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Author: Michael Nadeau, Token Terminal Research; Translator: LianGuaixiaozou

Arbitrum is a layer 2 blockchain built on Ethereum. Its developer, Offchain Labs, launched the platform on August 31, 2021, with the aim of improving user experience with lower fees and faster throughput. We like to think of L2 as the “broadband of Ethereum.” Before broadband, YouTube, game streaming, and SaaS businesses were not possible. Similarly, we believe L2 can unlock the next generation of use cases for Ethereum – catalyzing a new era of development as the ecosystem matures.

In this article, we will take you through the following topics:

– Problem

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– Solution

– Business model

– Applications that bring the most value to Arbitrum (and its competitors)

– Potential market

– Product

– Team, investors, community

– Financial situation

– Token economics

– Competition

– Why now?

– Risks

– Conclusion

1. Problem

Ethereum sells block space. That’s the product Ethereum offers – but only so much. Supply lacks elasticity with demand. As a result, Ethereum becomes slow and expensive when demand increases. If you’re a developer trying to find the right product/market fit for your new application, it’s a problem. Additionally, Ethereum lacks flexibility and customization, limiting the range of use cases for application developers.

Zooming out a bit, the evolution of the Ethereum technology stack has many similarities to the evolution of the internet. In the early days, if you wanted to host a website, you had to run your own physical server. Then, Geocities came along, supporting developers with shared servers. Over time, innovation was limited due to the lack of flexibility with Geocities. When AWS emerged, virtual servers became the right answer. Along with AWS came e-commerce, SaaS businesses, and social media – all of which were not possible in the early days of the internet.

2. Solution

Arbitrum expands the block space supply available to application developers while enhancing user experience – it delivers greater throughput and reduces fees by 95% compared to L1. It’s a win-win for developers and users. This is achieved while maintaining Ethereum as the shared settlement layer’s interoperability and security, thanks to Arbitrum.

Additionally, solutions like Arbitrum Orbit and Arbitrum AnyTrust support application developers in building customizable blockchains that serve specific niche use cases. These L2 solutions, combined with data availability networks like Celestia, resemble the transition from Geocities (Ethereum) to AWS in the early days of the internet.

In short, solutions like Arbitrum are laying the foundation for the next wave of blockchain-based applications. It’s the “broadband moment” for the Ethereum ecosystem!

3. Business Model
Arbitrum essentially acts as a dealer of Ethereum block space. Think about the last time you tried to send a bunch of large documents via email. Due to data transmission restrictions, you probably had to compress the files into a zip folder, packing and compressing the data in the process.

That’s how Arbitrum and other L2 solutions work. They process many transactions at low costs, bundle them up, and then publish the “call data” to Ethereum in a single transaction.

Here’s a comparison of the revenue generated (fees paid by users of applications using Arbitrum) versus the fees paid to Ethereum validators for Arbitrum “call data”:
– Cost of 365-day “calldata” paid to Ethereum: $34.2 million
– Net value to Arbitrum: $13.2 million
– Gross profit margin: 27.8%

4. Which applications bring value to Arbitrum?
Where does Arbitrum fit in the product market? Is it DeFi? NFTs, gaming, payments, bridges? Or something else?

Let’s dive deeper starting with the 365-day gas fees.

Currently, bridges (Stargate and LayerZero) bring the most gas fees to Arbitrum – makes sense because users must first transfer their assets from Ethereum to Arbitrum. Besides bridge activity, DeFi and payments are the main drivers of activity on Arbitrum.

Let’s compare it to the trends of the past 30 days.

The “MEV Bot”, a high-frequency trader on DEX, has driven most of Arbitrum’s activity in the past 30 days, with a value almost surpassing the total of Uniswap and GMX.

Now, let’s see what the situation looks like in terms of 365-day transactions. As expected, we see many of the same names.

Comparison between Arbitrum and other L2 solutions.

Let’s start with the OP Mainnet, the second-largest TVL L2 solution.

Similar to Arbitrum, LayerZero (bridging) consumed the most gas last year.

Most of the activities on the OP Mainnet are DeFi and payments, except for Galxe, which is a protocol that helps businesses build customer loyalty programs using on-chain data. Please note that there are still many “unlabeled” contracts on the mainnet, and we hope to have more understanding of them in the near future.

Here are some recent releases of L2 on Coinbase, Base:

Base shows some differences. Just three months after its launch, it already has the strongest product/market fit project – friend.tech – a new web3 social media platform that has generated over $1 million in gas fees.

