Which L2 token is the BEST pick for your bag?

The good, the bad and the ugly of Layer 2s

August 03, 2024

GM, this is Milk Road PRO, the crypto newsletter that gives you multiple angles like an isosceles triangle.

Layer 2s have become the hottest real estate for the crypto world to build on top of this cycle.

In the last cycle, Ethereum reigned supreme while faster and cheaper Layer 1 blockchains like Solana, Avalanche, and Terra Luna aimed to dethrone it and become the new prime properties in crypto.

Some have failed… “Sup, Do Kwon 🤡_” – Morgan Freeman_

Meanwhile some have continued to ship, aiming to become a legitimate contender in the blockchain world (looking at you Solana 🫡).

Today, Ethereum is fighting back against these fast L1s by moving down the tech stack and powering Layer 2s to offer an abundance of cheap blockspace on its behalf. 😃

In the last few months, Ethereum L2s are offering blockchain transactions at less than a penny, effectively solving the issue of expensive blockspace that had plagued Etheruem since its early days of fame in crypto. ✨

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Source: Growthepie

This was Ethereum's scaling roadmap all along, to remain maximally decentralized at the base layer and use L2s to execute cheap blockspace for the masses — a very different strategy than that of Solana’s and other L1 blockchains.

Which strategy will win in the end? Only time will tell. It’s still too early to pick winners, though we think it won’t be just one. 🤝

But today’s report isn’t about the winning blockchain strategy…

We’re focusing on Layer 2s and their tokens, exploring whether they are assets worth investing in right now. 🧐

If L2s are a clear contender for the future of blockspace, shouldn't their tokens perform well?

Well, if you have been paying attention to the charts, you might have noticed that L2 tokens look similar to the Terra Luna chart in 2022. 📉

Ok ok, we are exaggerating, they aren’t THAT bad. But the last few months haven't been too nice to L2 tokens… 😅

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Source: CoinGecko

To be fair, $SOL has experienced some volatility too over the past 60 days. However, we remain bullish on Solana, and you can see why by reading our last week's report here.

But the question for today is.... Do we feel the same bullish vibes for L2 tokens as well?

Let’s go down the rabbit hole and see what we uncover. We’re going to break today’s report into:

1. The good, the bad and the ugly of L2s right now

2. Future considerations for the L2 ecosystem

3. Which L2 assets are a good investment this cycle

And then finish off with some thoughts and key takeaways for your portfolio. Vamos. ⤵️

THE GOOD ABOUT LAYER 2s 😁

Fundamentally, at least in terms of onchain metrics, L2s appear to be cooking! 🍳

The amount of wallets interacting across the L2 ecosystem is growing almost every month, even while prices have been heading to the shitter. 🚽 

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Source: Growthepie

The amount of transactions across L2s continues to rise and appear to be growing exponentially on a monthly basis.

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Source: Growthepie

Crypto’s most prominent use case is stablecoins and there’s no doubt in our minds that whichever blockchain(s) become the home of stablecoins will do really really well in the long term.

The stablecoin market cap on L2s is growing massively, about to surpass $10 billion and is showing no signs of slowing down anytime soon.

[

Source: Growthepie

For context, L2s combined are the 3rd biggest blockchain for stablecoin market cap.

We can continue to list every relevant metric for blockchains and L2s will report nothing but all-time highs and growing results across the board. 

In terms of activity and adoption L2s are on a roll.

But of course, as we suggest time and time again, protocols must generate sustainable revenues (or have a path forward for revenue) to remain relevant in crypto.

The good news once again is that L2s are quite profitable, generating a combined $15 million in the month of June.

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Source: Growthepie

Arbitrum, Base and Blast have each generated more than $3.5 million last month. But will those revenues remain? More on this later in the report. 👀

THE BAD ABOUT LAYER 2s 😢

You could consider this chart bad or ugly, it just depends on your perspective, but there’s no doubt that L2 token prices are down bad! 😬

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Source: CoinGecko

To be clear, all crypto assets are down bad in the last few months – this isn’t specific to L2s. The entire crypto market is down 14% since March.

