Understand the Layer2 Project Arbitrum in One Report

Chapter 1 — Introduction of Arbitrum

Table 1. Arbitrum Description

1.1 Technical solutions and features

The Arbitrum solution was proposed and created by Offchain Labs. It was originally a purely research-based academic project, and then gradually turned into practice after continuous optimization and improvement. This solution is also a solution based on Optimistic Rollup, which maintains security through the game model of economic incentives and maintains transaction validity through fraud proofs. The main difference lies in the challenge mechanism and implementation form. Optimism only needs the sorter and validator to perform a fraud proof interaction to determine the result, but Arbitrum believes that an interaction may cause the fraud proof to contain a large number of transactions and exceed the gas limit, and proposes that the fraud proof is caused by an abnormal execution of a single instruction. Not all instructions need to be executed. Therefore, Arbitrum divides the fraud proof into multiple rounds of steps. It only needs to prove that the sorter is abnormal when executing a certain instruction, which can prove that the sorter is evil and save costs.

Arbitrum's scheme is consistent with the main features of Optimism Rollup, so we won't go into details here, and we can focus on the changes brought about by the changes in the fraud proof mechanism.

（1）Multiple rounds of fraud proof interactions. Arbitrum uses multiple rounds of fraud proofs to verify the validity of transactions, reducing the gas consumption required for a single challenge, and there is no need to worry about gas fees exceeding the limit.

（2）Stronger compatibility with EVM. Although the Optimism team's OVM is compatible with the EVM, it is not 100% compatible. Existing projects still need to modify the code when migrating from the first layer. The Arbitrun team's solution is almost 100% compatible.

（3）Multi-step transactions may have security issues. The verification of the validity of Arbitrum transactions requires multiple rounds of interaction, and the built-in virtual machine needs to support an asynchronous mechanism, which is more complex, with a larger amount of code, and may have security issues.

Chapter 2 — Current status of Arbitrum

The performance of Layer2 is second to none at the beginning of 2023, which is in line with the predictions of most institutions and influencers. In terms of token prices, Optimism, Polygon and token on Arbitrum eco are also superior, for example, the token $OP peaked at $3.17 in February and $MATIC peaked at $1.32. As new L1 chains, such as Solana and Terra, are volatile under the influence of the incidents in bear market, the future will still be dominated by Ethereum; it is arguably that the competition yet to come will be between new L1 chains and Layer2. With a small climax in the crypto market, Arbitrum is the vanguard among others.

Currently, Arbitrum is the project with highest TVL in Ethereum’s Layer 2 scaling solution, reaching $3.85B, accounting for 3.63% of all networks combined, and 55.97% in Layer2. And after the Airdrop and economics leaked out, its TVL increased by 21.29%. Arbitrum Rollup is an off-chain protocol managed by on-chain Ethereum contracts, to be precise, Arbitrum is not a blockchain but an off-chain transaction uploaded to the main Ethereum network through a compression algorithm. This approach can partially solve the congestion problem faced by Ethereum, in order for creation of advantages on fast transaction, low gas fee, security guarantee and good user experience.

On March 16, 2023, Arbitrum announced its token $ARB, the DAO governance token for the Arbitrum One and Arbitrum Nova networks. The total initial supply of the Arbitrum token $ARB is 10 billion, with a maximum inflation of 2% per year. In terms of token airdrops, 11.62% of the initial total supply will be airdropped to Arbitrum users, and 1.13% will be airdropped to the DAO treasury that builds applications on Arbitrum. The specific token distribution is as follows:

Chapter 3 — Technical upgrade

In 2022, Arbitrum has been active. In addition to the Odyssey event, technical upgrades were frequently announced, including the launch of the Arbitrum Nova, Arbitrum One and the introduction of a new programming environment, Stylus. Core technical features and applicable scenarios will be dissected in below.

3.1 Arbitrum Nova - An AnyTrust Chain

On July 12, 2022, Arbitrum Network announced the completion of a new chain, Arbitrum Nova. This chain is built on AnyTrust and designed specifically for gaming, social applications and more cost-sensitive scenarios. AnyTrust is rooted on the assumption of minimal trust ensured through the Data Availability Committee. This committee will be responsible for managing off-chain transaction data and providing that data to support batches. As a result, AnyTrust eliminates the 7-day withdrawal period that users have to wait and improves the overall user experience. The core technical feature include:

（1）Sign data availability certificates (DACerts) for bulk transactions and issue DACert.

（2）If the committee is unable to reach consensus, the chain will revert to an Arbitrum aggregation protocol.

（3）Data execution will be performed on L2, and after a challenging period, the new aggregated state will be confirmed on Ethereum.

