IOSG Ventures: Interpreting the Rollup income and expenditure structure, is the Rollup token price overvalued?

Original author: IOSG Ventures

Background

Currently, the Ethereum Rollup L2 ecosystem is beginning to take shape, with a total daily TVL of over $37 billion, which is more than 3 times that of Solana and over 1/5 of Ethereum's. From a user perspective, the recent daily average user count of mainstream L2 has reached 158k, surpassing Solana's data of around 100k.

However, the short-term performance of Rollups' token price is not as expected. In terms of market capitalization, among the mainstream Rollups, Arbitrum has a market cap of $7.8 billion, Optimism has a market cap of $7.3 billion, Starknet has a market cap of $6.9 billion, and the recently airdropped zkSync has a FDV of $3.5 billion, while Solana's FDV reached $74 billion during the same period. Despite zkSync's recent launch, its poor market performance has also failed to meet the market's expectations for Rollups.

From a revenue perspective, Ethereum's revenue in 2023 reached $2b, while Arbitrum and Op Mainnet, which performed better in the same year, reached $63m and $37m respectively, which is a big gap with Ethereum. Base and zkSync, which are new entrants to the market this year and performed better, earned $50 m and $23 m respectively in the first half of 2024, while Ethereum generated $1.39 b in revenue during the same period, and the gap has not narrowed. Rollups have not yet been able to match the revenue scale of Ethereum.

The low activity of some Rollups is indeed one reason, which is a problem faced by most public chains. What we are more curious about is how well Rollups have fulfilled their mission as a Mass adoption infrastructure, and whether their value is underestimated due to the current low activity.

Everything still needs to go back to the original proposition. The birth of Rollups originated from the increasingly crowded Ethereum, and the fees have reached a level that users cannot accept. Therefore, Rollups was born with the inherent purpose of "reducing transaction costs." In addition to the well-known security of Ethereum L1 level, the advantages of Rollups also include its disruptive cost structure, the so-called "the more users, the cheaper the Rollups."

If this can be well implemented, we believe that Rollups have irreplaceable value. A more reasonable cost structure can also improve the resilience of Rollups in the face of market changes. The continuous investment brought by healthy cash flow is the source of competitiveness, and protocols with advantages in profit margins will naturally have higher valuations and long-term competitiveness.

This article briefly analyzes the economic structure of Rollups at present and looks forward to future possibilities.

1. Rollups Business Model

1.1 Overview

Rollups protocol uses Sequencer as a revenue point to charge users for transactions on Rollups to cover the costs incurred on L1 and L2, and to gain additional profits.

On the revenue side, the fees charged by Rollups to users include:

• Basic fees (including congestion fees)
• Priority Fee
• L1 related costs and fees

The potential costs that can be captured by formulating strategies in accordance with the protocol include:

• MEV Fee

In terms of costs, it includes the relatively small proportion of L2 execution costs and the main part of L1 costs, including:

• DA Cost
• Verification Cost
• Communication costs

The difference between the business model of Rollups and other L2 lies in its cost structure, where DA costs, which account for the largest proportion, are considered variable costs that change with data volume, while verification costs and communication costs are more considered fixed costs for maintaining the operation of Rollups.

From a business model perspective, we hope to clarify the marginal cost of Rollups, that is, to what extent the additional cost of an extra transaction can be smaller than the average cost of each transaction, to verify the specific degree of "the more users, the cheaper the Rollup".

The reason behind this is that Rollups batch process data, compress data, verify aggregation, resulting in higher efficiency and lower marginal cost compared to other public chains. In theory, the fixed cost of Rollups can be well spread over each transaction, so it can even be negligible when the volume is large enough, but this also needs our verification.

1.2 Rollups Revenue

1.2.1 Transaction Fee Revenue

Rollups' main income comes from transaction fees, namely gas. The purpose of the fees is to cover the costs of Rollups and to obtain a portion of the profits to hedge against long-term L1 gas changes, as well as to obtain some profits. Some L2 will charge transaction priority fees to allow users to prioritize emergency transactions.

Arbitrum and zkSync adopt the FCFS mechanism, which means that the order of transaction processing is first come, first served, and does not support 'cut-in' requests. OP stack takes a flexible approach to such issues, allowing 'cut-in' transactions to be processed with priority fees.

Source: IOSG Ventures

For users, the cost of Rollups L2 on-chain is determined by the lower limit base fee when the chain is less active. When the chain is busier, congestion fees will be charged based on the congestion level determined by each Rollup (often rising exponentially).

Due to the extremely low L2 overhead of Rollups (only off-chain engineering and operational costs), and the high autonomy of the execution costs charged, almost all user income used for paying L2 fees will become the protocol's profit. With centralized operation Sequencer, Rollups have control over basic fees, congestion fees, and priority fees, so the L2 execution fee will be a 'parameter' game of the protocol. In a thriving ecosystem, and under the premise that prices will not cause user resentment, the amount of execution fees can be freely designed.

