Arbitrum / Optimism pairs trades

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TLDR;

• Layer 1 blockchains face scalability challenges. Layer 2 solutions address these challenges by operating independently from the main network, improving scalability, reducing fees, and maintaining security.

• Optimism, Arbitrum, and Boba Network are layer 2 solutions addressing scalability challenges on the Ethereum network. They offer high throughput, low fees, and EVM compatibility.

• Arbitrum stands out by offering enhanced scalability, seamless compatibility, lower transaction fees, and optimized performance compared to its competitors in the layer 2 space. These advantages make it an attractive choice for developers and users seeking to scale their Ethereum applications effectively.

• Arbitrum is significantly undervalued vs Optimism. The margin of safety provides a cushion against errors in judgment or calculation, and in this case, a 38.46% valuation margin exists to give us a significant edge when looking for relative value opportunities.

• Between today and Arbitrum’s next unlock on March 23rd 2024, Optimism will unlock 193,273,528 tokens, representing a 29.98% increase in circulating supply. This means that $229,995,498 in value will hit the market, at an average rate of $919,981 every day until the ARB unlocks.

• In other words, Arbitrum is a more scalable, compatible, and cost-effective solution than Optimism. It is also undervalued on this basis, and there is a large embedded structural edge being long the ARB/OP spread into Q1 2024.

Introduction

Since Vitalik Buterin referred to them as the ‘future of Ethereum scaling’ in his 2021 Shanghai blockchain week speech, Layer 2s have been some of the fastest-growing blockchain platforms within the Web3 ecosystem - attracting billions in TVL over the past 12 months - more than any other large blockchain platform.

What is a Layer 2?

A layer 1 network, often referred to as the main net, serves as the foundational infrastructure of a blockchain system. It establishes the fundamental rules of the ecosystem and facilitates the validation and finalization of transactions. Major examples of layer 1 blockchains include Ethereum, Bitcoin, and Solana. While layer 1 blockchains prioritize decentralization and security, they frequently encounter challenges related to scalability due to their specific design and resource requirements.

To tackle these challenges, layer 2 solutions have emerged as a means to enhance scalability and overcome the limitations of layer 1. Layer 2 denotes a collection of off-chain solutions constructed on top of layer 1 networks. These solutions operate independently from the main network and aim to address scalability bottlenecks and data processing issues.

An analogy can be made with a shipping and logistics company. Imagine a company that receives numerous orders from different customers every day. Instead of a single person trying to handle every step of the shipping process, layer 2 solutions function as specialized departments within the company. Each department is responsible for a specific task, such as order processing, packaging, transportation, and delivery. By dividing the workload and having dedicated teams for each task, the company can efficiently handle a large volume of orders and ensure smooth operations. This approach is similar to how layer 2 solutions work by dividing transaction processing into separate off-chain entities, allowing for increased scalability and improved efficiency, just like how a shipping company optimizes its operations by assigning different tasks to specialized teams.

Ethereum, for instance, implements layer 2 solutions like Optimistic and zero-knowledge (ZK) rollups. These solutions offload transaction management from the mainnet, enabling higher transaction inclusion rates and increased throughput. Projects such as Arbitrum, Optimism, Loopring, and zkSync offer layer 2 solutions on the Ethereum network.

Layer 2 solutions play a critical role in addressing the scalability challenges faced by layer 1 blockchains. By consolidating multiple off-chain transactions into a single layer 1 transaction, layer 2 solutions reduce data load and associated fees. They maintain the security and decentralization of the mainnet while enhancing transaction speed and user experience.

Layer 2 protocols provide a distinct framework where transactions occur independently of layer 1. The data generated by layer 2 applications is subsequently posted back to layer 1 for verification and inclusion in the blockchain ledger. Rollups and sidechains represent two common types of layer 2 solutions. Rollups, such as Optimistic and ZK rollups, execute transactions outside of layer 1 and aggregate the data for posting back to the mainnet. Sidechains, like XDai and Polygon PoS, operate as independent chains but interact with the mainnet through bridges.

Not all L2s are made equally

Optimism, Arbitrum, and Boba Network are all layer 2 solutions designed to address scalability challenges and enhance transaction processing on the Ethereum network. While they share a common goal, there are differences in their technical approaches, implementation, and features. Let's compare and contrast these layer 2 solutions:

1. Optimism:

   • Optimism is an Optimistic rollup solution.

   • It aims to increase scalability by offloading transaction processing from the Ethereum mainnet.

