As the bear market progressed, DeFi total value locked (TVL) witnessed a return to ETH-centric ecosystems, and capital sought harbor in proven projects with well-funded and trustworthy developer teams. Ethereum layer-2 (L2) solutions were, therefore, center and front as they offered significantly lower transaction costs, a less congested network, innovative protocols, and fresh monetary incentives compared to the OG Mainnet. Following the successful Mainnet Merge, implementation of sharding is next on the roadmap to give Ethereum more capacity to store and access data. This will not only make the base layer more scalable, but also allow L2 rollups to achieve 100,000 transactions per second (TPS) making L2s even more scalable and affordable. Among L2s, Optimism and Arbitrum, both which follow the optimistic rollup technology route, have taken the majority of focus so far. The two chains currently sit comfortably in the top 10 TVL rankings of DeFi Llama, with Arbitrum ranking 6th, and Optimism ranking 7th as of 21 October. The launch of Optimism Summer revived memories of DeFi summer, but Arbitrum has been attracting more TVL than Optimism recently, even without an ongoing incentive program. We think this is not only due to Arbitrum Odyssey’s implied monetary incentives, but also the impressive organic innovation that outpaced its competitors.

In this article, we will first go through what exactly Arbitrum does and how it differs from L2 peers in the technical stack. We will then investigate the impact of past ecosystem incentive programs including Optimism Summer and Avalanche Rush to gauge what can happen when Arbitrum resumes Odyssey and launches its own incentive campaign. The article will wrap up with evaluations of emerging and upcoming Arbitrum-native protocols that, in our opinion, have delivered interesting new aspects into the world of decentralized applications (dApps).

What Is Arbitrum?

Arbitrum is a L2 built to scale Ethereum. It does this by utilizing optimistic rollup technology. The rollups work by executing transactions on a L2 rollup chain while a node, called a sequencer, rolls up and subsequently posts transaction state data to the Mainnet. This method of processing transactions has the advantage of compressing the data posted to Mainnet while also reducing the cost of writing transactions to layer-1 (L1) by grouping multiple transactions in each rollup batch. Figure 1 shows the different existing scaling solutions apart from optimistic rollups.

Arbitrum differs from Optimism in several important areas, despite both following the optimistic rollup tech route. Arbitrum conducts multi-round off-chain fraud proofing compared to Optimism’s single-round fraud proofing executed on the L1. Arbitrum’s method is, theoretically, more efficient and, hence, more cost-efficient. Arbitrum also uses its very own Arbitrum Virtual Machine (AVM) that supports both the Solidity language and all other EVM compiled languages such as Yul and Vyper. In contrast, Optimism uses Ethereum’s EVM, hence, only has a Solidity compiler. This makes Arbitrum far more extensible.

Arbitrum Nitro

Arbitrum One upgraded to Arbitrum Nitro on 31 August 2022 in order to improve efficiency as well as to speed up Ethereum scaling. Arbitrum Nitro is a fully integrated, complete L2 optimistic rollup system, but with architectural improvements such as fraud proofs, advanced calldata compression, and Geth tracing compared to pre-upgrade. Arbitrum Nitro was able to remove the network’s limitations thus significantly increasing the network’s transaction capacity. Following the upgrade, the average block time halved while the average block count more than doubled on Arbitrum. 


Advanced calldata compression was a significant upgrade that helped compress transaction data sent back to the Mainnet for validation, lowering transaction costs on Arbitrum even further. While Arbitrum already has 90 to 95% lower fees than Mainnet, calculations show that the Nitro upgrade could reduce fees by another 27% by eliminating zero bytes. At the time of writing this article, Arbitrum charges the lowest fees for sending ETH, and the second lowest fees for swaps among other L2s (Figure 2).

The crème de la crème of the Nitro upgrade is a new prover that can process Arbitrum’s interactive fraud proofs using WebAssembly code. This means that the Arbitrum engine can now be written and compiled using standard languages and tools, rather than the previously used custom-designed language and compiler. As a result, those building on Arbitrum will have a much more streamlined and intuitive experience, which could further attract developer talent and foster a stronger innovative builder community.

