Brett Palatiello & Omid Malekan

TLDR: The most important feature of any blockchain network is decentralized security. Achieving this state via cryptoeconomic incentives can be a powerful moat for layer-1 chains. But smart contract rollups inherit the decentralized security of an L1 chain, so they won’t have the same moat. This inability to distinguish themselves will lead to fierce competition and ultimately low profit margins for sequencers. This is good for users and adoption.

Introduction

Finding sustainable moats in crypto has always been a challenge. The combination of censorship resistance and transparency allows for the free flow of users, value, and information, which should lead to near-perfect competition.

An exception to this phenomenon is layer-1 blockchains such as Ethereum that have achieved the coveted status of being both decentralized and secure. Decentralized security is the primary feature of crypto, and the cryptoeconomic security provided by $200b in market cap—20% of which is now staked—is hard to top.

This gives Ethereum a protective moat. Other L1s offer lower transaction fees and arguably better tech, but aren’t as decentralized or secure, so Ethereum’s network effects remain strong.

Rollup-style solutions built on Ethereum, on the other hand, will have a much harder time differentiating themselves. L2s have fewer moats than L1s.

Rolling-up is easy to do

Censorship resistance means that anyone can launch their own rollup on Ethereum. Some teams already have, and more are coming. Unlike the base layer, smart contract rollups don’t need to achieve their own cryptoeconomic security. They can simply leverage Ethereum for data availability using cryptographic proofs. This makes it harder for rollups to differentiate themselves.

They can do so technologically—something we’ve already seen given the dichotomy of optimistic and zero-knowledge rollups—but these are fleeting differences. They can easily imitate each other. A prescient example is zkSync controversially using code from the Plonky2 proving system developed by Polygon Labs. Users care about security more than any other feature. And while the present state of these rollups offer material differences in proving systems, finality, and EVM-compatibility, many of these features will converge in the future.

Further exasperating the competitive landscape for rollups is the availability of safer bridges. Unlike L1 to L1 bridges, bridging between smart contract rollups is more secure because they share the same data availability layer.

Put together, these factors make it easy for new teams to launch new rollups, and for users to try them. But this ease cuts both ways, as new competition is always around the corner and user activity can be fleeting.

Examples of this phenomenon already playing out include:

  • Multiple general purpose rollups such as Optimism, Arbitrum, zklSync Era, Starknet, and Mantle launched a while ago
  • Others such as Scroll and Taiko are on the way.
  • Existing Layer 1s like PolygonPoS and Celo have decided to convert to rollups
  • Planned rollups tied to centralized entities like Base are on the way
  • The once popular “app-chain” approach is increasingly thought of as the “app-rollup” approach
  • Multiple app specific rollups such as Immutable X and dYdX are already live

A skeptic could argue that entirely new L1s are also always around the corner, but those need to achieve a minimum amount of security and decentralization to attract significant adoption. Rollups can have both from the start.

The proliferation of Ethereum rollups and the ease with which users can move back and forth across them is likely to impact the economics of these projects. If all rollups offer more or less the same amount of security and finality then the main differentiator will be transaction fees.

Today, rollup sequencers are thought to be highly profitable, and their profitability will likely increase once EIP-4844 is implemented, reducing their costs. But the ease of launching new rollups will lead to greater competition and thus the desire to continue lowering fees. It’s also possible that some rollup operators (such as Coinbase) will treat their platform as a loss leader, subsidizing user transaction fees to attract more people to their ecosystem.

Sources of differentiation

The proliferation of rollups is unlikely to last forever. Like most things in crypto, there is likely to be consolidation as the space matures. Rollups that hope to distinguish themselves can do so along the following axes:

Operational effectiveness (AKA don’t screw it up) Just because a rollup can inherit most of the security of Ethereum doesn’t mean that it will. A bug in its smart contract, proving system, or sequencer can be catastrophic. The reputational hit may be difficult to overcome.

Liveness (AKA rarely need to use the forced inclusion mechanism) Rollup users take solace in the ability to withdraw assets to Ethereum if something goes wrong with the sequencer or if they are being censored. But this contingency plan is not good enough for applications like DeFi where delayed inclusion could be deadly (e.g., a censored user has a loan liquidated before they can force the issue on Ethereum). An adequately decentralized sequencer set will be a critical determinant of liveness.

Governance (AKA the protocol is reflective of its community) Like most things in crypto, how a decentralized solution governs itself should never be taken for granted. Effectiveness is only revealed in time and usually after the project is forced to weather a crisis.

How a rollup handles governance may be tied to its own token. While the security guarantees inherited from the L1 diminish the need for a native L2 token, having one can aid in decentralizing the sequencer set—a desirable feature for rollups aiming for reliable liveness.

Tokens also play a role in decentralized governance, for the simple reason that there is no other way. Most rollup projects also offer tokens in incentive programs, but it’s unclear if bribing developers or users has any lasting value, as everyone could do it.

Conclusion

The lack of protective moats and proliferation of rollups will benefit users. Fees will come down and some projects will try to differentiate themselves with greater reliability. Rollups that achieve vibrant ecosystems around important activities (like DeFi) will have staying power.

The biggest losers will be alternative L1s who also compete by offering cheap blockspace and less efficient rollup projects that can’t keep up with the competition. Ethereum’s network effects will be further entrenched.