Thoughts on L2 tokenomics

Polynya
5 min readJun 16, 2021

Originally posted on r/ethfinance on 10th June 2021.

We expect to see at least four major smart contract rollups release this year in MVP, and possibly more. While many of them will not release with a token, it’s quite likely they eventually will. I have seen a fair degree of antagonism towards L2 tokens in this sub, so here let’s discuss why they should release their token, and how they could. I’m just thinking out loud here, I’m sure there are some bad ideas in here — hoping to discuss further here.

Before we begin, I’ll note that I expect all rollups to accept transaction fees in ETH, at least as an option.

Why token?

It’s possible to operate a rollup chain without its native token — you simply charge a commission/L2 fees over and above the ETH paid to L1. But here are some ways a native token for the rollup helps.

Decentralizing sequencers and provers

Rollups can have very different models, but let’s assume the most rollups move to a system with decentralized sequencers and provers. Note: I’m including validators/stakers/challengers/defenders in the optimistic rollup case under the “provers” umbrella.

It’s important to incentivize sequencers and provers, and this can be done with the L2 fees + MEV. However, both L2 fees and MEV are directly correlated to activity on the rollup chain, and thus unpredictable and probabilistic. I’ll also assume that rollups will introduce MEV mitigation techniques — indeed, I expect the rollups that have best MEV mitigation to be a significant value proposition for users. So, let’s assume MEV is not a reliable incentive either. This is why L1 blockchains offer issuance subsidies in a native token — to offer a consistent incentive to validators. Of course, with L2s security is not a concern, but rather liveness and censorship resistance. Adding a predictable reward in a native token could bolster incentives sequencers and provers.

Worth noting that sequencer nodes will be significantly more expensive to run than an Ethereum L1 node, due to their high throughput. I do expect innovation around state management that’ll decrease this cost over time, but sequencers are going to need adequate incentives to remain live.

Decentralizing L1 smart contract upgrades

Currently, most rollups and even other non-rollup bridges from L1 use multi-sig smart contracts on the L1 side. Any time the L1 smart contracts for the rollup needs an upgrade or bug fix, currently it’s usually committees that vote. Obviously, this is very centralized. One way to decentralize this process is to use a governance token and execute L1 smart contract changes using governance voting. Personally, I think this is problematic too, but it’s a lot better than a limited committee.

Enabling hybrid solutions like zkPorter

I’ve covered zkPorter in the past, so I don’t want to go into details here. However, we’ll see hybrid solutions like this which complement the rollup model with its own data availability, which is secured by its own consensus mechanism. There’s no way to securely run a proof-of-stake consensus mechanism without a native token, so a token becomes necessary.

Shilling

One of my primary observations around the Arbitrum launch has been the absolute lack of hype or chatter outside of the Ethereum enthusiast circles. Indeed, the same day as the launch, there was several orders of magnitude greater mentions of Cardano, despite Arbitrum being a far superior smart contract platform in every respect and literally launching a fully featured product now. I suspect things will change once Uniswap V3 and top DeFi apps are usable by everyone on Arbitrum, but I believe tokens can have a significant impact in getting people to form shill armies and actively market the product virally. While some may scoff at this, it’s a reality of the crypto world and it’s nothing but evening the playing field.

Decentralizing the protocol with a governance token

With a governance token, you’re decentralizing the entire rollup chain in every way. Sure, a rollup can remain private, and their private investors can be issued dividends from the L2 fees, but it seems very much like most rollups will be fully decentralizing their systems.

Native tokens on smart contract rollup chains have multiple other benefits. Once again, the design space for tokenomics is broad here, and different rollups will have different solutions. But let’s explore one possibility, where the rollup has a governance token.

Distribution

Token distribution has always been a challenge for blockchain protocols. We had the “fair mining” launch in the early days, but this usually ended up with a small number of people mining a significant proportion of the supply. We then had ICOs, but these have gone out of fashion for various reasons. Airdrops were sybil attacked and exploited. In 2020, we unleashed new forms of token distribution — targeted airdrops and usage incentives. UNI proved that a wide, targeted airdrop can be effective, while plenty of other protocols have usage incentives — mostly liquidity mining. Pretty much every new project/token since has followed this model, for good reason.

I believe all rollup tokens should do the same: a targeted airdrop to Ethereum L1 users who may be interested in using the rollup . Perhaps even users on other EVM chains like BSC, Polygon or Avalanche as they’ll likely share the same address. I haven’t thought about a suitable criteria for the airdrop — this a whole complex topic in itself! But here’s where things can get interesting, you can host the airdrop exclusively on the rollup chain. This will incentivize users to come and use the rollup to claim the tokens. Many will sell and move on, but some will come and stay. As a side note, rollups that require new addresses on the rollup chain without the ability to use your Ethereum address may be somewhat limited here.

Usage incentives

It can go beyond just the initial token distribution — users can be gradually distributed tokens based on their usage. Polygon is already experimenting with this, with liquidity mining for MATIC on Aave. Partnerships with top blue chip projects is definitely an avenue to consider. But this can be expanded upon.

This could be — reward for bridging tokens to L1, tokens can be distributed directly tied to using select protocols, or maybe even just transaction fees. Think of these as rebates. The more you use the protocol, the more tokens you are distributed. I’d even expect some rollups to subsidize the L2 fees entirely in the early stages, depending on how intense the competition is. Here’s another idea — how about protocols are rewarded tokens by how much they are used on the rollup chain? This’ll incentivize protocols to market their deployment on said rollup chain. Or, how about giving users a discount on L2 fees based on how many tokens they hold/stake? Alright, I’m just rambling here, so I’ll stop! But you get the idea, there’s a lot of space for creativity here. Of course, the key trade-off here is to ensure inflation stays sustainably low, while maximizing outreach.

Treasury

In addition to native tokens, those L2 fees can continue piling up in the treasury. For most rollups this will be ETH, but it’s possible to collect fees in multiple tokens. At this point, it becomes like any governance treasury — we have plenty of examples from the DeFi space. A portion of these fees can be distributed to token holders, they could be used to buy back and/or burn the token. Governance can list proposals, and grants can be issued for continuing research, development and marketing of the platform.

These are just some thoughts I had, would love to hear you add to it.

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Polynya

Rants and musings on blockchain tech. All content here in the public domain, please feel free to share/adapt/republish.