3.2 Nitro

At the end of August 2022, Arbitrum One was successfully upgraded to the Nitro version, which significantly improves network speed and reduces transaction costs. In general, the following technical upgrades have been made to Nitro:

（1）Some modifications to previous AVM architecture and ArbOS.

（2）The trending WebAssembly (WASM) architecture will replace the older, custom-designed AVM architecture.

（3）Customized EVM simulator is replaced by Geth.

（4）ArbOS will be downsized and rewritten in Go to provide a more optimized bulk-processing and compression system for transactions.

The core of the Arbitrum Nitro technology is a new prover that enables interactive fraud proofs of Arbitrum on WASM code, which is constructable and programmable by standard languages and tools. Also, Gethcore is compiled directly into Arbitrum to be more compatible with EVM.

3.3 Stylus

Offchain Labs, the official Arbitrum development team, has announced the launch of Stylus, a next-generation programming environment for Arbitrum One and Arbitrum Nova. Stylus empowers users to deploy applications with their favorite programming languages (including Rust, C and C++) through WebAssembly smart contract functionality so that EVM programs on Arbitrum can run simultaneously. Stylus is exponentially faster with lower cost and fully interoperable with the Ethereum Virtual Machine (EVM). Although Offchain Labs calls Stylus EVM+, Stylus will not replace EVM.

Chapter 4 — Collaborations across the ecosystem

In the past year, the market share of Arbitrum has grown significantly, and this growth comes from: 1. continued bullishness of Layer2; 2. the expected token offering of Arb; and 3. the growth of applications in the eco, especially native applications. Since the mainnet Arbitrum One went live last September, applications such as Uniswap, Sushiswap and Curve, the leading DeFi protocols on the Ethereum Layer1 mainnet, have been integrated and deployed on Arbitrum One, as well as some well-known cross-chain protocols. The influx of these applications also demonstrates that developers are bullish on the Arbitrum scaling solution.

In June 2022, organizers of the Odyssey event selected the 14 most active projects on Arbitrum, including Cross-Chain Bridge, DeFi, NFT, and Games. The duration of the event was originally planned to be 8 weeks, but was suspended after the first week. The primary cause of the suspension was network congestion in the second week, which resulted in soaring gas fee. At that time, the gas fee has exceeded that on mainnet Ethereum. In fact, it has fully explained that Arbitrum was incompetent for such user capacity in its state at that time.

Although the Odyssey was only held for a week, the event still attracted considerable attention. Arbitrum, combined with NFT, in the form of an event week inspired users to participate and fostered the learning curve of users on Arbitrum's ecology; not only the overall user base is enriched, but also traffic is injected into the ecosystem. At the same time, it is a smart move that expectation of future token offerings is preserved rather than the hasty way of giving out tokens as airdrops.

According data from browsers, 207K addresses were added on Arbitrum from the beginning of the Odyssey on June 21 to the end of the first week. On June 27th, the number of daily new addresses hit the record of 55K, which further proves the success of the Odyssey.

After the Odyssey event, Arbitrum has extended its technical efforts and launched projects with innovative mechanisms in the eco, elevating the degree of expectation for a mini-bull at the end of January to full. Currently, Arbitrum's average monthly active address count for October 2022-January 2023 is 608,365, an increase of 51.2% from September. A corresponding rise in Arbitrum's transaction volume and user base are also in presence.

Chapter 5 — Analysis of trending projects

In the past 2 months, native ecological projects on Arbitrum have been the center of the whole crypto market. Some projects are sorted out in below that the market cap on each of these projects is lower compared with projects in the same category on other L1 chains, which implies that these projects may be undervalued. Along with the token offering and future development of Arbitrum, there will be plenty of room for improvement.

Table 3. Summary of . Arbitrum ecological high-quality project information (compiled by Huobi Research)

5.1 DeFi

There are already well-known projects deployed on Arbitrum with multi-chain deployments, such as Uniswap and AAVE, but instead, Arbitrum's native projects have exhibited stunning momentum, such as the perpetual contract exchange GMX, revenue aggregators for derivatives and the vault Jones DAO. Arbitrum has found the holy grail for sustaining a lucrative model: derivative protocols are similar to casinos with ongoing business revenue; various types of revenue aggregators adopt tactics to lure more capital inflow and expand the revenue streaming; therefore, as more people jump into revenue aggregators, more liquidity is available, thus creating more revenue.

5.1.1 Trending Project 1: GMX

GMX is a decentralized perpetual contracts exchange. Users are provided with options to trade ETH, BTC, LINK and UNI perpetual contracts with up to 30x leverage on a decentralized platform rather than shoring or longing with leverage on centralized exchange, such as Binance or FTX.

In terms of execution, it is more complex than that on centralized exchanges, and price feeding is needed by oracles. Therefore, external forces will engage to perform opening and closing; Keeper (similar to crowdsourcing) serves as the external force to help GMX with these functions.