Arbitrum Odyssey

Although Arbitrum has not launched a token incentive program yet, they previously launched Arbitrum Odyssey on 21 June 2022, an 8-week program which incentivized users to explore Arbitrum’s ecosystem with NFTs. Arbitrum collaborated with NFT artists, Ratwell and Sugoi, as well as with Project Galaxy (now known as Galxe), a Web3 credential provider. Users had to complete missions consisting of on-chain actions such as swaps and bridging assets to Arbitrum to claim NFTs designed by Ratwell and Sugoi on Galxe’s website. If users collected at least 13 out of the total 16 NFTs for this campaign, they would have been eligible for an NFT, signifying the completion of the Odyssey. The campaign only lasted until 29 June 2022 before it was suspended due to network congestion, which caused gas fees to significantly increase. The Arbitrum team decided to put Odyssey on hold until after the Nitro upgrade. However, the date of resumption has not been announced as of the time of writing this article despite a successful Nitro upgrade. During the brief Odyssey, the number of daily transactions on Arbitrum doubled from 121K on to 244K. 

History Doesn’t Repeat, But Often Rhymes

We review the impact that previous incentive programs, most notably, Optimism Summer and Avalanche Rush, had on their corresponding ecosystems in the following section.

Optimism Summer

The launch of Optimism Summer was incredibly successful. The Optimism token (OP) rose 4× from the lows on 13 July 2022 after initially falling post-airdrop (Figure 3). Optimism TVL went from US$281.4M at the start of the incentives program to a peak of US$1.21B in mid-August (Figure 4).

Next, we observe how leading protocols on Optimism performed during Optimism Summer. Velodrome, an Optimism native automated market maker (AMM) protocol, will be used here for case study. It demonstrated that token incentive or liquidity mining programs could greatly help bootstrapping (and, to a certain extent, maintaining) the TVL of protocols with a strong value accrual mechanism. 3M OP tokens were allocated to Velodrome as part of the Optimism Summer incentives. TVL for Velodrome grew from US$24.59M on 13 July 2022 and peaked at US$136.63M on 31 July 2022, increasing by 455%. However, the TVL has significantly dropped ever since then due to market conditions, as well as an exploit on 4 August 2022 that resulted in a loss of US$350K in operational funds. Meanwhile, Velodrome’s token, VELO, went from US$0.012 on 13 July 2022 to US$0.073 on 31 July 2022, increasing by 482%, although it has since declined, especially after the aforementioned exploit (Figure 5). 


VELO utilizes the veToken model, similar to that of Curve. On top of locking up veVELO to vote on gauge weights for LPs, veVELO voters also earn all of the fees and bribes for the liquidity pairs that they have voted for. The innovative value accrual mechanism of VELO, paired together with 750K OP incentives (out of 3M), jointly contributed to the TVL increase. 1.75M OP incentives were also used for bribe matching, vote boosts, and liquidity provision for partner tokens.

Apart from Velodrome, other protocols such as Rubicon and Thales rolled out incentives 2 days after Velodrome. As we can observe from the charts below (Figures 6-8), the Optimism Summer incentives have catalyzed TVL growth for these 3 protocols , with Rubicon enjoying the most growth percentage wise.

All of the TVL bootstrapping featured above were achieved despite several controversies involving Optimism following a botched airdrop. The price of the OP token dropped from US$4.50 to US$1.20 immediately after the airdrop. Users complained that some claimants were able to front-run prior to the airdrop’s launch, and a portion was allocated to airdrop hunters who used multiple wallets to generate inorganic OP ecosystem interactions, only to dump the token right after. 

The OP airdrop fiasco could be a reason for the Arbitrum team’s postponement of their own incentive program and airdrop, since the system’s projects enjoyed impressive organic TVL growth even without monetary incentives.

Avalanche Rush

If Optimism Summer reminds you of sipping a Piña colada at the beach, the Avalanche Rush might bring back the memory of speeding through a snowboard course at a ski resort. Avalanche Rush (AR), which took over the L1 wars by storm, experienced a 600% increase in its native token price (AVAX) from July to November 2021. The surge was fueled not only by bullish macro markets, but also by significant interest in the Avalanche ecosystem projects.

Avalanche Rush (AR) is a US$180M liquidity mining incentive program that aims to expand the ecosystem by introducing new applications and assets. The incentive program was announced on 18 August 2021, which boosted AVAX’s TVL from US$285M to US$12.15B in just four months (Figure 9). AR Phase 1 included top DeFi protocols such as Aave (US$20M) and Curve (US$7M). Other protocols, such as BENQi, StakeDAO, and Avalanche Bridge, were also bootstrapped with AVAX tokens as user incentives.

TraderJoe, Avalanche’s largest native decentralized exchange (DEX), saw its TVL jumping 18× within just 10 days after the initial incentive program was announced, despite the protocol not being part of AR initially. TraderJoe’s later participation in AR further boosted its TVL to a peak of US$2.55B from US$1.23B in less than a month. The protocol’s native token (JOE) rose from US$0.03 to an all-time high of US$4.61 (Figure 10).

