Issue #3 : Layer 1 vs Layer 2 - How to value them?
A guide to valuing blockchain using fundamentals
In a future where chains will dominate our world, I thought of putting down my thoughts at how chains work and how to value them using various parameters.
At its core, chains or blockchains are databases that have certain characteristics, the most well-known of which is the immutability of what is already recorded in the database. (immutability refers to irrevocability or unchangeability) and its open source nature.
Each block contains a piece of data or information that gets added to the previous block and forms a chain of blocks, thus creating a giant ledger of information recorded from the genesis block.
These blockchains are not running on a single centralized server, but instead, run on a network of computers (or nodes that we call them). The data is thus available across thousands and thousands of nodes running worldwide, allowing each node access to this database. This is what makes blockchains decentralized as it’s not controlled by a single party or server but rather managed by the entire network.
We won’t get into the deeper intricacies of how blockchains work (let’s reserve this for another day).
Since we have a fair understanding of what blockchains are - let’s dive into the most common blockchains that dominate the crypto universe and their core offering.
Most blockchains suffer a common problem, what is known as the blockchain trilemma - this means that in order to achieve one, one needs to make trade-offs with the other.
The 3 core tenets of blockchain trilemma are -
1. Security
2. Scalability
3. Decentralisation
Ethereum is the king of all chains due to its security, network effect, and composability. It settles 1.5 million transactions/day and has 177 million unique addresses that use the network. Developers are comfortable building on top of Ethereum due to ease of development, ecosystem support and easily learnable programming language (solidity).
But all of this comes at an expensive cost, as the network can only handle so many transactions at a given time. Whenever demand exceeds capacity, transaction fees rise, which eventually price out the smaller users. Lately, the gas fees for executing a single transaction on Ethereum is hovering between 50$ - 150$. This means, that if you want to do a transaction worth 100$ or 50$, you still have to pay the same gas fee, which in this case is higher than the value of the transaction. The below chart showcases the average gas price to settle a transaction on Ethereum.
The Ethereum base layer can currently only execute about 15 transactions per second (TPS), so when network usage is high the fees can get prohibitively expensive.
Therefore, if Ethereum needs to maintain the status of the world’s prominent decentralized smart contract platform, it has to scale so that everyone can afford to use it.
To combat this, new Layer 1(L1) and Layer2 (L2) and sidechain solutions have launched which either compete with Ethereum or complement Ethereum; in either case, each of them has attracted its own set of users and network effects.
Layer 1 is a standalone network with its own set of validators and security guarantees, whereas layer 2 is a scaling solution built on top of an existing layer 1, with security guarantees which is very close to the underlying network it sits on top of. They generally compete with Ethereum with their own unique characteristics.
For ones who are new to crypto, having strong security in this context means that the validators cannot manipulate or steal from the blockchain.
L1 and L2 have their own unique offering which sets them apart from others. Some have been widely adopted while some are still in the nascent stages. Let’s look at some of these L1 and L2.
Examples of L1 - Bitcoin, Ethereum, Polkadot, Solana, Avax, Fantom, Terra, BSC etc
Examples of L2 - Polygon, Arbitrum, Optimism, ZK Sync etc
Each L1 blockchain is designed using unique strengths, with Ethereum being the first open-source blockchain that offers smart contract functionality and is optimized for security, Polkadot optimizing for cross-chain communications, BSC optimizing for low fees, Avalanche for time-to-finality, and Solana for high transaction throughput.
L2’s on the other hand are optimized to solve scaling and cost issues for the underlying L1. They batch write the post-transaction data validated on their network to the underlying L1. They typically offer higher throughput and increased performance. While the security aspect of some differs from others, the underlying objective of L2 is to help Ethereum scale.
Now that we have a clear comparison between L1 and L2, let’s move on to doing some fundamental analysis of some of these protocols.
We will use the following metrics to do a peer-to-peer comparison between various L1’s and L2’s.
1. Circulating supply - Circulating supply of the tokens
2. Total supply - Total supply of the tokens
3. FDV - Fully diluted valuation (Price x total supply)
4. MCAP - Current market cap (Price x circulating supply)
5. TVL - Total value locked on the chain
6. Revenue - Fees paid by users to execute transactions
7. Earning - % of Revenue which goes to the treasury of the protocol
8. FDV/TVL - gives us a multiple; shows how a product is valued in relation to its TVL
9.MCAP/TVL - gives us a multiple; shows how a product is valued in relation to is TVL
10.P/S Ratio - gives us a multiple (FDV/Revenue); shows how a product is valued in relation to its revenues
The chart (click on the chart to get access to the spreadsheet) below helps us look at the above metrics and get some leading indicators for a blockchain in terms of current valuation.