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Source: TradingView

Even $SOL dumped a whopping -42% from its top in March to its bottom in July. 

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Source: TradingView

But one of the key differences between Solana and L2s is that there is only 1 $SOL.

There’s currently 61 Layer 2s and another 79 on the way. 😣

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Source: l2beat

If you’re bullish Solana, you simply grab $SOL. If you’re bullish L2s, what do you buy…?

This is an obvious fragmentation problem for L2 tokens as an investment. 🧩

Before we share our thoughts on this problem and ultimately provide the 4 avenues to capitalize on L2s, let’s move to the ugly…

THE UGLY IN LAYER 2S 😣

We believe one of the big reasons that L2 tokens have performed so poorly this year is the amount of new tokens put into the supply. ♾️

We already mentioned above about the sheer amount of L2 tokens that exist, but that’s not the end of it. 

Every L2 token today is continually adding more tokens into circulation on a monthly basis.

This is A LOT of supply the market needs to absorb, just to keep the price of these assets afloat. 🧽

Not only do all of these projects have vested tokens being unlocked for their team and investors, they also use their token to incentivize the growing metrics listed above.

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Source: token.unlocks

L2s use their tokens to pay applications to build on their chain in the form of grants, retroactively reward users for onchain interactions, and/or incentivize activity via points programs and airdrops. 🪂

To be clear, none of this is necessarily bad practice or should be frowned upon. This is one of the great unlocks of crypto — using liquid tokens to bootstrap new ecosystems! 🥾

But, in the short term it's something investors need to be aware of and consider as they look to invest in these tokens (that there’s a lot of people selling these tokens).

The second ugly truth of L2s is their current state of decentralization and security. 

Most L2s are little more than a multisig and shouldn't yet be considered the future of blockchain. 

They have plenty of work to do to become even remotely close to an acceptable means of decentralized and permissionless technology that crypto promises. 🙏

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Source: l2beat

That said, all of this can and will change, as L2 teams are working very hard to decentralize their tech stacks and improve their risk analysis. 

Most recently, Optimism launched fault proofs and will soon be expanding this to the many L2s within the Superchain.

While permissionless and decentralized technologies are very important for the future of the underlying protocol layer of crypto, we aren’t overly concerned that L2s haven’t solved this issue yet, considering they are still very new in their development lifecycle.

It’s an ugly scenario now, but we feel confident that (some) teams will progressively solve these problems in the months to years to come.

THE GOOD, THE BAD AND THE UGLY 🔤

Here’s the situation of L2s in a nutshell:

As an ecosystem, L2s are growing massively — both in users and activity but also in the number of L2s and tokens that exist in the market.

Don’t be fooled, though. Competition is a good thing. It means there is something here, as it's attracting so many different teams and builders from varying walks of life. 🚶

Competition will also push innovation as teams work hard to differentiate themselves from the rest. 🥊

Overall, things look very promising for the L2 ecosystem. We’re not sure the same is true for the L2 ecosystem tokens, though. More on this in just a second…

In early stage industries and competitive markets like this, it’s important to think through how the market dynamics will change in the coming months to years.

By understanding where the industry is going, we can make better assumptions on where value will accrue and what might happen to L2 tokens.

THE FUTURE OF L2S: SOME RANDOM THOUGHTS 💭

We’re going to use this section to mull over a few thoughts around L2s and their future. What is explained below is not fact, but instead an opinion on what we think could happen or implications to think through with L2s. 💭

1/ Power laws 

Onchain metrics look great across MOST L2s right now, but surely that can’t persist. 

It’s very likely that power laws kick in and specific L2s begin to take over most of the market share of users, liquidity and applications.

It would also make sense that the playbook of launching an L2 with a points program and airdropping some tokens to incentivize users will fade away or become less effective over time. ⌛

This means that not only will certain L2s suck up most of the capital, users and builders— but it will also only get harder and harder for new L2s to eat into that market share. 🥧

2/ The underlying tech is no longer the moat

In the near future (and potentially already at this point), the underlying technology of L2s will have minimal differences. 

