Let’s Talk About Crypto Protocol Layers and Why Investors Must Examine Them

Finding new and profitable investment ideas is the unending task facing any investor or allocator of capital. While bitcoin (BTC) and ether (ETH) dominate the discussion around cryptocurrencies, the opportunity set for investors expands well beyond.

Some of those candidates are, however, intrinsically tied to the Bitcoin and Ethereum blockchains, borne out of the need to enhance their capabilities. Bitcoin and Ethereum are known as layer 1 (L1) protocols, and these attempts to scale and expand them are called layer 2s (L2).

An L1’s value stems from “blockspace,” territory on a blockchain where information or a smart contract lives. BTC, ETH and tokens for other L1s are valued based on demand for that. They are, so to speak, the tickets to a dance and cost more when more people want to attend; one reason to buy is because you expect higher prices later due to people scrambling to get in the door.

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Bitcoin lets people engage in peer-to-peer transactions; the price of BTC rises with demand for that. Ethereum and similar L1 protocols grant people access to smart contracts, decentralized finance (DeFi) protocols and, eventually, stuff we can’t currently envision; ETH and its peers ride along with that.

But blockspace is scarce. And Ethereum, the biggest smart contract-based layer 1, cannot handle anything close to the volume seen elsewhere in finance. It can process a few dozen transactions per second, trailing the Visa network or New York Stock Exchange by several orders of magnitude – a big obstacle to decentralized finance (DeFi) taking over traditional finance tasks.

So, if a layer 1 protocol is a room people are rushing to get into, imagine a long line at the door and skyrocketing price of admission. That’s where layer 2s come in. They act like an overflow room at a convention. If you can’t get into the main auditorium to see the hot keynote speaker, you can get into a side room with a TV screen showing their speech and meet with other attendees.

An L2 is similar. It is a place where transactions can be offloaded from the L1 for faster and/or cheaper processing, but the trades are intrinsically linked to and can be fed back into the L1. If an L1 is a room people want to get into, L2s represent the construction of new ways to get inside, allowing broader access and reducing congestion.

For Ethereum, well-known layer 2 protocols include Polygon, Arbitrum and Optimism. For Bitcoin, there’s Stacks.

Like their L1 counterparts, L2 protocols generally have their own native token, which serves as an incentive to use the network. As an investor, I view a layer 2 as an investment in the infrastructure that allows greater access to the main room, while providing space for developers to build new and useful things. And so even if I don’t know what those useful things are yet, I know that more levels and doorways are needed in the building itself. Knowing that, I want to invest in the materials that will provide the new infrastructure.

Let’s examine a few:

• Polygon is the first layer 2 platform that comes to mind for most. Acting as a scaling system, the platform lets developers build decentralized applications on Ethereum. It’s much faster, capable of about 65,000 transactions per second versus 30 on Ethereum. JPMorgan generated buzz last year by doing a DeFi trade using Polygon. Its native token, MATIC, currently has a $9.8 billion market capitalization and revenue of $47 million. Year to date, MATIC is up 48%.
• Immutable X operates as a scaling system for non-fungible tokens (NFT), aiming to address high gas fees and slow processing times. Its native token, IMX, lags behind MATIC in market capitalization at $880 million. The dispersion between the two highlights both MATIC’s significant market share and the potential opportunity for the tokens that fall behind it. Year to date, IMX is up 173%.
• Stacks has made quite a splash in the past month or so. While Polygon and Immutable X help Ethereum scale, it is focused on Bitcoin, where it has enabled NFTs known as Ordinals. Stacks has expanded Bitcoin beyond just peer-to-peer transactions, which has, for good reason, caught the eye of the crypto community. Its native token, STX, leads all crypto assets with market caps in excess of $1 billion in year-to-date performance (up 254%).

The layer 2 list certainly doesn’t stop here. Optimism (OP), Loopring (LRC) and numerous others are designed to increase utility within the crypto ecosystem. Also, Arbitrum has gained major traction as an Ethereum L2, having recently surpassed it in terms of number of transactions in a 24-hour period.

The success or failure of these projects will be determined over time, but the impact, opportunity and access they provide should be on everyone’s mind.

Takeaways

From CoinDesk’s Nick Baker, here’s some recent news worth reading:

• SILVERGATE SAGA: New week, new source of trouble. Crypto bank Silvergate said it’s on shaky financial footing by giving the dreaded “going concern” warning. But something else it did might matter more to the institutional community: It closed the Silvergate Exchange Network (SEN), a platform that helped traditional finance (TradFi) players tie into crypto exchanges. It was a “24/7 instant settlement service the bank's clients could use to conduct transactions between each other at any time, including nights and weekends,” according to a recent CoinDesk story. It was an important service given so much of TradFi is not 24/7; this was a vital bridge. Signature Bank's Signet is an alternative, though, and BCB Group is rushing to add features to help fill the gap.
• COURT BOMBSHELL: Courtrooms generally aren’t as exciting as they’re portrayed in movies and on TV. But the Voyager Digital bankruptcy case got spicy last week when a U.S. Securities and Exchange Commission official said agency staff believe Binance.US is an unregistered securities exchange. While the SEC’s five commissioners would have to back that statement for it to have any teeth, in the dense thicket of Washington regulation-ese this counts as high drama and a big allegation.
• ANOTHER BOMBSHELL: SEC Chair Gary Gensler rejected the idea that exchanges could be safe custodians of crypto assets. "Based upon how crypto trading and lending platforms generally operate, investment advisers cannot rely on them today as qualified custodians," he said at a recent meeting. "To be clear: Just because a crypto trading platform claims to be a qualified custodian doesn’t mean that it is." The government crypto crackdown is getting real, real fast.
• COINBASE DEAL: Coinbase has acquired One River Digital Asset Management, an institutional crypto asset manager and SEC-registered investment adviser. This is approximately item number 19,362 on the list of examples over the years of TradFi and crypto intersecting (or trying to), but arguably one of the bigger ones. What Coinbase bought is an onramp for conventional finance players to get into crypto. Conventional finance players actually getting into crypto in a big way remains the elusive Holy Grail, but Coinbase is positioning itself for if/when that finally happens.

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