Source: David_c @Dune Analytic

1.2.2 MEV Revenue

MEV transactions are divided into malicious MEV and non-malicious MEV. Malicious MEV refers to front-running transactions similar to sandwich attacks, which are more about seizing the value of user transactions. For example, in a sandwich attack, the attacker inserts their own transaction before the user's transaction, causing the user to buy at a higher price or sell at a lower price, known as "being sandwiched".

Instead of malicious MEV for arbitrage and liquidation, such back-running transactions, arbitrage can balance prices between different exchanges and improve market efficiency; liquidation can remove bad leverage and reduce systemic risk, and is considered beneficial MEV behavior.

Source: IOSG Ventures

Unlike Ethereum, Rollups do not provide a public mempool. Only the sequencer can see the transactions before they are finally confirmed, so only the sequencer has the ability to initiate MEV on L2 chain. Since most L2s currently have centralized sequencers, there is temporarily less possibility of malicious MEV. Therefore, the current MEV revenue needs to consider arbitrage and liquidation types.

According to research by Christof Ferreira Torres et al., it replays transactions on Rollups and concludes that Arbitrum, Optimism, and Zksync have on-chain non-malicious MEV behavior. The three chains have currently generated a total MEV value of $580m, which is worth paying attention to as a source of income.

Source: Rolling in the Shadows: Analyzing the Extraction of MEV Across Layer-2 Rollup

1.2.3 L1 Related Cost and Expense

This part is the fee charged by Rollups to cover L1 related costs, the specific cost composition will be discussed later. Different Rollups have different charging methods. In addition to covering the cost of L1 gas for predicting L1 data, Rollups will also generate additional fees as a reserve fund to deal with the future risk of gas fluctuations, essentially a revenue for Rollups. For example, Arbitrum will add a 'Dynamic' fee, and OP stack will multiply the fee by the 'Dynamic Overhead' coefficient. This part of the fee, before the EIP 4844 upgrade, is estimated to be about 1/10 of the DA fee.

1.2.4 Profit Sharing

Base has a relatively special profit sharing mechanism due to the adoption of OP stack. Base promises to contribute 2.5% of the total revenue / 15% of the profit after deducting the cost of submitting data to L1 in L2 transactions, whichever is higher, to the OP stack. In return, Base will participate in the on-chain governance of OP Stack and Superchain, and receive up to 2.75% of the OP token supply. Based on the latest data, Base's income contribution to Superchain is 5 ETH/day.

We can see that Base provides a considerable revenue share for Optimism, and in addition to cash flow, a healthy network effect also makes the OP Stack ecosystem more attractive to users and the market. Although some performances of Arbitrum, such as TVL or stablecoin market capitalization, are higher than Base + Optimism, they are currently unable to surpass the latter in terms of trading volume and revenue. This is also evident from the P/S ratio of the two—considering Base revenue, the PS ratios of $OP are 16% higher than $ARB, reflecting the additional value that the ecosystem brings to $OP.

Source: OP Lab

1.3 Rollups Cost

1.3.1 Ethereum L1 Data Cost

The specific cost structure of each chain is different, but the general categories can be divided into communication costs, DA costs, and verification costs unique to ZK Rollups.

• Communication Cost: Mainly includes state updates between L1 and L2, cross-chain interaction, etc.
• DA Cost: Includes compressed transaction data, state root, ZK proof, etc. published to the DA layer.

Before EIP 4844, the main cost of L1 came from DA cost (over 95% for Arbitrum and Base, over 75% for zkSync, and over 80% for Starknet)

After EIP 4844, the cost of DA dropped significantly, and due to the different mechanisms of different L2s, the degree of cost reduction varied, with a decrease of about 50% -99%.

1.3.2 Verification Cost

Mainly used for ZK Rollup to verify the reliability of Rollups transactions through ZK means.

1.3.3 Other Costs

It mainly includes off-chain engineering and operation and maintenance costs. Due to the current operation mode of Rollups, the operating cost of the node is close to the cost of cloud servers, which is relatively small (close to the cost of enterprise AWS servers).

Comparison of Profit from L2 and Data from Other L1s

So far, we have a rough understanding of the overall income-expenditure structure of Rollup L2, which can be compared with Alt L1. Here, Rollups selected Arbitrum, Base, zkSync, Stakrnet weekly average data as the source of data.

Source: Dune Analytic, Growthepie

It can be seen that the overall profit margin of Rollups is close to Solana, which has obvious advantages compared to BSC, reflecting the excellent performance of Rollups' business model in profitability and cost management.

2. Rollup Horizontal Comparison

2.1 Overview

Different stages of Rollups development show significant differences in fundamentals. For example, when there is an expectation of new token issuance in transactions, Rollups will experience a significant increase in volume, followed by a significant increase in fee income and expenses.

