Arbitrum: What You Need to Know

The essentials of this trending Layer 2

In crypto, there are seemingly infinite projects, all of them vying for your attention (and money). Every so often, one of those projects captures the zeitgeist, filling our feeds and dominating the conversation. Recently, that project has been Arbitrum. Let’s take a look at what Arbitrum is and why it’s getting so much attention these days.

What is Arbitrum?

Arbitrum is a Layer 2 optimistic rollup for Ethereum, first launched in 2021. It is the most popular rollup, with a 67.1% market share,3.9 million users and $6 billion TVL, according to Arbitrum. DefiLlama pegs the TVL figure much lower at $2.2 billion -- or $3.65 billion, if borrowed and staked tokens are also counted.  

Arbitrum is developed by Offchain Labs, led by former White House CTO Ed Felten and his PhD students Steven Goldfeder and Harry Kalodner. Since March 2023, governance is controlled by the Arbitrum DAO.

Ok, but what does “Layer 2 optimistic rollup” mean?

Let’s break it down, word by word.

What is a Layer 2?  

Think of a blockchain. You’re probably thinking of a Layer 1, like Ethereum, Bitcoin, or Aptos. Layer 1s are blockchains which can validate and finalize transactions on their own, the base levels of blockchain ecosystems. Layer 2s function on top of them as scaling solutions that improve transaction speed and throughput.

Ethereum in particular has numerous Layer 2s, as it has significant scaling challenges for such a popular blockchain. Even after The Merge, in which Ethereum was upgraded from a Proof-of-Work consensus mechanism to cheaper, greener Proof-of-Stake, it is still only seeing throughput of 20 to 30 transactions per second.

What is an optimistic rollup?

Rollups are the most common type of Ethereum Layer 2. They make Ethereum faster and cheaper by processing a bunch of transactions, then executing them together on Ethereum as one single transaction. There are two main types of Ethereum rollups: optimistic and zero-knowledge.  Since these rolled-up transactions are happening off the network, they must be verified as a batch when the rollup transaction is processed on Ethereum.

Optimistic rollups optimistically assume that nobody is trying to lie. They submit all of the transactions to Ethereum without verification. But users stake ETH in order to use the rollup, and can contest transactions. If they are caught submitting a fraudulent transaction or incorrectly contest a valid one, they lose their staked ETH.

‍Arbitrum is the most popular optimistic rollup, followed by Optimism. While Arbitrum is the most popular optimistic rollup today, Optimism actually came first (hence the name). Arbitrum made some crucial improvements to the tech stack, namely handling the fraud proof off-chain, using its own Arbitrum Virtual Machine for validation, and its own permissionless bridge.

Zero-knowledge rollups, in contrast, use a special type of mathematical proof to verify the transactions independently. (We discussed these in detail in our Zero Knowledge 101 article, so check that out if you haven’t already.)

Arbitrum currently offers two parallel chains: Arbitrum One and Arbitrum Nova. Arbitrum One is the original rollup L2. In August 2022, Arbitrum Nova was introduced, using a newer rollup technology called AnyTrust. Arbitrum Nova further reduces fees by only posting a data availability certificate to the L1, rather than the complete data set. These certificates are produced by a data availability committee of just a few members, including Infura, Offchain Labs, Google Cloud, and Reddit. This makes Nova a more centralized option compared to Arbitrum One.  

(For what it’s worth, Arbitrum Nova handles just 1.2 transactions per second, despite its massive market share. Aptos, for example, sees 6+ TPS. Remember, market share and TVL statistics don’t necessarily indicate widespread usage.)

How does it work?

A single Arbitrum transaction can be analyzed into five steps. (This process is generally  the same other optimistic rollups.)