   • Optimism uses a technique called Optimistic Execution, where transactions are initially executed off-chain and later verified on the main net through fraud proofs.

   • It supports the Ethereum Virtual Machine (EVM) and solidity contracts, allowing developers to seamlessly migrate their applications to layer 2.

   • Optimism offers competitively low fees and fast transaction confirmation times.

   • Its design focuses on simplicity and compatibility with existing Ethereum infrastructure.

   • Optimism has gained significant attention and usage within the Ethereum community.

2. Arbitrum:

   • Arbitrum is also an Optimistic rollup solution.

   • It aims to improve scalability by processing transactions off-chain and submitting aggregated data to the Ethereum mainnet.

   • Arbitrum focuses on achieving high throughput and low transaction fees.

   • It provides an EVM-compatible environment, allowing developers to deploy existing smart contracts to Arbitrum with minimal modifications.

   • Arbitrum uses fraud proofs to ensure the validity of off-chain transactions.

   • Its implementation offers a seamless user experience and compatibility with existing Ethereum wallets and dapps.

   • Arbitrum has gained popularity as a reliable layer 2 solution for Ethereum.

3. Boba Network:

   • Boba Network is an Optimistic rollup solution that originated as a fork of Optimism.

   • It aims to reduce transaction fees, enhance transaction throughput, and strengthen the capabilities of smart contracts on Ethereum.

   • Boba Network focuses on optimizing performance and user experience by offering faster transaction confirmation times.

   • It supports EVM-compatible smart contracts, ensuring compatibility with existing Ethereum applications.

   • Boba Network aims to provide an alternative layer 2 solution with improvements and optimizations compared to other offerings.

   • While still in its early stages, Boba Network is actively developing its infrastructure and gaining attention within the Ethereum community.

   In summary, Optimism, Arbitrum, and Boba Network are layer 2 solutions built on the Optimistic rollup framework. They aim to address scalability issues on the Ethereum network by offloading transactions from the main net. While they share similarities in their technical approaches, each solution has its own implementation, optimization strategies, and developer ecosystem. Optimism and Arbitrum have gained significant adoption and usage, while Boba Network is a promising emerging player in the layer 2 space.

Introducing Arbitrum

Arbitrum is a layer 2 scaling solution for the Ethereum network that aims to address the scalability limitations of the Ethereum mainnet. It is based on the Optimistic rollup framework and operates by processing transactions off-chain and subsequently submitting aggregated data to the Ethereum mainnet.

Arbitrum was developed by Offchain Labs, a company founded by Ed Felten, Steven Goldfeder, and Harry Kalodner. The project emerged from extensive research in the field of scaling blockchain networks, with a focus on optimizing performance and user experience. Arbitrum has garnered significant attention and support within the Ethereum community due to its potential to alleviate congestion and reduce transaction fees.

One key feature of Arbitrum is its ability to support Ethereum's full programming capabilities, including smart contracts and decentralized applications (dapps). It achieves this by providing an EVM-compatible environment, allowing developers to seamlessly deploy their existing Ethereum applications on Arbitrum with minimal modifications.

In terms of its history, Arbitrum has gone through several iterations and improvements. The initial version, known as Arbitrum Rollup, was launched as a developer preview in 2020, enabling developers to experiment and build on the platform. Since then, it has undergone rigorous testing and enhancements to ensure its reliability, security, and compatibility.

Advantages over competition

• Enhanced Scalability: Arbitrum aims to achieve high throughput and significantly increase transaction processing capacity on Ethereum. By processing transactions off-chain and submitting aggregated data, Arbitrum can handle a larger volume of transactions, resulting in improved scalability compared to the Ethereum main net.

• Seamless Compatibility: Arbitrum offers full EVM compatibility, making it easier for developers to migrate their existing Ethereum applications to the Arbitrum layer 2 solution. This compatibility reduces the effort required to adapt and deploy applications on Arbitrum, providing a smoother transition for developers.

• Lower Transaction Fees: Arbitrum aims to reduce transaction fees compared to the Ethereum main net. By aggregating multiple off-chain transactions into a single on-chain transaction, Arbitrum reduces the overall cost per transaction, making it more cost-effective for users and developers.

• Optimized Performance: Arbitrum focuses on optimizing transaction confirmation times, aiming for faster and more efficient transaction processing. The reduced latency enhances the user experience and facilitates the seamless execution of decentralized applications on the Arbitrum layer 2 solution.