Similarly, other protocols in the Avalanche ecosystem saw their TVL (Figure 11) and token price skyrocket as a result of the incentive program, bringing in a flood of new users and capital.

The key distinction between Avalanche Rush and Optimism Summer is the intrinsic value of the native token airdropped to users. AVAX is the Avalanche blockchain’s native token that is used to secure the network through staking, pay for gas fees, and it serves as a basic unit of account between Avalanche’s multiple subnetworks. Avalanche also has a mechanism that burns all gas fees, allowing it to reduce the total effective supply. At the time of writing, more than 1.99M AVAX tokens have been burned since the mainnet’s launch in 2021, worth approximately US$29.7M at current value. Prior to Terra’s implosion, the overall rate of burn for AVAX had been increasing since the AR inception in August 2021, reflecting the increasing usage of the Avalanche chain (Figure 12).

The Optimism OP token, on the other hand, only grants participation rights in the Optimism Collective, which includes both governance houses (Token House and Citizen House). OP adds value by redeploying sequencer revenue, creating a value ecosystem, and driving blockspace demand. However, unlike Avalanche, Optimism lacks a mechanism for burning gas fees. Furthermore, OP is not the Optimism network’s native gas token.

Another significant difference between Avalanche and Optimism is that AVAX is locked in validator staking. On Avalanche, validating a subnet necessitates validating the C-Chain. Any validator must stake at least 2K AVAX. More AVAX will be staked as more subnets are launched, regardless of their gas token. As new subnets are launched and validator demand increases, new nodes will need to be spun up to meet that demand, leading to more staked AVAX. At the time of writing, 65% of AVAX’s total supply is staked.

In contrast, Optimism does not currently feature a validator staking model. This casts questions on $OP’s intrinsic value as the token lacks a value accrual method.

Both Optimism and Avalanche had similar TVL at the start of the incentive program (Figure 13). However, Avalanche gained more than twice the amount in TVL compared to Optimism, likely partially due to the difference in market conditions when the two incentive programs occurred. Therefore, any projection of Arbitrum’s TVL trajectory after its own incentive program is launched will need to be assessed together with market conditions at that time. 

As of 21 October 2022, Arbitrum has US$937M in TVL. With the launch of its incentive program, Arbitrum TVL could reach somewhere between US$1.9B to US$3B. As we can see on DeFiLlama, Arbitrum managed to reach an ATH TVL of US$2.6B back in November 2021. Although market conditions were much more favorable then, the Arbitrum ecosystem is much more mature now with over 120 protocols, even more than Optimism’s 79 protocols. Moreover, Arbitrum managed to reach these levels of TVL even without monetary incentives.

Since Optimism and Arbitrum are very similar in nature, we believe that Optimism Summer is a good reference point since it was more recent. Hence, by using the FDV/TVL ratio of Optimism a month after Optimism Summer at 6.54, Arbitrum’s fully diluted valuation (FDV) after an incentive program lies in the range of US$11.4B to US$11B.

The Rising Stars of Arbitrum

Arbitrum is well-known for protocols such as GMX, Radiant, and Vesta Finance. In this section however, we will take a closer look at some of the emerging protocols on Arbitrum that offer intriguing innovations.

Sperax

Sperax is a protocol that issues its stablecoin, Sperax USD (USDs). USDs is 100% backed by other stablecoins which currently includes USDC, DAI, VST and FRAX. Users can mint USDs with these four stablecoins in combination with SPA, the governance token of Sperax. Minting of USDs burns SPA, while redeeming USDs would mint SPA and return the stablecoin of the user’s choice. The interesting feature of USDs, compared to FRAX which adopts a similar mint/burn mechanism with assets and its governance token, is that USDs generates auto-compounded yield automatically for holders. The collateral of USDs is used to produce the yield for USDs holders and SPA stakers, adopting the following strategies:

  1. Frax | Curve-LP FRAX/VST – FRAX and VST from vault-core are deposited into the Curve FRAX-VST pool and the LP tokens are staked in the Frax gauge. Revenue generated from the strategy is in the form of fees (in FRAX and VST) and farm rewards (in FXS and VSTA).
  2. Stargate | Stargate-LP USDC – USDC from vault-core is deposited into the Stargate USDC pool and the LP tokens are staked in the Stargate farm. Revenue generated from the strategy is in the forms of fees (in USDC) and farm rewards (in STG).
  3. Aave | DAI – DAI from the vault-core is lent to the Aave DAI market. Revenue generated from the strategy is in the form of fees (in DAI) and rewards (in Aave).