When a user performs a close action on GMX, it is divided into two parts: one is to send a transaction, and the other to execute, which is done by GMX Keeper.

In addition to the Gas fee for sending the transaction, the sender is required to pay a Gas fee to Keeper for executing it.

TVL of GMX has accumulated to $496 million, representing 27.53% of the TVL of all DeFi protocols on Arbitrum (date on Mar.20, 2023). The protocol generated $33.9 million in revenue over the past year, making GMX tokens one of the best assets in the volatile 2022, returning 84.0% in USD and 428.5% in ETH.

5.1.2 Trending Project 2: Camelot

Camelot, as Arbitrum's native DEX, has completed token sales in December 2022, which is a regular Uniswap V2 + Curve type of DEX overall but with more features available, such as adding Launchpad, incorporating custom transaction fees, combining LP with NFT, and allowing project parties to set incentives. A brief conclusion of the features is as the following:

（1）The same AMM DEX as Uniswap V2 with liquidity dispersed over the entire interval from zero to infinity.

（2）Similar stablecoin trade pairs to Curve.

（3）Support dynamic targeted transaction fees. Camelot allows project parties to set the percentage of transaction fees based on market conditions and specific protocol requirements.

（4）Provides revenue and incentives through NFT. Users providing liquidity will receive spNFT representing staking positions.

（5）The protocol is license-free and project parties can set incentives through the incentive pool of Nitro Pools. These are additional incentive pools.

（6）With Launchpad, project parties can benefit from many operations, not limited to raising funds and guiding liquidity.

The project with highest TVL on OP is Velodrome, with $77.14 million in liquidity. This figure even surpasses Uniswap V3, which is currently at $44.87 million, but with an FDV of only $9.46 million and an FDV/TVL of 0.21. Relative to Camelot, Velodrome has a higher TVL, but a lower valuation.

5.1.3 Trending Project 3: RDNT

RDNT, a lending protocol on Arbitrum, has two major innovations: multi-chain lending with LayerZero and revolve lending (unavailable for now). It is currently the leader of the kind on Arbitrum, with higher TVL than the Arb version of AAVE V3, but the competition in the long run will still be intense.

Since it is an all-chain lending protocol, users can deposit any major asset on any major chain and borrow various assets with different underlying assets across chains. Here is how it works: the lender deposits the assets, then the borrower can choose to borrow; 50% of the fees (platform revenue) goes to the lender, and the remaining 50% will be in the form of RNDT as a reward, but locked. The protocol is currently in v1, while v2 will make the following upgrades:

（1）Full cross-chain lending will be enabled for BTC, ETH and USDC, followed by additional assets voted on by Radiant DAO.

（2）Fee structure will be more centered toward LPs, thereby increasing liquidity and reducing slippage.

（3）Introduction of the "Dynamic Liquidity" mechanism, which is promising for long-term investors.

（4）Withdrawal from the liquidity pool will trigger a penalty.

5.2 Gaming

Arbitrum has a booming GameFi ecosystem, especially prominent on three trending projects: Treasure DAO, The Beacon, and Trident DAO. The GameFi eco on Arbitrum does not have the absolute advantage as the derivative sector compared to other chains, on the contrary, it is merely a temporary comparative advantage; the future development depends on the performance in the next.

5.2.1 Treasure DAO

Treasure desires to build a "decentralized Nintendo," a series of on-chain games that are interconnected through the interoperability of in-game assets and Treasure's native token, MAGIC, as a shared currency. Some of the most popular games include the strategy game Bridgeworld, The Beacon and Smolverse, as well as the resource management and strategy game Realm.

These games can be accessed through Trove, which is the hub of the Treasure ecosystem, and the marketplace for in-game assets and treasure NFT collectibles. The most popular collections are Smol Brains (the basis of the Smolverse) and The Lost Donkeys, which is also the name of the game.

5.2.2 Trident DAO

Arbitrum's latest project, Trident, proposed a sustainable GameFi economic model of "Risk to Earn", which stimulated the interest of players and communities, and became the most sought-after project in the Arbitrum eco after its public offering of tokens.

PSI is Trident's official utility token that can be used to purchase items, redeem NFTs, and place bet between players, etc. Trident will charge a fee for each successful bet and then destroy it permanently; once the integration of Risk to Earn is completed, the supply of PSI will see deflation.

Chapter 6 — Future Development of Layer2

6.1 Bottleneck and Prospect of Rollup Solution

Rollup is a highly anticipated expansion solution, and its transaction gas consumption is greatly reduced compared to the Ethereum mainnet. According to actual statistics, the cost of Optimism and Arbitrum is only 10%-30% of the Ethereum mainnet, and the cost of ZK rollups is less than 5% of Ethereum. On the one hand, it reduces the consumption of resources on the chain, and on the other hand, it can maintain the availability of data, that is, the main network of Ethereum can check and ensure that no one can tamper with transactions under the chain. Rollup can inherit the decentralization and security of Ethereum , has become the mainstream technical solution of Layer 2.