Yes, there are many small details, but in the grand scheme of things, it’s essentially all the same.

The ability to deploy an L2, add features like ZK or gasless transactions and most other things are becoming streamlined. 

The technology of an L2 is no longer the primary driver of adoption or the key differentiator. 🔑

To further emphasize this point, shared sequencers are coming to Ethereum in the next 1-2 years. 

This means that while liquidity is currently fragmented across different L2s (fragmenting where and what users can do), shared sequencers will share liquidity across any L2, effectively removing the liquidity moat that some L2s currently have.

This is great for users and the overall Ethereum ecosystem and its scaling roadmap, but it makes things even more challenging for a specific L2 to stand out. 

With that in mind we think that distribution, niche UX and controlling the tech stack from top to bottom will be the things that allow L2s to stand out the most. 🗣️

3/ Distribution matters

The L2s that can acquire the most quality applications that then drive the users will be the ones who succeed. 🏆

Base is a prime example, becoming the top L2 in almost every metric within just 1 year, thanks to the distribution from the Coinbase Exchange. 

Not only can they drive users from their CEX, they can also dangle that distribution in front of the entrepreneurs to acquire more applications to deploy on Base.

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Source: Dune

The same thing is happening with TON and its relationship with Telegram.

Here’s the thing with L2s: Users on Base can easily switch from using one application on Base to using a similar application on another L2. 

In some cases, they can even use the same application on another L2 that also exists on Base.

This is why it’s not just about distribution but about controlling the UX.

4/ Controlling the UX matters more

If you can control the tech stack from top to bottom, you can ensure that users remain on your platform. 

If users are on your platform, you can find ways to monetize them. The best example of this right now is Immutable, the popular crypto gaming L2.

Immutable set itself apart by focusing solely on gaming and building out the entire tech stack to interact with their games. 🎮

Their blockchain is completely gasless for all apps and users. 

They have an NFT marketplace to share and manage liquidity across all the games on their L2, and most importantly, they’ve created a built-in wallet called Passport, which controls the entire UX for all games on Immutable.

Once a user starts playing a game on Immutable using the Passport wallet, they can’t go anywhere else without losing most of the functionality and, in some cases, losing out on gasless transactions.

This is a true technological moat that no other L2 is even remotely close to competing with.

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Source: Immutable

Another example of this is Blast – which has features in their tech stack that no other L2 has: native yield.

It provides an innovative ground for applications to build on and generate different products and forms of revenue. 

This doesn’t exist anywhere else currently and gives Blast an upper hand in acquiring new entrepreneurs and applications.

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Source: Blast

In addition, with the launch of $BLAST,  they announced they will be launching a mobile wallet, further leading Blast to control the UX from top to bottom for its users. 📲

It's the combination of innovative and niche features, with top to bottom seamless control of UX and distribution that will separate one L2 from another.

This fits well with the “app chain thesis” that every app will have its own chain (L2) to control its UX, its users, and its business models/features.

5/ Fees are going to zero

It’s very clear to us that fees for users are going to zero. 

Whether the transaction fees will be paid for by the application or the L2 itself is still unknown, but what we do know is that users will not have to worry about fees in the near future.

Businesses don’t directly pass along their web hosting fees or electricity bills to the users (it’s built into the product cost instead), so why would they pass on the gas fees of a blockchain? They won't. ⛽

This means that the idea of L2s generating revenue from fees is probably not going to hold true in the future. Maybe they will generate fee revenue from the applications, but if that's the case, applications with users will simply launch their own L2. 🤔

So, we need to rethink how L2s generate revenue.

Again, Immutable is a leader in this regard. Immutable doesn’t charge gas fees on their chain — instead, because they control the UX for the marketplace and exchanges, they take a small % of every token swap or NFT sale on their L2.

L2s like Optimism have also built an “L2 as a service” model where they support other L2s with technological development and in return receive a % revenue share from what the other L2s earn. 💲

I’m sure L2s can find other ways to generate revenue outside of these methods, however, it’s likely to be more B2B or they will need to launch their own applications (DEXs, etc.) or ecosystem tools (wallets, etc.).