Source: IOSG Ventures

The vast majority of Rollups are still in the early stages, and absolute profitability is not so important for them. It is more about ensuring a balance of income and expenses and ensuring long-term development. This is also the concept that Starknet has always announced, not charging users additional fees and hoping to achieve profitability.

However, since mid-March, Starknet has been operating at a continuous loss and its on-chain activity has been poor. But what is the root cause of the negative returns and will it continue in the long term?

Let's continue to delve into this issue. In fact, the income structure of Rollups is relatively convergent, and the marginal cost structure brought by the Rollup mechanism of each chain and the differences in data compression methods also bring cost differences due to different calculation mechanisms.

Source: IOSG Ventures

We hope to compare the costs in Rollups to help us compare the different features of various Rollups.

2.2 Cost Structure of Different Types of L2

ZK Rollup

ZK Rollups mainly differ in verification costs, which are often considered as fixed costs that are difficult to recoup through fee sharing, and are also the root cause of Rollups running into deficits.

Source: David Barreto @Starknet, Quarkslab, Eli Barabieri, IOSG Ventures

This article mainly discusses two relatively mature ZK Rollups with substantial trading volume.

Starknet

Starknet uses its own validation service SHARP for sharing, and after transaction sorting, confirmation, and block generation, forms batches to build transaction proofs through SHARP and sends them to L1 contract validation. After passing, the proof is sent to the Core contract.

The validation and fixed costs of DA in Starknet come from blocks and batches respectively.

Source: Starknet community - Starknet Costs and Fees

The variable cost in Starknet increases with the number of transactions, mainly the DA cost, which theoretically does not incur additional expenses. In fact, quite the opposite - Starknet's transaction fees are charged per write, but its DA cost depends only on the number of updated memory units, not the number of updates per unit. Therefore, Starknet has previously charged excessive DA fees.

There is a time lag between the collection of Money Laundering and the payment of operating costs, which may result in partial losses or profits.

Therefore, we see that as long as there are transactions being generated, Starknet needs to continuously generate blocks and pay for the fixed costs of blocks and batches. At the same time, the more transactions there are, the more variable costs need to be paid. Fixed costs do not significantly increase marginal costs.

Source: Eli Barabieri - Starknet User Operation Compression

Due to the limitation of computational resources (Cairo Steps) for each block, the gas fee calculation method of Starknet is based on the computational resources and data size, covering fixed costs and variable costs respectively. Since the cost of block/batch is difficult to spread to each transaction, but each block is closed only after reaching a certain amount of computational resources (fixed costs are triggered), a portion of the fixed costs can be calculated and collected through the dimension of computational resources.

However, due to the limitation of block generation time, if the transaction volume is insufficient (the computation in a single block is insufficient), the computing resources cannot well measure the price that needs to be amortized, so the fixed cost still cannot be fully covered. At the same time, the "limitation of computing resources" will be affected by the upgrade of Starknet network parameters, and the substantial losses in short-term operation after EIP 4844 reflect this point, and the losses will only be eased after the computing resource parameters in the fees are adjusted.

Source: Growthepie

Starknet's fee model does not effectively cover fixed costs in every transaction, so when the Starknet Mainnet is updated and the volume of transactions is extremely low, negative income will occur.

zkSync (zkSync Era)

After the Boojum upgrade, zkSync era has shifted from block validation to batch validation and storage state difference, effectively reducing the cost of validation and DA. The process is similar to Starknet, where the Sequencer submits the batch to the utor contract (state difference and DA commitment), the proving nodes submit the validation (ZK proof and DA commitment), and after successful validation, the batch is executed (once every 45 batches); the difference is that Starknet incurs validation costs for both blocks and batches, while zkSync only incurs validation costs for batches.

Cost Comparison of zkSync and Starknet

The batch size of Starknet is much larger than that of zkSync Era. The transaction limit per batch for zkSync Era is 750 or 1000, while there is no transaction limit for Starknet.

Source: IOSG Ventures

In this way, Starknet has stronger scaling capabilities. Due to the computational resource limitations of each block, its ability to process more transactions and batches in a single block makes it perform better in scenarios with high-frequency transactions and a large number of simple operations. However, it may encounter the problem of high fixed costs when the transaction volume is small. zkSync, with its compression efficiency and flexible block resources, has advantages in situations where it needs to flexibly respond to L1 gas price fluctuations and its own on-chain activity is scarce, but it may have limitations in terms of block generation speed.

For users, Starknet's fee model will be more user-friendly, with less correlation to L1 and stronger economies of scale. Zksync's fees are more efficient but will fluctuate more with L1.