At present, there are still some shortcomings in the Rollup technical solution, which prevents it from developing on a large scale. These shortcomings include the following points:

-Poor user experience

It is manifested in (1) There is a challenging period for OP withdrawals. Currently, the withdrawal waiting period of the official cross-chain bridges of the four major OPs is 7 days; (2) The interoperability between Rollups is low, and some assets supported by cross-chain bridges The types are very limited; (3) OP lacks cost advantages. According to l2fees data, OP’s ETH transfer, token transfer and token exchange fees are all higher than 1$; (4) The recharge steps are cumbersome.

-Low capital efficiency

It is manifested in (1) the problem of liquidity fragmentation reduces capital efficiency, and different Rollup platforms and applications built on them will further fragment liquidity. (2) OP's challenging period reduces capital efficiency.

-Potential security risks

Both Layer 2 and Rollup are relatively cutting-edge technologies, and many users have doubts about its security, mainly in the following aspects:

(1) There are loopholes in the smart contract of Rollup itself, which leads to the theft of user funds;

(2) Rollup’s The operator fails or does evil intentionally, resulting in the freezing of user funds;

(3) the cross-chain bridge is attacked or the operator does evil, resulting in the theft of locked funds from users.

From the above three aspects, we can look forward to the key directions for the future development of the Rollup solution:

(1) To improve user experience, wider use of fast cross-chain bridges and more convenient exchange deposits and withdrawals can reduce the impact of the waiting period for OP withdrawals, reduce the amount of uploaded data and improve off-chain processing efficiency to reduce costs.

(2) To improve capital efficiency, capital efficiency can be improved by gathering liquidity.

(3) Improve security by promoting the decentralized operation of Rollup and setting up a mandatory withdrawal mechanism to ensure security.

6.2 The continued outbreak of Arbitrum in 2023

The success of Arbitrum bodes well for Layer2 to be the starting point of the next bull market. But before that, technical challenges remain in both Optimistic Rollup and zk Rollup. In the future, Arbitrum will see major developments from 3 perspectives:

(1) continuous technical upgrades;

(2) continuous support to ecological projects;

(3) attracting users utilizing their expectations on token offering.

First of all, Optimistic Rollup is still criticized by semi-centralized sequencers. Arbitrum currently has centralized sequencers and whitelist proof verification, along with scalable contracts. While these do not pose threats on security at the moment, and competent in protecting user assets, the risk of censorship and loss of user funds remain rising concerns. As a result, decentralized sequencers and proof verification without permission are the ultimate solutions. Offchain Labs has also provided the appropriate technical routes addressing these issues:

（1）Continue to reduce costs and improve tps；

（2）Decentralization；

（3）Decentralize of the management and licensed software upgrade；

（4）Decentralization of validators ；

（5）Decentralization of sequencers；

In terms of the eco, Defi, cross-chain bridging and gaming categories are Arbitrum's signature applications. However, in the future, as the developer community and user base continue to pop up, more new applications will be deployed on the platform, and the most anticipated are projects in the social and NFT categories. In the meantime, provided that the success of Treasure and the growth potential of Arbitrum Nova, Arbitrum is destined to find its favorable position in gaming.

In terms of the tokenomics, it cannot be more anticipated, as the token offering is critical to the long-term success of Arbitrum, including (1) the token distribution plan, (2) the airdrop and incentive plan, and (3) the rule of governance. A good economic model will lead Arbitrum to a more positive direction, which is appealing to developers and users. Token distribution is also crucial in determining the governance of L2 and the long-term concentration of power within the ecosystem. In addition, tokens can also be applied to decentralize key network functions, such as sequencers - the entities that sort, bulk-process, and submit transactions to L1.

From the above analysis, it is eminent that 2023 will be a year of continued booming era for Arbitrum: The Odyssey event may be extended; current DeFi and gaming will be strengthened, as well as distinctive native applications in social and NFT sector are expected to emerge. At the same time, the anticipated tokens will be in place to reward users and protocols, and Nova will see practical initiation and protocol deployment.  

References：

1. https://candydao.notion.site/Arbitrum-Odyssey-17634b06aa084a3a8407d212927e5f16

2. https://www.bitance.net/category/jingzhengbizixun/18081.html

3.https://mirror.xyz/0xB10DF4c0D1C767b3cEdd911a30E78d2bfdFb5888/prNC3wNLuAUi2imlVFuibvxc151x8cT3kTdWOtkFhXM

4. https://newsletter.banklesshq.com/p/arbitrum-is-mooning

5. https://norswap.com/bedrock-vs-nitro/

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