its multi-chain strategy), and thus it is fair to believe that they are one of the farthest along in terms of development, and should be ready to launch when Arbitrum does.
They’ve also recently managed to close a $7m round with various funds, including Alameda, Delphi, DeFiance and Multicoin. High demand for trading perpetuals (“perps”) on centralised exchanges and growing volume on Perpetual Protocol has already given us a good indication of the demand we might see on MCDEX.
A potential integration with Uniswap v3 has also been discussed, extending the capabilities of MCDEX far beyond what is achievable alone. With the ability to permissionlessly create perp markets, all eyes will be on MCDEX. They may eventually evolve into the staple decentralised perp trading platform and pull in significant capital into Arbitrum.
Update: Tracer’s perps are coming too.
Chainlink?
There have been many conversations about LINK’s role in Arbitrum lately, with some speculating that it was going to be the native asset (check this thread). We now know that to be false, yet LINK likely does play a big role in Arbitrum.
According to @chainlinkgod, “$LINK will be used at the app level to pay for oracle services such as Price Feeds, verifiable randomness, & L2->L1 messages”. dApps launching on Arbitrum will require validators to bring information from L1 Ethereum, off-chain to L2 Arbitrum, and back for settlement on L1 Ethereum.
Aside from Chainlink nodes providing this oracle service, they have also been suggested as potentially simultaneously operating as Arbitrum validator nodes. Since LINK must be staked as the bond, more transactions flowing through Arbitrum should correlate to more Chainlink nodes and demand for LINK.
Overall, it’s still too early to say if Link nodes will indeed be able to be used as Arbitrum validators, but the potential remains along with price growth.
What Else Will it Take for Growth?
Bridging
A big reason why BSC blew up in the way it did is due to Binance. The largest exchange, onboarding massive amounts of users is not something you can easily pass over. If we want strong liquidity on Arbitrum, safe and effective bridging options are a must — security is the name of the game.
Binance acts as the key bridge for users into BSC. Polygon has been able to take off despite not having a major exchange enable direct deposits/withdrawals, however not to the degree of BSC (based on TVL). Unfortunately, it makes sense that Binance refrains from enabling exits to sidechains and other L2s for as long as possible in the best interest of BSC. Another indicator of this is the continued high ERC-20 withdrawal fees of >$30 despite gas between <50gwei at the time of writing.
Yet, Binance has never refrained from doing anything if it makes financial sense (e.g listing of the SHIB meme token during the recent dog coin mania). Luckily, OKEx has indicated their interest in supporting Arbitrum with direct deposits and withdrawals. This will no doubt go a long way to attracting more retail interest.
The importance of permissionless and decentralised bridging cannot be understated either. Before Nerve and AnySwap, funds could only bridged across BSC and ETH via Binance and their bridge. Early DeFi exploits were able to be stopped from siphoning funds out of BSC by Binance themselves. This is no doubt a highly controversial topic as these powers used positively, could also be used for far greyer purposes. However, with bridges provided by Nerve and AnySwap, funds from recent exploits can no longer stopped from exiting — truly a double-edged sword.
A Short Blurb on Security
Yet, you need exit doors from new ecosystems due to their inherent platform risks, and all chains can have hiccups. Polygon recently faced issues and caused a little scare due to their nodes getting stuck.
Nodes within the BSC network recently faced synchronisation issues that some suggest are a harbinger of more bad things to come. Big money coming into Arbitrum need to feel safe that they won’t face catastrophic losses should there be any technical issues. They need to be able to bridge whenever they want, and a CEX likely won’t fulfill this need either.
Besides OKEx, we have the main bridge being developed by the team developing Arbitrum. In time, we’re sure to see many more bridging solutions developed — some great, some not so. Bridges like Chainswap with little to no Github activity might be one to stay away from. They’re likely centralised and you could face major issues in the future.
Other bridging solutions might be more product-specific. MakerDAO has been developing a bridging solution for Optimism allowing for instant withdrawal that is likely to be replicated on Arbitrum. Given the structural importance of DAI within DeFi, this is a great addition.
Other Infrastructure and UX
Central to good UX is the block explorer. Etherscan is by far the most popular explorer for Ethereum due to its excellent UX. Having that same great UX on BSC via Bscscan has similarly been great for adoption BSC’s adoption. The same can’t be said for Polygon’s block explorer and might have reduced adoption to some degree. Luckily, Etherscan is coming to Arbitrum, and we’re likely to enjoy the same great UX.
Many other infrastructural implementations are coming as well, including Metamask support and The Graph.
Closing Thoughts
It’s still early to say how Arbitrum will turn out. The experience will undoubtedly be very different from exploring a different blockchain/sidechain (Avalanche, Fantom, BSC, Polygon…) — potentially fewer sketchy farms to explore and more incumbents live with their core product offerings.
dApps are now scrambling to build on Arbitrum (with 250 indicated interest), likely with the aim of launching when Arbitrum does to capture as much growth momentum as possible. Overall, it’s an extremely positive development that brings us one step closing to decentralised scalability.
The contents of this article are solely the opinion of the author in which he has exposure to a number of the projects mentioned. Nothing here should be construed as financial advice.
Hillrise Group supports ambitious Web3 startups with early-stage venture capital and fundamental research.
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