Layer 2 in the eyes of institutional investors Growth challenges, ecological cooperation, and future trends

Exploring Layer 2 from an Institutional Investor's Perspective Overcoming Growth Challenges, Fostering Ecological Collaboration, and Predicting Future Trends

Author: Jocy, Founder of IOSG

L2 Summer or Dilemma?

Recently, I heard a few friends who work in the “hair plucking” studio complaining to me. Many studios have invested a huge amount of resources and transaction volume in zkSync and Linea, only to find them empty and instead helping several major L2s contribute tens of millions of dollars in transaction fees. As a result, when these studios see new L2s go live, they no longer have the same enthusiasm to create transactions.

What we originally expected was a prosperous L2 Summer that does not require studios. However, now we discover that as studios gradually fade out, the transaction volume and TVL of several major zkEVMs have not reached the expected levels. When speculators in the market no longer participate in L2, no longer creating vitality for the ecosystem, the dilemma of slow growth and ecological contraction appears.

L2 Competition in the Eyes of Investors

From the perspective of investors, the investment logic behind laying out L2 infrastructure lies in our belief that these teams will compete in different dimensions of the ecosystem with abundant capital support, encouraging a blossoming of applications within the ecosystem. However, most of the current L2 arms races have not focused on ecosystem building. They still invest a large amount of funds in high-priced recruitment of ZK experts and technical heavyweights from PSE (of course, from a strategic point of view, investment in L2’s technological research and talent competition is understandable). However, I believe that a high-concurrency-compatible Rollup without applications has little value and will just be a castle in the air.

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The Growth Dilemma of L2 Ecosystem

Waiting for natural growth of the ecosystem will be a lengthy process. If this arms race does not help Ethereum achieve an explosive growth of application ecology, but instead continues to excessively invest and repeat investment in underlying technologies such as share sequencers/Bytecode design, we will not see a flourishing ecosystem emerge.

Currently, the competition for ecosystem applications on L2 is extremely fierce. If an application is bound to a specific L2 chain, it will be very difficult for them to obtain support from other L2s. At this stage, the application also does not dare to easily migrate to other L2 chains because once they do, it means they will have a much harder time obtaining the original bound L2’s grant.

Therefore, choosing suitable partners becomes a difficult problem for the application. For this reason, every L2 wants to have exclusive applications and then engage in divisive battles across different L2s. Of course, when the application grows bigger and appears on application chains or deploys across multiple L2s, the problem lies with L2 itself. When they cannot figure out whether the future application will stay on their L2, they temporarily hesitate to invest too much.

We also often see L2 applications that have not yet matured, unable to obtain grants or incentives on certain L2s, leading them to travel between different L2s seeking financial support to survive. So, which L2s currently do not have their own public ecosystem grant programs?

Breaking the Game Plan 1: Top L2 Projects Take on the Responsibility of Ecological Construction

Of course, we don’t want to see a situation where L2 projects are competing against each other, causing a relative fragmentation of the Ethereum ecosystem. Perhaps this is a result of a competitive market, but in our view, it is necessary for L2 applications to incubate and support the emergence of more diversified application products through a combination of L2 solutions, ultimately leading to the binding and scaling of applications for the entire L2 ecosystem.

Unicorn companies with a valuation of over one billion dollars should definitely take on the responsibility of ecological construction; this is extremely important. There are many ways to build an ecosystem. For example, Starkware and Optimism have provided significant support to Dojo and Mud engines in the FOG game. Arbitrum Grant incentives have been very successful in supporting ecosystem investments, with the trading volume and user experience of GMX, which was exclusively launched on Arbitrum, comparable to that of dydx. They have also jointly invested with IOSG in the game platform TreasureDAO, known as “Chain-Side 4399” in the industry. Optimism and Coinbase launched the Base chain based on Opstack, and the Base chain has already witnessed phenomenal applications like http://Friend.tech, with protocol revenue exceeding 20 million dollars in less than two months and TVL surpassing 20 million as well…

What they are doing is very simple: attracting developers within the ecosystem based on network effects and incentivizing more diversified innovation and investments through protocol tokens. Of course, recently, I also discussed with some L2 projects using zkEVM, and many founding teams believe that providing airdrops and incentive expectations, including how to support ecosystem projects internally, does not encourage the emergence of innovation. They prefer a more laissez-faire approach, allowing projects within the ecosystem to compete naturally. On this level, I believe that not investing heavily in funds and tokens to build the ecosystem, and employing a more aggressive strategy, will create an advantage in terms of future market capacity and positioning. Platforms that do not implement a certain level of investment will also encounter bottlenecks in their development.