While Arbitrum offers notable advantages, it's important to consider some critical aspects:

Competition and Ecosystem Fragmentation: With multiple layer 2 solutions like Optimism and Boba Network also vying for adoption, the layer 2 ecosystem may become fragmented. Developers and users may face challenges in choosing the most suitable solution, and the network effect could be diluted if efforts and resources are spread across different platforms.

Security and Trust Assumptions: As an Optimistic rollup solution, Arbitrum relies on fraud proofs to ensure the validity of off-chain transactions. The security of the system relies on the assumption that fraud proofs are correctly implemented and that malicious behavior can be detected and prevented. Robust security measures and continuous audits are necessary to ensure the integrity and trustworthiness of the Arbitrum network.

Early Stage Development: While Arbitrum has made significant progress and gained attention, it is still in its early stages of development. Further testing and community adoption will be crucial to assess its long-term viability and stability. Users and developers should be mindful of potential risks associated with using a technology that is still evolving.

Valuation Model

Given the nascent nature of the crypto market, there is a large amount of discretion available to approach platform valuations. The most respected and used metrics usually stem from total value locked (TVL), and transaction count which we will break down below.

Total Value Locked (TVL)

Arbitrum: As of July 10th, 2023, Arbitrum's TVL is $2.09 billion, which is more than double that of Optimism's $807 million. This shows that Arbitrum is the more popular L2 scaling solution at the moment.

Optimism: Optimism's TVL has been growing steadily in recent months, but it is still far behind Arbitrum. This could be due to a number of factors, such as the fact that Arbitrum has a larger ecosystem of dapps and a more gradual token unlock schedule.

Transactions per day

Arbitrum: Arbitrum also has a higher number of transactions per day than Optimism. As of July 10, 2023, Arbitrum is averaging 1 million transactions per day, while Optimism is averaging 300,000 transactions per day. This shows that Arbitrum is more widely used by users.

Optimism: Optimism's transaction volume has been growing steadily in recent months, but it is still far behind Arbitrum. This could be due to a number of factors, such as the fact that Arbitrum has a lower gas price and a more user-friendly interface.

Arbitrum is a significantly undervalued investment opportunity.

On the surface, the numbers may not seem significant. However, when we consider the circulating and total market caps, a different story emerges. Arbitrum is significantly undervalued relative to its peer, Optimism.

Arbitrum has over 2.5x the TVL of Optimism, yet the two projects have very similar total market cap/TVL metrics (see below). On a circulating supply basis, Optimism has a 38.46% premium to Arbitrum. This is despite the fact that Arbitrum has a larger ecosystem, lower gas prices, and a better user interface.

This discrepancy can be explained by Warren Buffett's margin of safety argument. Buffett argues that investors should only buy assets that are significantly undervalued. In the case of Arbitrum, the market is not pricing in the company's true value. This creates an opportunity for us to buy Arbitrum at a discount and potentially earn a significant return.

The margin of safety provides a cushion against errors in judgment or calculation. It also protects the investor from unforeseen events that could cause the value of the asset to decline. In this case, the 38.46% valuation margin provides a significant edge when looking for relative value opportunities.

Tokenomics

Between today and Arbitrum’s next unlock on March 23rd 2024, Optimism will unlock 193,273,528 tokens, representing a 29.98% increase in circulating supply. At current prices, this means $229,995,498 in value will hit the market, at an average rate of $919,981 every day until the ARB unlocks. In layman's terms - over the next 250 days when Arbitrum unlocks, $919,981 of new money needs to enter Optimism to keep the spread as is, ceteris paribus.

Arbitrum unlocks

Overall, the Arbitrum token unlock schedule is more gradual and staggered than the Optimism token unlock schedule. This means that there will be a slower influx of tokens into the market for Arbitrum, which could help to prevent a sharp decline in the token price.

Optimism unlocks

The Optimism token unlock schedule is front-loaded, which means that a large percentage of the tokens will be unlocked in the early stages of the project. This could put downward pressure on the token price in the short term.

The Trade

Over the next 250 days, we believe there is a significant edge trading ARB/OB on the long side. This is driven by a variety of factors both qualitative (better UX. lower fees, better experience), but more significantly. the 38.46% margin of safety, alongside a structural edge caused by optimism’s $919,981 (per daily average) token emissions.

Since March 2023, when the ARB 0.00 future was launched on Binance, we have seen significant pullbacks of between 10-20% in this spread. With that in mind, we look to position long on any 10% pullback and build a large position here over the coming weeks.