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Intro

In light of the recent Layer 2 (L2) airdrops observed in June, it is timely to explore the business models underpinning these entities. Contrary to the perception of many tech startups that consume venture capital without profitability, L2s present a different paradigm.

Layer 2 solutions operate by batching transactions and subsequently sending these batches to Layer 1 (L1) for settlement. This mechanism allows L2s to offer lower gas fees and higher throughput compared to a congested L1. However, for L2s to generate transactions, they require users who, in turn, need applications to interact with. These interactions generate transactions, which result in gas fees. A portion of these gas fees goes towards L1 settlement costs, with the remainder retained by "sequencers" as revenue. Sequencers provide the service of transaction ordering, batching, and submission, which justifies their share of the revenue.

Currently, L2s are largely centralized, with sequencer revenue being internalized. This centralization contributes to the perception of L2s as businesses and explains the proliferation of L2 solutions. Successful L2s can command significant fees, driving competition in the space.

Revenue and Market Share

Data from Token Terminal reveals that the leading L2s generated $154 million in revenue year-to-date, with Base capturing one-third of the market share. As part of the Optimism "Superchain," Base contributes 15% of its sequencer revenue to Optimism. This data underscores the importance of transaction activity for L2s. While there are long-term business considerations, such as avoiding illegal activities, L2s prioritize ensuring on-chain activity.

Revenue Generation

Rollups generate revenue primarily through transaction fees charged to users. These fees cover costs incurred on both Layer 1 (L1) and L2, while also generating additional profits. The fee structure includes:

• Base fees, incorporating congestion fees.
• Priority fees for expediting transactions.
• Fees to cover L1 costs, such as data availability (DA), verification, and execution costs.

Moreover, rollups can capture additional revenue through strategies like maximal extractable value (MEV) fees. The rollup cost structure is characterized by relatively minor L2 expenses and more substantial L1 costs, particularly the DA costs, which are variable and dependent on the amount of data submitted to L1. In contrast, verification and execution costs are typically fixed, essential for maintaining rollup operations.

Marginal Costs and Scalability

Understanding the marginal costs of rollups—where the additional cost of an extra transaction is less than the average cost per transaction—is crucial. This principle underpins the concept that increased user activity leads to cheaper transaction costs. Rollups manage data in batches, compress it, and aggregate verifications, which theoretically reduces marginal costs compared to L1s. High transaction volumes help amortize fixed costs, making them negligible and validating the phrase “the more users, the cheaper the rollup becomes.”

Transaction Fee Income

The primary revenue for rollups stems from L2 transaction fees, which cover operating costs and hedge against L1 gas cost fluctuations. Some rollups, such as Arbitrum and zkSync, use a First-Come, First-Served mechanism, processing transactions in the order received. The OP stack offers a more flexible approach, allowing transactions to “jump the queue” by paying a priority fee.

During low activity periods, L2 base fees are minimal. However, during busy times, congestion fees are applied, often increasing exponentially based on the rollup’s assessment of congestion levels. Given the low operational costs of rollups, nearly all income from L2 fees translates into profit. The centralized nature of current sequencers allows governance organizations to adjust fee parameters to meet short-term needs.

MEV Revenue

Maximal extractable value (MEV) transactions are categorized as malicious or non-malicious. Malicious MEV includes front-running transactions like sandwich attacks, while non-malicious MEV involves back-running transactions such as arbitrage and liquidations. Rollups, unlike L1, do not offer a public mempool; only the sequencer can see transactions before finalization, enabling them to initiate MEV. Research by Christof Ferreira Torres et al. indicates that rollups like Arbitrum, Optimism, and zkSync engage in on-chain non-malicious MEV activities, collectively generating $22 million in MEV value.

Fees to Cover L1 Costs

Rollups charge fees to cover L1 costs, predicting L1 gas to manage data expenses and creating reserves to hedge against future gas price fluctuations. For instance, Arbitrum adds a “Dynamic” fee, while the OP stack multiplies the fee by a “Dynamic Overhead” coefficient. These fees, before the EIP4844 upgrade, were estimated to be about one-tenth of the DA costs.

Revenue Sharing Models

Base, utilizing the OP stack, has a unique revenue-sharing model with the OP Superchain. It commits to giving the greater of either 2.5% of its total income or 15% of the profits (after deducting L1 data submission costs) from L2 transactions to the OP stack. In return, Base participates in the on-chain governance of both the OP Stack and Superchain and receives up to 2.75% of the OP token supply. Recent data shows Base contributes approximately 5 ETH per day to the Superchain’s revenue.

Rollups Costs

The costs associated with Layer 2 (L2) rollups on the Ethereum blockchain are multifaceted, reflecting the complexity of maintaining and scaling these solutions. These costs are generally categorized into execution costs, data availability (DA) costs, and verification costs, especially for zero-knowledge (ZK) rollups.

Execution Costs

Execution costs encompass the expenses related to state updates between Layer 1 (L1) and L2 and cross-chain interactions. These costs are essential for ensuring seamless communication and data consistency across different blockchain layers and chains.

Data Availability (DA) Costs

DA costs represent a significant portion of L1 expenses for rollups. These costs involve posting compressed transaction data, state roots, and zero-knowledge (ZK) proofs to the DA layer. Before the Ethereum Improvement Proposal (EIP) 4844 upgrade, DA costs dominated the expense structure for various rollup protocols. For example, DA costs accounted for over 95% of total costs for Arbitrum and Base, over 75% for zkSync, and over 80% for Starknet. The introduction of EIP-4844 significantly reduced DA costs, with reductions varying between 50% and 99% depending on the rollup mechanism employed.

Verification Costs

Verification costs are particularly relevant for ZK rollups. These costs are associated with verifying the integrity and reliability of rollup transactions using zero-knowledge proofs. The ZK approach ensures that transaction verifications are both secure and efficient, albeit at a higher computational cost compared to other methods.

Other Costs

In addition to the primary costs of execution, DA, and verification, rollups incur other operational expenses. These include off-chain engineering and operational costs, which cover the infrastructure needed to support the rollup's functionality. Notably, the cost of node operation for rollups is relatively low, akin to the costs of running corporate cloud servers such as those provided by Amazon Web Services (AWS).

Competitive Landscape

The competition among L2s revolves around applications that attract and engage users, driving ongoing transaction activity. Developing a standout application is challenging, and successful applications often get ported across different ecosystems to capture market demand. Consequently, the industry remains highly competitive despite its early stage in the adoption cycle.

To compete effectively, L2s typically need a unique value proposition for user acquisition and some form of lock-in or incentives for applications to build on their platform. Base, for example, leverages the marketing power of Coinbase to attract both retail and crypto-native users. This corporate backing enables Base to focus on use cases beyond financial transactions, such as decentralized social platforms like Farcaster. This strategy also benefits Optimism, which gains from Base’s growth through the OP Stack.

In contrast, Blast offers native yield and gas rebates to dApps, creating an ecosystem that appeals to builders seeking unique value propositions. While the user-focused "casino" for rewards garners attention, the underlying value for builders lies in leveraging native yield or gas rebates effectively.

Conclusion

The business model of Layer 2 solutions hinges on transaction activity and user engagement through compelling applications. Successful L2s manage to attract and retain users by offering low gas fees, high throughput, and unique value propositions. As the industry evolves, the ability to innovate and provide differentiated services will determine which L2s thrive in this competitive landscape.