Breaking the Game Plan 2: Competition Should Focus on Strategic Cooperation

In theory, the competition among L2 projects is different from that of L1. Ethereum emphasizes equal rights and open cooperation, where different technical routes are challenged, and all scaling solutions are helping to establish a stronger network effect for Ethereum.

After the transition from ETH2.0 to Rollup, the responsibility of ecological technology falls on L2. The industry’s prospects lie in the entry of super applications and large-scale users. Capital always follows Ethereum’s roadmap at the first opportunity. So, should the L2 projects with capital support launch an arms race based on the construction of ecosystem applications? With a valuation volume of hundreds of billions of dollars and capital investment exceeding 5 billion dollars, how can it be transmitted downstream to industry applications that focus on user-oriented innovation?

I believe that in addition to continued heavy investment and support for application ecosystems by capital, zkEVM represents the hope of the industry’s innovative force and should shoulder the mission of repositioning the development plan for the ecosystem. L2 should learn from DeFi’s Lego-like approach, where entrepreneurs and developers should not just replicate similar technology service stacks but explore different ideas and directions to generate more new perspectives and possibilities. In terms of open-source protocols and directions, they should strive to use the same standards as much as possible to reduce redundant waste of resources. When it comes to competition, strategic cooperation should be emphasized, deploying more financial resources on breakthrough applications, and striving for every platform to support applications like GMX/Friend.tech at all costs.

The Final Outcome of a Thriving Ecosystem – L3 and Application Chains are on the Rise

The industry is currently going through a tumultuous phase of innovation. We have witnessed far too many sigh-inducing moments during bear markets, and many first-time founder entrepreneurs have encountered various difficulties. To overcome these challenges, L2 project founders need to truly understand their importance in the industry. And in such difficult times, instead of focusing solely on competition, there should be more collaboration to encourage and support the diverse growth of the Ethereum ecosystem.

Mainstream VCs and L2 projects can work on developing the developer environment and ecosystem. The industry should dare to support projects that provide value to other projects without necessarily getting listed, focusing on building an open-source community, improving developer experience, enhancing application frontends, and enabling developer education and training. I firmly believe that the L2 Summer, driven by application breakthroughs, can lead us out of the bear market!

When dydx decided to leave Starkware, they chose to deploy application chains on Cosmos, and more and more application projects are starting to detach themselves from mainstream L2 solutions, rebuilding their own infrastructure, valuation logic, and product architecture. Simultaneously, we can observe a significant increase in the number of projects, such as Conduit/Caldera/Gelato deployed on opStack, providing Rollup as a Service. These projects are also playing a more substantial role in supporting game and application ecosystems.

For example, Caldera helps protocols and games build small-scale temporary features. Each feature requires 2 to 5 engineering days and provides highly interactive and custom application functionalities (with monthly payment options per functionality). There is also Gelato, which helped Astar complete the launch of zkEVM on the Polygon chain, charging on a monthly basis according to Raas. Additionally, emerging projects like Arbitrum Orbit/Risc0/Nil foundation are competing and building ecological protocols within this new Raas landscape.

Over the past year, IOSG’s investment strategy has shifted from 80% infrastructure investments to the current focus of over 40% investments in applications. We are very optimistic about the innovative potential of Asian teams in fields such as product-user interaction, AI-driven applications, and social gaming. Moreover, we will support these application teams in collaborating with various L2 solutions to gain more extensive ecosystem support.

This article solely represents personal opinions and does not constitute any investment advice. Many thanks to Jiawei/Weikeng for their editing suggestions. Additionally, with regard to disclosure of interests, IOSG is an investor in the majority of L2 protocols (including but not limited to Arbitrum/Optimisim/Starkware/zkSync/Aztec/Scroll/Risc0/Linea/Taiko).

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