Optimistic about Arbitrum: Three driving factors will help Arbitrum become the relative winner of Layer 2

Author: DeFi Surfer

Source: substack

Crypto protocols that performed well in the last bull market have a unique ability to attract users, capital and attention.

The top Ethereum Layer 2 (L2) Arbitrum and its ecosystem have the potential to attract a lot of users, capital and attention in the coming years.

In the crowded field of smart contract platforms, there are three clear drivers behind Arbitrum.

Ethereum halo effect: True L2s like Arbitrum will benefit from ETH dominance;

Favorable relative users and TVL: Arbitrum is relatively small;

Novel Ecosystem: Arbitrum is full of innovative projects.

This post provides a brief introduction to Arbitrum, followed by the impetus behind this promising smart contract platform.

In short: I am bullish on Arbitrum.

Arbitrum and Layer Season 2

The proposition of Alternative L1 blockchains (Alt L1) is old. According to CoinGecko, there are 186 smart contract platforms in total. How many times have you heard the "faster, cheaper, more scalable than Ethereum" hype? How many ecosystem funds have been launched? In the next cycle, we RUN-IT-BACK-TURBO (when someone says something so crazy or ridiculous that you need them to repeat themselves because you don't understand what they said) the chance of "the next Solana" has How old is it?

Data suggests that Ethereum and the Ethereum Virtual Machine (EVM) are becoming the standard of choice for public blockchains. Ethereum hosts about 60% of the total value locked (TVL) of all public blockchains, and about 90% of the TVL of all cryptocurrencies is EVM compatible. Additionally, Ethereum dominates the fee market for smart contract platforms, accounting for more than 90% of the total block space market by revenue.

While still in its early stages, Ethereum appears to be becoming the Apple of smart contract platforms: dominating both in terms of innovation and value creation. In the next few years, it will be a very difficult task to choose the Android of the smart contract platform to replace the Apple of the Ethereum.

Good luck to the VCs!

On the other hand, the Ethereum Layer 2 (L2) narrative is fresh and easier to understand.

Ethereum, the most popular smart contract platform in the encryption field, has a maximum daily transaction volume of between 1 million and 1.2 million transactions, which requires L2 to grow. L2 as a theme is almost certain.

Ethereum L2 scaling solutions are nascent. According to L2BEAT, of the 22 Ethereum L2 scaling solutions, only four have a TVL above $100 million. The only one of the four that doesn't have a token also happens to have the most protocols, and ranks second in TVL.

Which L2 am I referring to? Nothing but Arbitrum.

Arbitrum is a layer 2 (L2) rollup blockchain compatible with the Ethereum Virtual Machine (EVM).

Arbitrum uses Optimistic Rollup technology to expand the capacity of Ethereum from about 12-15 transactions per second (tps) to 40000 tps. Transactions are also only a fraction of the cost of Ethereum. Currently, the cost of an Ethereum transaction is in the single digits to >$10, depending on chain usage and the price of ETH. An Arbitrum transaction costs about $0.10.

Arbitrum is operated by New York-based Offchain Labs and will open to users in August 2021.

Compared to other L2s such as Optimism and Metis, Arbitrum has the second highest TVL at $900 million; it was recently overtaken by Optimism after it launched its liquidity rewards program. Arbitrum has the most protocols with 108, ranking sixth among all smart contract platforms, even though it has only been around for a year. Most impressively, this has been achieved without tokens or ecosystem funds.

Arbitrum's growth to date has been entirely organic.

Arbitrum will be releasing a major update - Nitro - on August 31st . Nitro set the stage for Arbitrum Odyssey 's return. Arbitrum Odyssey is Arbitrum's marketing campaign encouraging users to try out various protocols on the Arbitrum blockchain in exchange for NFTs and potential airdrops (rumor). There is also the possibility of setting up an ecosystem fund later this year or in 2023 to accelerate Arbitrum’s liquidity and adoption by developers and users.

Needless to say, Arbitrum is off to a great start and its ecosystem will have many catalysts in the coming months.

But there's more to this story.

The halo of Ethereum, the relative size of Arbitrum, and the new ecosystem are the three driving forces for this smart contract platform in the next few years. Let's explore these further, because they are important to know.

