Analyzing Coinbase’s Ethereum L2
Direct and indirect implications from Base
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This Friday we evaluate the implications of Coinbase’s big announcement. We explore the current state of Ethereum and its L2s, and how this is likely to evolve as a large entity like Coinbase enters the game.
Network Fees — Sum of total fees spent to use a particular blockchain. This tracks the willingness to spend and demand to use Bitcoin or Ether.
- Bitcoin fees dropped as Ordinals NFTs cool down
- Ethereum recorded another yearly high, with Blur incentives and Coinbase’s free NFT mint leading the way
Exchanges Netflows — The net amount of inflows minus outflows of a specific crypto-asset going in/out of centralized exchanges. Crypto going into exchanges may signal selling pressure, while withdrawals potentially point to accumulation under regular circumstances
- Bitcoin and Ether recorded modest outflows for a fourth straight week
Analyzing Coinbase’s Ethereum Layer 2
Yesterday Coinbase announced the upcoming launch of an Ethereum layer 2 solution, Base. Built on Optimism’s OP stack, Base is intended to help onboard 1B+ users into crypto by offering lower fees and be able to process more transactions per second.
To understand the implications of Base, it is worth reviewing the current state of Ethereum and existing layer 2 solutions.
Fee Resurgence — Average fees on Ethereum have tripled since November
- While high fees are positive for burning ETH, they act as a barrier preventing mainstream adoption of blockchain applications
- Currently simple transactions cost between $5-$10 and smart contract interactions for dapps can be four times more expensive
- These constraints on Ethereum’s mainnet have been apparent for years now, which is why Vitalik has been pointing to a rollup-centric roadmap since 2020
Within the last three years Ethereum has already made major strides in this direction.
More L2 Transactions than L1 — For the first time we are seeing the number of transactions on layer twos surpass that of Ethereum’s mainnet
- The daily number of transactions on Ethereum mainnet has been on a slight decline over the last year, but the rise of Arbitrum and Optimism have more than made up for it
- Both Optimism and Arbitrum more than quadrupled in terms of average number of transactions during 2022
- More recently we set a new all-time high, with Arbitrum alone processing over 1 million transactions in a day and 2 million between Ethereum, Optimism and Arbitrum
Progress towards a roll-up centric Ethereum is already on its way and is bound to continue to accelerate with Base’s upcoming launch.
Direct & Indirect Effects of Base
Adoption vs Fees — Moving on-chain activity from L1 to L2s will be trading off a decrease in revenue (fees) for increased number of users
- Based on this week’s data, Ethereum is on track to record $2.5B in fees
- If economic activity were to move to more gas-efficient L2s, the total amount of ETH spent for fees would decrease immediately. For reference L2s made up only 4% of all ETH fees this week, despite processing more transactions
- However, as it becomes more accessible it should bring in more ETH holders and users of applications on Ethereum. Currently there are 87 million addresses holding ETH on mainnet, in contrast to 3 million in each Arbitrum and Optimism
- These numbers are likely to converge as Base makes it simpler to be onboarded directly into an Ethereum L2 rollup
Over the longer-term if the foreseen increased adoption materializes, then fees may grow back to current levels even if most activity takes place on L2s. In the short-term, though, L2s suggest lower revenues for Ethereum and thus a less deflationary ETH.
Indirect Value Accrual — Base and other L2s can still bring value to Ether holders despite leading to lower fees
- This is due to maximal extractable value (MEV), where users pay to get their transactions prioritized
- MEV is a function of economic activity, since the value to organize transactions increases proportionally to the output generated and opportunities available on-chain
- Since L2 transactions are ultimately settled on Ethereum and use ETH for fees, users can derive value from organizing transactions on Base
- Though it is more difficult to quantify, increasing adoption should result in a greater amount of value to be extracted by MEV searchers
- This then leads to higher ETH staking yields, thus indirectly benefiting holders even if transaction fees drop
Ultimately, this strengthens the case for why Base should act as a positive catalyst for Ethereum.