For protocols, in the low activity stage, Starknet's high fixed costs will result in more losses, while zkSync will be more suitable for this scenario. In the high activity stage, Starknet is more suitable for conducting a large number of high-frequency trades and controlling costs, while zkSync's current mechanism may perform slightly worse in high transaction volumes.

2.3 Optimistic rollup

The cost structure of Optimistic Rollup is relatively simple. Without verification costs, users only need to pay the computational costs of L2 and the data availability costs of publishing to L1. The publication of the state root is more fixed due to its relation to block production, while the uploading of compressed transactions is a variable cost that is easy to estimate and distribute.

Compared with Zk Rollup, its fixed cost is lower, more suitable for scenes with moderate trading volume, but due to the need to include signatures for each transaction, the variable cost of DA can be higher, and the advantage brought by marginal cost in large-scale adoption is relatively smaller.

Source: IOSG Ventures

Based on the current adoption scale, the fixed cost of ZK Rollup may result in a higher lower limit for unsubsidized transactions, which brings costs to users compared to OP Rollups, but the advantage of ZK is obvious in terms of scalability:

High trading volume and proof aggregation will distribute verification costs, and the marginal cost savings of L1 will exceed Optimism Rollups; running Validiums/Volitions, DA with only state differences, faster withdrawal speeds, etc. will better meet the economic needs and RaaS ecosystem of the scale model.

2.3 Data Comparison

Income

The gas fee charged by Rollups to users can be seen that Base has higher income, Starknet has lower income, Arbitrum and zkSync are on par, and the difference in trading volume leads to horizontal and vertical disparities. Therefore, we calculate the income per transaction. It is found that before the EIP 4844 upgrade, Arbitrum had higher income per transaction, and after the upgrade, Base had higher income per transaction.

Source: IOSG Ventures

Cost

From the perspective of the transaction cost, before EIP-4844, due to the high cost of DA, the transaction cost was high, actually in a situation of relatively high marginal cost, and the cost advantage caused by economies of scale was not reflected. After EIP-4844, with the significant drop in DA cost, the per transaction cost of Base dropped sharply, currently the lowest among all Rollups. Compared with OP and ZK, we can see that OP Rollups are the biggest beneficiaries of the upgrade, the actual cost of L1 DA of StarkNet can be reduced by about 4 to 10 times, slightly less than an order of magnitude of OP Rollups. This is also consistent with the theoretical inference: in the EIP-4844 upgrade, the benefits of ZK Rollups are not as significant as those of OP Rollups. The cost performance of ZK Rollup after the upgrade also reflects the impact of fixed costs.

Source: IOSG Ventures

Profit

Based on the data, Base has the highest gross profit due to economies of scale, far exceeding Arbitrum, which is also Optimistic. Starknet, another ZK Rollup, has a negative transaction gross profit due to low transaction volume, which cannot cover fixed costs. zkSync has a positive gross profit but is also limited by fixed costs, lower than OP Rollup. The upgrade of EIP 4844 did not bring direct help to the profit margin - the main beneficiaries will be users, whose cost will be significantly reduced.

Source: IOSG Ventures

3. Summary

3.1 Cost Side

Currently, most Rollups appear to be in the front half of their Margin curve. As transaction volume increases, marginal costs gradually decrease, and average fixed costs will also decrease significantly. However, as transaction volume in the Ethereum L1 or L2 ecosystem increases in the future, the rise in average transaction costs due to network capacity will lead to a gradual upward trend in marginal costs (as seen from the performance of Base 3-5 months), which is a problem that cannot be ignored for the long-term development of Rollups. When we pay attention to the cost changes caused by short-term adoption, we also need to pay attention to the efforts made by Rollups on the long-term cost curve.

Source: Wikipedia - Cost curve

In the short term, for Rollups, it is best to establish barriers by effectively reducing marginal costs, and adjusting revenue and cost models according to market conditions is a better solution.

3.2 Revenue Side

In order to maintain long-term competitiveness, protocols try not to charge users extra fees, and even pay costs to keep user expenses low and stable, as we see in the current situation of Starknet. Priority fees will certainly bring in more revenue, but the premise is that the chain must have sufficient activity.

After EIP 4844, the revenue of some Rollups, such as Arbitrum, has decreased significantly. This is because a significant portion of the hidden revenue from DA data fees has been almost eliminated. The revenue model of Rollups will become relatively single, mainly derived from L2 fees. With the increase in transaction volume, the generated priority fees and congestion fees will be important components of revenue. At the same time, in terms of active income, extracting MEV through the Sequencer will also be an important source of revenue for future Rollups.

Overall, the business model of Rollups does have the advantage of economies of scale, especially ZK Rollups. The current market conditions are not suitable for Rollups to leverage their advantages, and we need to wait for the Base moment, similar to March to May this year. The diversity of business models and the adaptability of different Rollups in different market conditions also give us a profound consideration of the Ethereum L2 Rollups ecosystem.

References

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