[Please note that “unverified” refers to many unlabeled on-chain contracts, not any individual project.]

Polygon (sidechain, not “L2 rollup”). Polygon uses its own token to pay user fees:

It’s great to see Chainlink (the largest web3 data oracle network) making a strong appearance here. Planet IX is a crypto game. CoinTool is an “online crypto toolbox.” Finally, it’s nice to see Lens Protocol (social media) on the list. It’s reassuring to see the differences from Polygon.

Lastly, let’s take a look at a competitor to L1, Avalanche:

How is Avalanche doing overall? The gas fees brought in by its top 10 projects are much lower than any random L2 project listed in this article – and the difference is significant.

Arbitrum: Gas fees brought in by the top 10 projects is $14.8 million

Polygon: Gas fees brought in by the top 10 projects is $12.2 million

OP Mainnet: Gas fees brought in by the top 10 projects is $11.9 million

Base: Gas fees brought in by the top 10 projects is $3.6 million (annualized $14.4 million)

Avalanche: Gas fees brought in by the top 10 projects is $5.3 million

5. Potential Market

In general, so far, more value (market cap and locked value) has accumulated on the base layer networks (L1). We believe this trend will continue. In the future, higher returns may accumulate to protocols and applications built on the “top.” Please note: potential high returns also mean risks.

Some rough calculations:

Assuming Ethereum reaches a market cap of $20 trillion in the next cycle. Let’s assume L2 occupies 10-20% of Ethereum’s market value. This would make the potential valuation of L2 reach $200-400 billion. Given the power law we have observed in the crypto field so far, where the majority of value may flow to a few general-purpose L2s. Currently, Arbitrum has a market cap of $1.4 billion.

Once again. The value of L1 is higher, but the returns (and risks) of the layers above L1 may be higher.

Take a look at the revenue multiples over 365 days:

From a fully diluted perspective, the pricing of Arbitrum (and OP Mainnet) seems perfect.

Here’s an overview from the perspective of market capitalization:

All of a sudden, the valuation seems much more reasonable. However, investors should note that 3.3 billion ARB tokens will be unlocked in the next two years.

For the sake of conciseness, we’ll only do a high-level analysis here. Of course, there are many unknowns and unexplored subtleties. We believe investors should ask the following key questions:

– Can general-purpose L2 maintain a 28% profit margin? We believe the profit margin will decrease in the coming years.

– How many transactions will move from L1 to L2 in the future? We believe most transactions will move to L2, but the value will remain on L1 (for security reasons).

– How does the market value settlement guarantees (security and decentralization, i.e., Ethereum) vs. execution services (L2)? So far, the market has prioritized settlement over execution.

– How does value accrue to the token? The utility of ETH and its token economics are clear. It’s not so clear for L2 tokens today.

– Where does the structural advantage of L2 tokens come from? It requires using ETH to access services on both L1 and L2. Additionally, users can lock tokens to earn rewards. Why would one need to hold L2 tokens today? What rights or benefits can they provide in the future? It’s still unclear.

6. Products

Arbitrum One is the main rollup chain. When we say “rollup,” we mean L2s that inherit Ethereum security (like Arbitrum) rather than side chains like Polygon. This is where DeFi and other use cases that demand maximum security reside.

Arbitrum Nova is a second-tier network focusing on gaming, NFTs, and social applications that require greater flexibility and throughput. Since these use cases fundamentally involve less finance, they also require less security trade-off. Nova was launched in August 1922, leveraging the AnyTrust protocol, which introduces additional trust assumptions in the form of a Data Availability Committee (DAC) consisting of Reddit, Google Cloud, Consensys, Quick Node, and OpenSea.

Finally, in March of this year, Arbitrum released Arbitrum Orbit. Arbitrum Orbit is a product that allows anyone to easily create their own blockchain (application chain/L3) and manage it themselves, settling transactions on Arbitrum One or Arbitrum Nova (with all “call data” published to Ethereum).

There have been a lot of things happening in this regard. The key takeaway for us is that the network effect of Arbitrum is growing. Their customers are application developers. Their product is to enable developers to easily build on top of the Ethereum network effect and security infrastructure. The more developers they can attract, the faster and bigger the network effect will develop.

