What’s Governance Worth? Ethereum Scaling Tokens Say Billions
Some investors question whether rollup tokens use-cases justify their valuations
By: Owen FernauDefiant Premium Story
The launch of Arbitrum’s ARB has brought the market value of the two biggest Ethereum scaling tokens to more than $2B collectively. Now some investors are raising a seemingly obvious question: What are these tokens for? It turns out the answer isn’t so simple.
Right now, the only function for the ARB and Optimism’s OP tokens is governance, which amounts to the ability to vote on which direction the projects take. And with the kerfuffle surrounding the newly created Arbitrum Foundation, even the ability to vote is less than confirmed.
Governance is often cited as the key value proposition of many crypto tokens. DeFi’s most valuable token, UNI, is worth $4.7B despite its only unique value being its use in voting on the Uniswap exchange’s governance decisions. ARB has now joined the ranks of billion-dollar governance tokens, but so many other scaling solutions for Ethereum set to launch, investors are beginning to wonder whether these tokens’ valuations are justifiable.
With governance as the primary use case for rollups’ tokens, Tushar Jain, founding partner of the venture firm Multicoin Capital, asked in an interview, — “what exactly are you governing, how does that governance work, and why is it worth billions and billions of dollars?”
ARB and OP are the digital assets issued by Ethereum scaling platforms based on a cryptographic solution known as optimistic rollups. They are the main vehicles to enable faster and cheaper trasnactions on the second-biggest blockchain network as measured by value deposited in each platform.
ARB has a market capitalization of $1.6B, while OP’s is at $704M. The tokens with fully diluted values (FDV) of over $20B between them.
Rollup Token Use-Cases
Rollups’ tokens neither secure the scaling solutions’ networks nor do users pay for transaction fees denominated in them.
These are the two largest use cases for tokens associated with blockchain networks, argued Jain, whose Multicoin Capital raised $430M for its latest fund last year.
With rollups however, ETH, the native token to Ethereum, fills both roles, Jain said. The investor added that a third potential use for rollups’ tokens is to stake them in exchange for the ability to be a validator, but that this hasn’t been enabled yet. A validator is a partcipant in a blockchain system responsible for verifying transactions .
Potential Future Airdrops
ARB was distrubuted in an airdrop last month, and there’s potential for at least two more airdrops from major scaling solutions on the way — Starkware and zkSync, whose parent companies have both raised over a quarter of a billion dollars. Polygon and Consensus are also developing rollups.
With the potential for increased competition among Layer 2s, rollups teams will be under even more pressure to substantiate the value of their tokens.
No Token Needed
While Jain isn’t necessarily opposed to Layer 2 tokens across the board, but is skeptical of their current valuations, Tezos blockchain co-founder Arthur Brietman believes the tokens shouldn’t exist at all. When The Block Director of News Frank Chapparo asked on Twitter, “why does a Layer 2 need a token,” Breitman said, “it doesn’t.”
Tezos just shipped an upgrade on Mar. 29, called Mumbai, which enables developers to permissionlessly deploy rollups for the blockchain.
“The rollups are free to use, no special token, no restrictive licensing, no need to be approved by validators,” he told The Defiant. “It’s completely open.”
Neither the Arbitrum Foundation nor the Optimism Foundation, the companies behind each rollup, immediately responded to requests for comment about their tokens’ valuation.
To be sure, this isn’t to say there isn’t demand for rollups. L2BEAT, a data provider, shows Layer 2 transactions decisively surpassing those of Ethereum over the course of the last year.
Layer 2 vs. Ethereum activity. Source: L2Beat
Not only do rollups provide utility, but they may also already be profitable. A dashboard developed by Kofi, a former partner at the venture firm 1confirmation, shows the scaling solutions as increasingly profitable since July.
Rollup economics. Source: DeFi Llama
Crucially, how tokens access that potential profit is what is still unclear.
The on-chain costs component of rollups’ profit comes from paying the Ethereum blockchain to post the transactions which happened on the Layer 2.
Kofi said in an interview that the dashboard doesn’t include costs not captured on the blockchain. Depending on those off-chain costs, rollups as a whole may or may not be profitable ventures.
The revenue component comes from two sources both currently captured by a software component called the “sequencer,” David Mihal, an engineer who develops the data platform CryptoStats, told The Defiant.
The sequencer is responsible for taking users’ transactions on a rollup and submitting them to Ethereum’s mainnet. Its two sources of revenue are users’ transaction costs, referred to as “gas costs,” and Maximal Extractable Value (MEV), a complex subfield of the blockchain space whereby validators, or sequencers in this case, reorder, and otherwise remix transactions waiting to be processed.
“There’s lots of money behind MEV,” Mihal said.
Decentralizing the Sequencer
Right now, the sequencers for Arbitrum and Optimism are controlled by the companies which developed the solution, according to each projects’ documentation. In short, they’re centralized.
The potential to decentralize the sequencer is perhaps the most likely possibility for revenue rollups’ tokens have.
Kofi, the developer of the economics of rollups dashboard, said that, were a rollup able to decentralize its sequencer, tokens like ARB and OP could gain additional utility.
A decentralized sequencer would give users the ability to participate in its operations by “staking,” meaning temporarily locking, rollups’ tokens. This would in turn pass on some of the revenue which comes from the transaction fees and MEV on a rollup to token holders.
Both Arbitrum and Optimism indicate in their documentation that they plan to decentralize their respective solutions’ sequencer.
Jain said the key reason why the two rollups have launched without a decentralized sequencer is that it’s “technologically really difficult.”
“As soon as you try to decentralize the sequencer you run into the same problems that you do [when] scaling a Layer 1,” he said.
Regulatory Risk Protection
Cynics may find an additional reason for why Layer 2s are releasing “just” governance tokens: Crypto has entered an extremely adversarial regulatory environment in 2023. A token with obvious means to accrue value is more likely to attract the attention of regulators.
Polynya, a well-known researcher in the crypto space, said while rollups’ tokens may not be indispensable, they’re at least useful.
“They don’t necessarily need a token, but it makes decentralizing governance, ownership and upgrades easier,” they said. “So I’d expect most L2s to have one.” The researcher added that a foundation can use a token for grants and other incentives as well as helping an L2 to decentralize its sequencer.
Looking forward, Jain sees a world where rollups are going to essentially split off from Ethereum, the blockchain currently responsible for securing the scaling solutions. The investor said this will come from the projects’ own token holders as they try to capture more value through their digital asset.
“I think that that battle’s coming in a year or two is my guess,” he said. “Once the colony gets big enough they start to want things, like independence.”