Cryptocurrency infrastructure is growing - do we need so many L2s?

Author: Donovan Choy, Blockworks; Translator: Deng Tong, Golden Finance

The growing negativity about the current bloated infrastructure and lack of consumer applications in cryptocurrencies has reached a fever pitch.

It’s such a familiar topic on social media and podcasts that it has largely become a consensus. Previous cycles saw innovations in smart contract blockchains, ICOs, DeFi, Layer 2, and NFTs, but the new tools of the current cycle are mainly memecoins and increasingly redundant infrastructure.

According to L2Beat, There are currently 71 L2s online, with another 82 coming soon.That doesn’t even include Layer 3. Why so many?  

In an industry where investors are still struggling to find a “fundamental” valuation methodology, the standard approach to valuing upcoming L2s is to perform a comparative analysis (or “comps”) with the largest L2s to determine their potential value. The general idea is that since the largest L2s have already amassed multi-billion dollar valuations, newer L2s should also capture at least a significant share of that pie.

This is perhaps a testament to one of the most successful investment themes in crypto, the “Fat Protocols Thesis.” Written in 2016 by Union Square Ventures’ Joel Monegro, the thesis argues that value accumulation at the Web3 infrastructure layer will generate the most value, in stark contrast to Web2, where value has leaked from the TCP/IP/SMTP protocol layer into the walled gardens of large tech companies.

This idea has largely been realized; of the top 30 crypto tokens by market cap today, 18 are either L1 or L2.

And, thanks to Rollup-as-a-Service (RaaS) providers like Conduit and Caldera, it’s never been easier to launch a Rollup chain. The result is that nearly identical Rollups are competing against each other for capital.

Conduit founder Andrew Huang claims that his company focuses on projects that are “uniquely differentiated from day one.”

“I don’t deny that there is little differentiation between L2s, which has led to users becoming tired of Rollups,” Huang noted.

Market participants may finally be expressing their rejection of Rollups. For example, the much-hyped Blast L2 issued its token at a $2.7 billion FDV, severely below market expectations. The token has since fallen to just over $1 billion.

There’s more to the Rollup story than just hyperscale marketing. Minimizing costs is also a driving factor for most on-chain app builders.

“We’re seeing more and more rollup deployment patterns because as dapps become popular, the ‘rent’ they pay to L1/L2 becomes very expensive,” Huang said. “Chains like Base are charging $50 million in fees, but dapps don’t get a penny.”

However, launching your own application-specific rollup lets your dapp capture those revenues. “It’s a very sound business decision,” he said.

We Still Need Infrastructure

Despite progress in infrastructure, some argue that it’s not enough. Tangible and intangible limitations of existing Rollups remain, such as fragmented liquidity and other friction points in the user experience.

Caldera CEO Matt Katz noted that Ethereum’s rollup-centric vision is exacerbating this situation, “and there could be tens of thousands of these rollups in the future.”

“These rollups are siloed and it’s hard to talk to each other,” Katz said, noting that connecting via the Ethereum mainnet is slow and costly. “There needs to be a more efficient way.”

In Katz’s view, applications and infrastructure must work together. “It’s a mistake to think of it as a zero-sum game,” he said.

Another area where infrastructure development is still lacking is interoperability, which goes beyond cross-chain bridges. This is sometimes called “chain abstraction,” a broad design philosophy that aims to remove all the inconvenience of cross-chain movement for ordinary on-chain users.

Wei Dai, research partner at 1kx, said that Shared settlement bridges, such as Polygon’s AggLayer and Zksync’s Elastic Chain, will help.

“With better interoperability infrastructure, there is no need to rely on external service providers for high-risk cross-chain transfers,” Dai noted. “Shared sorters can guarantee atomic swap transactions across Rollup chains, which is a big improvement in user experience,” he said.

Yes, certain areas of infrastructure are overfunded, and many areas will fail, Dai said. “But there are some underfunded areas, like AVS tools and interoperability layers, that are sorely lacking,” he added.

It may be premature to argue that ignoring infrastructure development is the way to go. After all, the value of infrastructure development is often not immediately obvious. Many of today’s much-cherished consumer innovations are largely emergent and unplanned outcomes, the result of decades of hard work in making piecemeal improvements to infrastructure.

Netflix, for example, was a decade into its mail-order movie rental business before broadband internet became ubiquitous enough to deliver high-quality on-demand streaming services at scale today.

Consumer Apps: Just Do It

So is infrastructure ready for consumer app builders? Vitalik Buterin believes that developers “no longer have any excuses.”

“Until a few years ago, we were setting a low bar for ourselves, building applications that clearly couldn’t be used at scale, as long as they worked as prototypes and were reasonably decentralized,” he wrote in a blog post in May. “Today, we have all the tools we need, in fact, most of the tools, to build applications that are both cypherpunk-esque and user-friendly.”

Venture capital funds may have realized the valuation trap. In the second quarter of this year, the share of crypto infrastructure investments fell to 15% from 24% in the previous quarter, according to Galaxy Research.

Infrastructure builders are working hard, but that doesn't mean consumer application builders are dozing off.

Seed Club, a venture fund organized as a DAO that runs a consumer cryptocurrency-focused accelerator, received 350 project applications in its last accelerator, according to partner Josh Cornelius.

"Historically, it wasn't until the last six months that we've been able to cheaply build great consumer products on the blockchain and easily bring them to market," Cornelius said.

He attributes the success of protocols like memecoin and Farcaster to the growth of abundant and cheap block space and developments like embedded wallet technology.

So why haven’t consumer apps caught on? For Cornelius, a big remaining sticking point is marketing — “the socio-cultural side of things.”

“The hardest challenge for consumer builders is educating users about the novel, differentiated experiences that cryptocurrencies and blockchains bring,” Cornelius said.

The old go-to-market strategies no longer apply.

“We need founders who are great brand builders, who have cultural influence outside of crypto, who can tell the story of what’s happening here in a way that’s accessible and culturally relevant,” he said.