Ethereum is the king as usual sitting at a 3x multiplier of FDV/TVL.
Fantom on the other side looks the most undervalued in FDV/TVL ratio and Solana looks the most overvalued between Avalanche, Solana, Fantom, Polygon, Eth, Terra and BSC.
Fantom has already captured a TVL of 5.06B and a FDV of 8.22B which implies a 1.62 multiple in FDV/TVL. This is the only chain which has a lower FDV/TVL multiple than Ethereum. Fantom has also generated 2.05M USD in revenue (fees paid by users) last month which brings its annualized revenue to ~24M USD.
Comparing this with other chains like Avalanche, whose FDV is 9x of Fantom's FDV, Avax is only generating 33% higher revenue than Fantom.
Solana on the other side has captured a TVL of 14B$, Eth has a TVL of 180B$, BSC has a TVL of 21B$, Avalanche has a TVL of 10B$ and Ronin (the latest chain started by Axie Infinity to support low fee breeding and selling) has already seen a TVL of 1B$ after it launched its DEX (named Katana just a couple of weeks back.
In terms of revenue generated by the blockchains, Ethereum generates the highest monthly revenue of 1B$ and above, while Terra generates the least monthly revenue of 512,000$
While the above parameters are not sufficient to identify if a protocol is overvalued or undervalued, these are pure numbers that offer some leading indicators. However, blockchains cannot be valued as traditional public companies.
They are mere protocols where dapps are launched on top of them. So the value for most of these chains is accrued from the number of dapps that are launched on top of them, the number of users using the chain and the underlying token which appreciates from increasing usage. Unlike a traditional internet company which is built on top of an existing protocol (like HTTP, IP, TCP,FTP etc) and generates value for itself instead of accruing value to the base protocol.
Thus, one needs to take into account more qualitative parameters for each chain -
Some parameters worth mentioning are -
Throughput, Security, Number of wallets, Fiat gateways, Developer experience, Ecosystem support, Existing brand power, Asset mobility, DAU, Demand for the token.
Let's learn about each of these parameters and how we can view them -
1.Throughput helps in understanding how fast the chain is - can be measured quantitatively using TPS
2.Security - This refers to the decentralized nature of the chain i.e. the validators running the network can't manipulate or steal. While Ethereum is highly secure, its throughput is very poor. @0xPolygon and @BSC on the other side have very high throughput but security is compromised due to limited validators.
3.Asset mobility refers to the ease of interoperability i.e. ability to move assets from one chain to another chain. Bridges like Hop Protocol and Celr Network allow us to live in an interoperable blockchain world.
4.Dev experience refers to ease of development, detailed docs available, adoption of programming lang used (eg.EVM compatible),
5. No of wallets imply wallet integration with mainstream wallets like Metamask etc and ease of configuring a wallet compatible with the chain.
6. DAU - refers to daily active userbase
While the above parameters are important, some are more difficult to implement than others. Therefore each needs to be weighted differently.
Delphi has a really good piece where it gives weighted scores for parameters based on the difficulty of implementation and its relevance.
So using the above weighted score, one can generate a score for each blockchain which can thereby help us understand which ones are more favorable or unfavorable.
Due to limited time, it wasn’t possible to generate a score for each blockchain (can think of adding this inV2 of this piece) but based on some rough internal calculations, it was clearly evident to me that nothing surpasses Ethereum in terms of having a vast ecosystem of applications, strong security through widely distributed node providers, smooth developer experience and numerous asset bridges and the network effect of existing users. The only parameter where Ethereum gets beaten badly is the throughput otherwise it scores exceptionally well in all the above parameters.
With this in mind, we can also come to a conclusion why a solution that interoperates closely with Ethereum (Polygon, Avax, Arbitrum, Optimism, Ronin i.e. all are EVM compatible chains) can also benefit from these attributes as well.
How did you like this newsletter? Your feedback helps me work on my blindspots and improve my writing style.
Awesome Average Poor
See you soon,
Abhishek.