The Sperax team ensures that collateral is only deployed in audited DeFi projects to generate reliable and organic yield. Strategies can be proposed by the team or the community, and then voted on to determine adoption. SPA can be staked and locked up for a fixed period for veSPA (vote-escrowed SPA) which grants voting rights. The longer the lock-up period, the more veSPA and, hence, more voting power allocated to the staker. All veSPA holders are also entitled to rewards including:

  • Yield Share Rewards – 25% of the yield generated by USDs protocol
  • Fee Rewards – 100% of the fee income from USDs mints and redemptions
  • Incentive Rewards – Staking incentives sponsored by the Treasury to bootstrap the staking protocol

As the TVL for collateral deposited to mint USDs increases, more fees are earned from the minting of USDs, resulting in more rewards for SPA stakers, incentivizing buying and staking of SPA to share protocol revenue. With increased minting of USDs, more SPA tokens will be burnt, leading to deflationary tokenomics. As of 21 October 2022, it has a deflation rate of 7.66%.

SPA price and Sperax TVL are not very correlated as current macro market conditions are depressing altcoin performances. However, since stablecoin yields may be more sought after in a bearish market, Sperax has the potential to outperform peers should an incentive program bring TVL to the Arbitrum ecosystem. Thus far, USDs’ has largely held its peg, with its largest depeg at US$0.943 on 11 September 2022 before restoring within approximately an hour. With transparency on the collateral being deposited and the strategies being used to gain yield on Sperax’s official analytics site, it is an Arbitrum protocol to be looked out for.

The next section will discuss unique protocols which we find interesting, but have not fully launched yet.

Single Trade Finance Exchange

The first up and coming project to look at is Single Trade Finance Exchange (STFX). It is a DeFi/SocialFi protocol that allows traders to share their trading ideas in the form of Single Trade Vaults (STVs). 

STVs are vaults where users invest their money to copy trade strategies. An STV only executes one pre-defined strategy. Investors of the vault will be entitled to 80% of the profits of the trades, while the remaining 15% and 5% goes to the vault manager and the protocol, respectively. There will be no performance fees charged for vaults that break even or make losses. There are also no management fees for STVs.

The following are the steps required to set up an STV:

  1. Manager outlines trade parameters: instrument type, direction, approximate entry, stop or liquidation, take profit, and leverage. The managers have the autonomy to disclose or hide trade parameters.
  2. Manager “initiates” the vault, which pushes the underlying trade parameters from step #1 as metadata into a smart contract on Arbitrum.
  3. Following initiation, the STV fundraising period commences. The fundraising will be complete when one of the following ensues: the vault raise capacity is hit, or the duration limit expires.
  4. Once the fundraising is over, a commission fee is levied on the vault, and the collected capital is autonomously transferred to GMX. This capital is then used as margin collateral to execute the trade according to the contract specifications of step #2.
  5. The trade is executed on GMX.
  6. Once the position is closed (TP/SL/liquidation is triggered), the P&L is sent back to the Arbitrum smart contract.
  7. If profit is generated, the manager and STFX platform performance fees are debited, and investors can claim their original principal and accrued profits.
  8. If the trade resulted in a loss, investors can claim their original principal without the accrued losses.

STFX’s token, also named STFX, can be staked or held for multiple benefits which include:

  • Fee Rebate – Token stakers will be granted fee reduction and rebates on STVs, both as managers and investors.
  • Governance Decisions – Token holders will have pro-rata influence over governance parameters and future implementation proposals. This could include raising or lowering vault capacities, adding new tradable instruments, integrating new DEX protocols, raising or lowering fee structure, etc.
  • STV Capacity – Managers will have vault restrictions based on their historical profile. In addition, the protocol will set a hard-capped maximum dollar value that STVs can raise. As managers accumulate more history, they will unlock more features for future vaults. Staking STFX into their vault will allow them to access these perks more quickly, and allow them to raise higher collective values.
  • Priority Access – Large STFX token holders will get first access rights to high-profile manager STVs that may be otherwise oversubscribed.
  • STV Advertising – In a competitive marketplace for investor mindshare, managers will be able to stake and/or buy and burn STFX to get higher visibility on the protocol’s discover page.

To accrue value to STFX token, stakers will receive 80% of protocol revenue, with the remaining 20% accruing to the DAO treasury. Rewards will be paid out to stakers in USDC weekly. Staking will be subject to a 1-week “cool down” period before becoming re-liquid. 