PRO TEAM TAKEAWAYS AND L2 INVESTMENT STRATEGY 👍

The L2 world is full of unknowns right now, making investing in this space extremely challenging. But that’s often where the biggest opportunities lie.

To complicate things, we believe there will be 1000s of L2s launching over the next few years. 

Most of these won’t be general-purpose L2s like Artbirum or Optimism, but specific applications or ecosystems from existing web2 businesses (e.g. FlipKart and Time) and successful web3 native applications (Pudgy Penguins, Rarible, Zora, etc.).

It’s not clear to us how general-purpose L2s like those we see today are going to monetize or how their token will fit within the ecosystem to accrue value.

We also think that many existing web2 businesses or web3 native apps won't need a token at all to run an L2, similar to how Base works currently. 

In the distant future, we believe every business will have a token, but they will look and function very differently from the tokens we see today. 🗓️

We see most L2 tokens as useless governance tokens that exist to bootstrap a network during a time when L2s needed incentives to onboard users. 

We’re moving into a world where users will simply use L2s because use cases and applications exist there, making their lives better or solve clear problems (ie. stablecoin payments).

For this reason, we are bearish on a lot of L2 tokens that exist today. 

Not to mention, many of the current L2s have large token unlocks for years to come which will be difficult for the market to absorb.

That said, there are a few tokens that we believe could be a great opportunity to capture the upside in L2 growth.

4 WAYS TO CAPITALIZE ON L2S 💱

1/ $IMX - Immutable is not an L2 bet, but instead a bet on web3 gaming. 

We believe Immutable has done an incredible job at building an ecosystem perfect for gaming companies to build onchain (it's why they have attracted 100s of games). 

Immutable also controls the tech stack from top to bottom, which enabled them to create a UX perfect for gamers that abstracts away all of the blockchain complexities as well as redesigning the monetization model for L2s.

$IMX also has the least overhang of vested tokens vs. any other L2 token today, with more than 75% of all tokens already in circulation. 

If just 1 or 2 games on Immutable break out, we believe $IMX can be one of the best performing assets this cycle.

2/ $OP - While the supply dynamics of Optimism are not great and the issues around monetization and building a moat will be a struggle for Optimism, we invest in $OP more as a bet on the team and their existing track record more than anything else.

It’s likely that 1 or 2 general purpose L2s will succeed and Optimism is already seeing success across its ecosystem with Base, Zora, Mode and many others.

In addition, with its secondary revenue stream via its profit share with Base and the others, we feel they could continue to outperform the market.

The end result with $OP is less clear than something like $IMX, however we feel Optimism is a solid bet on the general L2 success narrative playing out.

3/ $BLAST - Once again, the supply dynamics of $BLAST are awful, considering it just launched a few weeks ago. 

However, the native yield on Blast is opening the door for new business models and innovation, as well as their plan to control the tech stack from top to bottom makes us bullish on what Blast can eventually become.

We believe Pacman (the founder) is one of the best innovators in all of crypto and a bet on $BLAST is simply a bet on Pacman.

FYI: We have not bought any Blast, however we did earn some in the airdrop. We have not sold and plan to hold it long-term. If the price continues to dip, we may think about buying more.

You can see all of our holdings in the Milk Road PRO Portfolio.

4/ $ETH - The simplest way to capture the upside of L2s is to hold $ETH. 

$ETH is like a diversified bet on the entire L2 ecosystem. 1000s of L2s can fail, but as long as a few succeed, so too does $ETH.

This is one of the reasons that $ETH makes up 50% of our portfolio. 

If you’re not planning to get in the weeds on L2s and be on the forefront of understanding how the dynamics above play out, simply buy and hold $ETH. 

Save yourself the time and worry of trying to find the needle in the haystack L2 token that might outperform the rest.

That’s a wrap, friends. We hope you enjoyed this one.

Good luck out there!

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