Arbitrum (ARB)

What's the Purpose of Arbitrum? 

Arbitrum is a project that aims to scale Ethereum.

Why does Ethereum need scaling?

The blockchain has become very popular in recent years with thousands of dApps being built on top of it.

The problem is that the network is relatively slow. It is not able to handle more than a maximum of 119 transactions per second (TPS).

And this is the theoretical maximum.

In reality, the number is more like 20-40 TPS.

That is the capacity for all dApps built on Ethereum.

As a comparison, Solana is in theory able to handle up to 65,000 TPS.

In reality, it has recorded a TPS of over 7000.

Limited capacity and high demand has resulted in very high fees on the Ethereum network.

In the end, this makes the network expensive and less user friendly.

But why do we have to build something on top of Ethereum? Why can't we just expand the TPS on the blockchain itself?

There has been made attempts, but it turns out to be challenging.

A very relevant problem in crypto to mention here is the blockchain trilemma:

 

The perfect blockchain would have three features: it would be secure, decentralized, and scalable.

Unfortunately, a simple blockchain architecture (like Ethereum or Bitcoin) can only have two out of three. 

Ethereum is secure and decentralized, but it struggles when it comes to scaling.

As high security is especially important for dApps like decentralised exchanges, Ethereum is still the first choice for many platforms.

But the problem remains.

There are two ways to solve them:

1. Upgrading Ethereum.
2. Layer 2 scaling solutions.

Though there have been attempts to upgrade the Ethereum chain, and there is a plan for Ethereum 2.0., scaling it by L2 solutions seems like the more viable solution, at least in the short term.

Arbitrum is an L2 that aims to do this scaling.

Let's see how it works!

Arbitrum, in Simple Terms

Arbitrum aims to give us the best of both worlds: the security and decentralization from Ethereum, and the scalable capacity from their optimistic rollup solution.

The optimistic rollup is basically the main offering of Arbitrum and how they're going to scale Ethereum.

Rollup technology

Before I explain rollups, let's take a look at the problem and why rollups are even needed.

Earlier I discussed transactions per second (TPS).

This is just how many transactions that can be handled by a blockchain per second.

If Ethereum is a highway, the TPS is the number of cars it can handle per second.

There are several ways to increase TPS.

One type of solution seeks to increase the number of cars that can be handled by the road, for example by building more lanes.

Another seeks to compress data so that the transactions require less processing power.

This approach would be like building buses (where one bus can handle 90+ people) instead of cars that normally handle 5 passengers (transactions).

A rollup is an example of this approach.

The concept is basically just bundling transactions so that they take less space.

The Ethereum Organization visualise it like this:

 

Let's say you use Arbitrum for running your app.

You need to run 1k transactions a day.

Instead of sending each transaction to Ethereum which would lead to 1k transaction fees, you bundle them all up.

You "roll them up" in a box let's say, and send the box to Ethereum.

This box only counts as one transaction.

And the fee is divided between the owners of the 1k transactions or possibly 1k users.

The process leads to way lower fees and less traffic on the Ethereum main chain.

Now, there are two kinds of rollups:

• Optimistic rollups.
• Zero-Knowledge rollups.

Polygon, another layer 2 on Ethereum uses ZK-rollups.

Arbitrum on the other hand, uses optimistic rollups.

Optimistic rollups move computation and storage off-chain. The transactions are bundled and submitted to Ethereum.

Without getting too technical, the "optimistic" part means that rollups don't publish validity proofs on-chain.

In other words, they don't contain a validity proof because they assume that nobody is trying to lie or double-spend.

However, if someone suspects fraud, there is a time window from a rollup is submitted to Ethereum where anyone can challenge it by posting a fraud proof.

The idea is: if anyone can prove that a bundle was fraudulent, it will be re-executed and invalidated.

The sequencer responsible receives a penalty.

If you want to read more about optimistic rollups and their security, I recommend ​this​ article.

Tokenomics

The ARB token has a cap of 10 billion tokens and the inflation rate is 2%.

With 3,6 billion tokens in circulation, about 33% of ARB tokens are in circulation already.

The ARB token is used in two ways:

• For governance
• As a reward for validators

It is not used to pay fees, making it different from most tokens on similar protocols.

Arbitrum has received some criticism due to the ARB token's lack of utility beyond governance.

Still, as everyone investing in memecoins know: tokens without much (or any) utility can be desirable to a large number of people.

Therefore, the lack of utility is not a reason in itself to believe that the ARB token is worse off than any other.

The adoption of Arbitrum

Arbitrum is currently the largest L2 on Ethereum in terms of value locked:

At $4 billion, it lies about 0.75 billion ahead of Base which is second on the list.

When it comes to daily transactions, which is a measure of on-chain activity, Arbitrum is performing okay. 

It is doing better then Blast and Optimism, but is beaten by Base and Polygon: 

Future value of Arbitrum

Lets do a thought experiment to calculate the potential future value of Arbitrum. 

In this experiment, I'll create three scenarios where we compare the future potential TVL of the DeFi market to the previous top in 2021 where it was approximately $300b.

Scenario 1: The market reaches 75% of the top in 2022 or $225 billion

Scenario 2: The market reaches 10% of the top in 2022 or $300 billion

Scenario 3: The market reaches 130% of the top in 2022 or $390 billion

All the scenarios are quite sober if you take into account that the total TVL increased more then 10x from 2021 to the top in 2022. 

In comparison, an increase to 390 would just be about a 2.2X from the current TVL

Currently, the total TVL of the DeFi market is 178b and the total TVL of Arbitrum is 4 billion.

This equals about 2.2% of the total.

I'll assume that Abitrum manage to keep a market share of 2.2% in all three scenarios, in other words, that its TVL will be 4.95 billion, 6.6 billion and

The next step is to calculate what the market cap would be given the increase. 

The ratio between TVL and market cap has been the following in 2024: 

Except for in March when the market boomed, the ratio has been ranging from 0.38 to 0.59. 

A high ratio means that the market cap increases faster than the TVL, or that the TVL decreases faster than the market cap. 

A lower ratio means that the TVL increase faster than the market cap, or that the market cap decreases faster than the TVL. 

In a bull run, both will increase, but as the market cap reacts faster to changes in the market, the ratio will be higher. 

So, in our scenarios, we assume that the ratio is 1.00, in other words that the market cap is the same as the TVL.

Given a market at 225 billion, we get a market cap at 4.95 billion. 

Given a market at 300 billion, we get a market cap at 6.6 billion. 

Given a market at 390 billion, we get a market cap at 8.58 billion. 

The current supply of ARB is 3.5b and the annual inflation rate is 2%. 

If the bull run happens in 2025, the supply is roughly 3.6b

The potential price targets are:

Scenario 1: 4.95b / 3.6b = $1.37

Scenario 2: 6.6b / 3.6b = $1.83

 Scenario 3: 8.58b / 3.6b = $2.38

If the TVL of the total DeFi market increase to 2021 levels and Arbitrum keeps its current share of the market, the price will increase to $1.37 - $2.38.