STFX opens up a new financial primitive in DeFi. It is disruptively innovative as it expands into the market of copy-trading and democratizes a portion of asset management business. Prospective traders or strategists can monetize on their ideas and intellectual properties, while investors enjoy wider access to strategies previously too complicated or time-consuming to develop on their own.

nftperp

Last but not least, we would like to introduce nftperp. As the name suggests, nftperp is a perpetual futures exchange for NFTs. Traders can go long or short on the floor price of different NFT projects. Up to 5× leverage is provided and traders have to use ETH as collateral to trade. Nftperp has teamed up with Upshot, a provider of NFT analytics, and Chainlink to provide the floor price feeds. For now, only NFTs that are deemed blue chips are available. Nftperp uses a modified virtual Automated Market Maker (vAMM) model, adopted from Perpetual Protocol. vAMM does not need liquidity providers and uses the same x*y=k constant product formula as actual AMMs.The trader’s collateral is kept in a smart contract vault, and the price is discovered through the AMM formula. The vAMM simply acts as an independent settlement market where all profits and losses are directly settled in the collateral vault. One trader’s profit is another trader’s loss – just like normal perpetuals, every perpetual trading pair on nftperp will also have a standard 8-hour period funding rate. Nftperp also plans to launch its token by the end of this year although there are no specific details as to what the token will be used for.

NFT perpetual trading opens up the NFT markets to further securitization. Collectors can use perp to hedge their market beta while speculators can participate in a capital efficient way. Moreover, the pricing of rarity features are now implementable: buying a rare BAYC that is higher than floor price due to rare features while shorting BAYC floor price perp yields the market pricing of said rarity values. Of course, the NFT perps market might run into the similar lack of liquidity and oracle manipulation risks like its predecessors, but the innovation has a huge addressable market. To get a general idea of perpetual trading in crypto, readers can check out one of our previous insight articles.

The Future Of Arbitrum and ETH L2s

Arbitrum Nova

Arbitrum consists of 2 chains currently. They are “Arbitrum One”, an Arbitrum rollup chain, and “Nova”, an Anytrust Chain. An Anytrust chain offers lower fees at the cost of trustlessness, because data is managed off-chain in Anytrust while always posted to the L1 in the Arbitrum rollup chain. Arbitrum Nova is a chain that is suited better for some gaming and social applications as the need for speed outweighs the need for security. We believe such design of Arbitrum improves the interoperability potential of the ecosystem and positions it steps ahead of competitors in this aspect.

Would ZK-Rollup Overtake Optimistic Rollup Chains?

As we have mentioned, ZK-rollup is another ETH scaling solution but most of the chains that follow this technical route still lack in terms of ecosystem building. Using Immutable X (IMX), an NFT-focused L2 that uses StarkEx ZK-rollup technology as an example, the trading volume of the top 10 NFT collections on IMX do not even add up to half a billion dollars. Meanwhile, Loopring, a L2 that utilizes ZK-rollups to enable high-throughput, low-cost trading, and payments on Ethereum, only processed about 8.54M transactions as of 21 October 2022, over the course of its lifetime of 190 days. Arbitrum and Optimism, have processed ~12M and ~13M transactions respectively just in Q322. Admittedly, there are more successful ZK-rollup chains when it comes to adoption, such as dYdX which uses StarkEx ZK-rollup technology (to be noted that dYdX V4 will be on Cosmos instead). The complexity of the ZK-rollup technology makes it less compatible with EVM as compared to Optimistic rollups, which hinders the developer community’s growth to a certain extent. However, it is very likely that there will be similar incentive programs for ZK-rollup chains with a deep warchest from VC backers – we will then be able to tell which ecosystems will become more organic.

Conclusion

To sum up our observations on the Arbitrum ecosystem, we believe the chain is on the right track in both technical and ecosystem aspects. On the technological layer, Arbitrum’s infracture of one rollup plus one Anytrust chain enables easier interoperability within its ecosystem in the future, as builders, notably from GameFi/Metaverse, can capitalize on the specialized design. On the application layer, Arbitrum has amassed an impressive roster of TVL behemoths without a formal incentive program – organic growth of a developer community and capital from early believers (Arbitrum maxi) is critical to an ecosystem’s sustainable expansion. We are already witnessing the spontaneous innovation sprouting from Arbitrum communities as demonstrated in the emerging and upcoming projects, compared to some other newer L1 and L2 competitors that are still relying on VCs’ injection to attract mercenary talents. 

An incentive program, on top of current organic growth, could potentially propel the ecosystem to the critical mass of becoming a permanent contender in the DeFi and blockchain application space. BUIDLers ourselves, we at Treehouse truly admire the pioneers in Arbitrum ecosystems. And finally, WAGMI.

Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up to date or accurate.