7. Team, Investors, Community

Team:

Arbitrum was born at Princeton University, when Professor Ed Felton (former Deputy Chief Technology Officer in the Obama administration) convinced some of his PhD students – Steven Goldfeder and Harry Kalodner – to work on solving Ethereum’s scalability issues. It all started in 2015, and you can find a video on YouTube where this technology was first discussed. In 2018, a research paper proposed a deeper vision, and Princeton University granted the team the authority to develop the technology now known as Arbitrum. Today, Offchain Labs (the developers of Arbitrum) team consists of 73 employees. The Arbitrum Foundation currently has 62 employees, whose mission is to support ecosystem development.

Investors:

The team raised $120 million in August 2021, with a valuation of $1.2 billion. Major investors include Lightspeed Ventures, Polychain Capital, LianGuaintera Capital, and Mark Cuban. The team raised a total of $143 million in three funding rounds.

Community:

Twitter: 886k members

Reddit: 9k members

Discord: 21k members

8. Financial Situation

9. Token Economics

Circulating Supply: 1.275 billion

Total Supply: 10 billion (12.75% circulating)

Token allocation and release schedule overview:

– Offchain Labs (Arbitrum development team): 26.9% allocation. The team’s tokens have not been released yet. 25% (673.5 million tokens) will be released on March 19, 2024, followed by linear release schedule until March 2027.

– Arbitrum DAO and Treasury (supporting ecosystem growth): 42.8% allocation. 105.8 million tokens (3%) have been released. The remaining tokens will be released on a linear schedule before March 2027.

– Investors: 17.5% allocation. The first batch of 25% (438.25 million tokens) will be released on March 19, 2024.

– Individual users: 11.6% allocation. Arbitrum airdropped this batch of supply to users in March 2023, which now constitutes the majority of the circulating supply.

– Ecosystem DAO: 1.1% allocation, already distributed.

Please note: Arbitrum was launched in August 2021. Considering that neither the team nor the investors have had the opportunity to monetize their holdings yet, we can expect liquidation to occur in the next cycle. Over 1.1 billion tokens (11% of the supply) will unlock on March 19, 2024 (approximately 5 months from now). The remaining internal tokens will unlock on a monthly linear schedule within the next 3 years. Overall, over 30% of the token supply will unlock within the next two years.

10. Competition

We believe Arbitrum’s main competitors are OP Mainnet and Base (both are rollups). For simplicity, we categorize Polygon as an L2 camp, even though it is a “sidechain” that uses its own token for gas fees, making it less aligned with Ethereum.

L2 is actively addressing the key challenges of cost and throughput on Ethereum L1. Alt L1s are also seeking to address the same issues to compete with L2. As we can see from the data, Arbitrum is not only the strongest L2, but also surpasses Alt L1 in many important metrics.

We believe Arbitrum’s main competitive advantage comes from its alignment with Ethereum and the versatility of its product suite for various use cases. However, this market is still young.

In our view, the winning L2/Alt L1 will create a moat through massive network effects and generate a flywheel effect for permissionless innovation in the coming years.

11. Why now?

– Expand network effects through Arbitrum Nova and Arbitrum Orbit (application chains and new consumer use cases).

– EIP4844 (scalability): A significant Ethereum upgrade planned for the fourth quarter will reduce costs on L2 by an order of magnitude.

– Considering the strong fundamentals of L2 but smaller market cap compared to Alt L1, L2 has the potential to outperform in the next cycle.

– Bitcoin halving will occur in April 2024, which historically marks the beginning of a bull market.

12. Risks

– Technical risks.

– Value capture risks. It is currently unclear how value will be returned to token holders in the future and where the structural advantage of the ARB token will come from.

– Competition risks. L2 is a complement with commoditization potential.

– Centralization risks. Arbitrum is currently centralized.

– Tied to Ethereum’s success. Arbitrum is strategically aligned with Ethereum, so if Ethereum fails, Arbitrum will also fail.

13. Conclusion

We like Arbitrum because:

– It aligns with Ethereum.

– It has a mission-driven strong team and community.

– It is building tools that cover a wide range of use cases, which could lead to strong network effects in the future.

– It ranks first in many important metrics among L2 solutions.

The biggest unknown is how to capture value for the tokens and where the structural advantage will come from. Clearly, Arbitrum is one of the most important projects in the crypto space.

Like always, if you’re investing in the Ethereum technology stack, you need to have a clear view on why the token you chose is better than ETH.

That’s up to you to decide. We hope this article will provide you with a framework to help you form your own opinions.

We will continue to update Blocking; if you have any questions or suggestions, please contact us!