Note that most of the content below is also highly relevant to Optimsim, but this post will focus on Arbitrum.

Ethereum halo effect

While there are many chains that are fast and cheap, Arbitrum is unique in that it is an Ethereum scaling solution and nothing more.

L2s like Arbitrum separate the execution and security layers. L2 executes transactions quickly and cheaply, and then publishes a batch of transactions to Ethereum L1 for maximum decentralization and security.

Arbitrum's native token is ETH, and this L2 pays fees to Ethereum L1.

Arbitrum is complementary to Ethereum; it provides ETH with scalability - faster and cheaper transactions, while in return paying for Ethereum's best-in-class decentralization and security.

This is in stark contrast to other "Ethereum scaling" solutions like Polygon.

Polygon is a well-known EVM-compatible smart contract platform that promotes itself as an Ethereum scaling solution. However, Polygon has its own token and does not pay gas fees to Ethereum L1. Additionally, Polygon executes transactions and maintains state on its own servers.

Ethereum L1 does not participate in Polygon's activities. EVM-compatible chains such as Polygon or Binance Smart Chain (BSC) are considered more suitable competitors to Ethereum and Ethereum scaling solutions.

This distinction is important. True Ethereum scaling solutions like Arbitrum share Ethereum's mission - to make Ethereum, the most decentralized and secure smart contract platform, the global public blockchain standard.

Due to Arbitrum's complementary role in scaling Ethereum, Arbitrum is more likely than Ethereum competitors to benefit from Ethereum's brand and scale. In other words, Arbitrum is more likely to attract liquidity and users from Ethereum's huge ecosystem than alt L1s and sidechains that are Ethereum's competitors.

Favorable Relative Subscriber and TVL Scale

Arbitrum is relatively small compared to Ethereum.

Arbitrum has a TVL of $1 billion, while Ethereum has a TVL of $58 billion.

Source: DeFiLlama

Also, Arbitrum is a ghost town compared to the parent chain. Arbitrum has only attracted 1 million unique addresses, while Ethereum has 200 million. Arbitrum averages around 100,000 transactions per day, compared to 1.2 million for Ethereum.

But the trend is clear. Despite facing a brutal bear market throughout 2022, Ethereum Layer 2 activity has been steadily increasing, growing from 20-40K transactions per day to >100K transactions in a 7-month period. It is only a matter of time before leading L2 surpasses Ethereum L1 in terms of daily trading activity.

Sources: Etherscan, Arbiscan, and Optimistic Etherscan

However, what will push Arbitrum to surpass Ethereum in total users and daily transaction volume? Aside from marketing moves like Arbitrum Odyssey (#wen), perhaps the biggest driver of Arbitrum's continued adoption is its novel ecosystem.

novel ecosystem

The amount of innovation on Arbitrum is hard to keep up with.

According to DeFi Llama, Arbitrum already has 108 protocols, ranking sixth overall despite only being launched for a year.

Source: DeFi Llama

Remember, this is ex-token and ex-ecosystem fund.

What's more, Arbitrum's native project stands out in the crowded field of cryptographic protocols. Arbitrum is especially strong in derivatives. No less than 7 native protocols of Arbitrum are chasing the derivatives market.

As I wrote in the profile of Arbitrum’s #1 app, GMX, the derivatives market is the top market opportunity in crypto, both in terms of revenue and users. Compared to other parts of the cryptocurrency ecosystem, such as DEXs, lending platforms, and stablecoins, the "white space" for derivatives is much larger.

The smart contract platform space is crowded. As a leader in the nascent on-chain derivatives market and a top destination for Ethereum developers, Arbitrum will stand out from dozens of low-value Ethereum copycats.

Wrapping Up - It's Arbitrum Season

The macro context is challenging. Tight liquidity, inflationary pressures and a general "risk off" sentiment will make next year's crypto space even more challenging compared to the very favorable backdrop of 2020 and 2021.

Fortunately, Arbitrum has plenty of power. Ethereum's halo effect, favorable relative user/TVL scale, and novel ecosystem suggest that Ethereum's #1 Layer 2 has the potential to be a relative winner in the months and years ahead.

So don't let the VC or market background fool you. It's Arbitrrum season.