1. Users send their transaction to an Arbitrum node using the Arbitrum Bridge, or connecting their wallet to the Arbitrum chain. The node then sends their transaction to the Sequencer, which collates the batch.
2. The Sequencer posts the transaction batch to Ethereum. This ensures that all of the transaction data is publicly available, just like a normal Ethereum transaction. Once the transaction reaches finality, it can not be reversed or altered. However, it has not yet been confirmed. Confirmation occurs later, which is why  transactions occur quickly on rollups, but withdrawals are slow. (See Step 4)
3. With the data posted to Ethereum, validation occurs off-chain on Arbitrum. The validators post an assertion containing the results of the transaction batch to Ethereum. In this way, Ethereum only has to process the net results of the transactions instead of the transactions themselves, reducing computational workload to improve speed and costs. Validators post a stake with their assertion, which is their incentive to validate honestly.
4. A challenge window begins in which any validator can challenge the authenticity of the assertion and post a fraud proof if necessary. Successful challengers receive a large reward, which is taken from the validator’s stake. This is the incentive for both parties. Only one honest validator is needed to prove fraudulent assertions. Because of this process, withdrawals from Arbitrum can sometimes take up to a week. However, you can speed this up with a fast-bridge application.
5. The batch is confirmed. In the rare event of fraud, a correction is confirmed on Ethereum alongside the batch.

Why did it blow up recently?

Short answer: Arbitrum launched their ARB governance token via public airdrop.

Long answer:

On March 16, 2023, Arbitrum announced the launch of a new governance DAO, as well as a corresponding governance token: ARB.

While the shift to decentralized community governance was certainly interesting, the market focused their attention on the ARB token itself, which could be claimed starting March 23. This delay period was designed to give users “the option to delegate their tokens during the claiming process, but we also wanted there to be a fair and open process in which a diverse set of community members can nominate themselves to be delegates.”

During this interim week, Crypto Twitter went into “a kind of frenzy, with people speculating about the token’s eventual price on the open market.” Individual airdrop eligibility was determined by a user’s past activity and participation on Arbitrum, which led to power users bragging about their expected payout. The crypto hype machine was operating at full force.

Of course, scammers took advantage of that hype. Soon, Twitter was flooded with fake accounts impersonating Arbitrum, phishing links for fake airdrops, and other scams. According to one analysis by De.Fi, more than 10,000 people fell victim to these schemes.  The sheer quantity of spam even broke Twitter’s content moderation algorithms, causing the actual Arbitrum account to be temporarily banned!

Then, it got even worse. On March 23, the day of the airdrop, the feeding frenzy overwhelmed Arbitrum’s website and block scanner, preventing users from claiming their ARB tokens. Nonetheless, 23,000 individual wallets were able to claim 42 million ARB in the first hour by interacting with the smart contract directly. Eventually, the site came back online and the rest of the 625,000 total eligible wallets were able to claim their ARB.

56% of the total ARB supply was designated for the community, with the other 44% reserved for Offchain Labs team and investors. This airdrop represented the first 12.75% of the community allocation. Each wallet’s allocation was calculated based on the number, recency, and value of their Arbitrum transactions, as well as the amount of funds they’d bridged. The minimum airdrop amount was 625 tokens and the maximum entitlement was 10,250 tokens. The vast majority of recipients (about 445,00 wallets) received small stakes of fewer than 2000 ARB.

However, those figures are just per wallet; once wallets were aggregated across entire organizations, some ended up with very large holdings. The decentralized exchange GMX was the largest recipient with 8 million ARB tokens. Interestingly, the FTX bankruptcy estate received 33,125 ARB.

The ARB token debuted around $11, but plummeted within minutes to just above $1, where it has stayed since. At time of writing, ARB is trading at $1.21 with a $1.5 billion market cap.

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The  governance scandal Following this airdrop, the Arbitrum DAO is now operational, and every ARB holder is a voting member. The story of this DAO, however, began with a scandal.

On March 28, Arbitrum Foundation introduced AIP-1 (Arbitrum Improvement Proposal no.1). It laid out the structure of the Foundation and its Security Council, and their governance powers. Two of the AIP’s many points were:

• the Foundation would be able to distribute Special Grants without having to go through the AIP voting system;
• a Foundation-controlled wallet (separate from the DAO treasury) would be created and funded with 750 million ARB to cover Special Grants, operational costs, and payments to service providers.

130 million ARB’s worth of votes were cast,  with 77% against the proposal. So imagine the DAO’s surprise when the Arbitrum Foundation announced that it had actually already taken the tokens from the Treasury, and even spent some of them!

In a forum post, the Foundation stressed that the vote hadn’t been a true proposal but a ratification. It had called upon the DAO to approve the decisions retroactively taken by the Foundation.Indeed, in the “Steps to Implement” section of the AIP, it says “Ratification of funding the Administrative Budget Wallet.”

The Foundation admitted that communication on its part had been poor. For example, in the tokenomics documentation, both the DAO treasury and administrative wallet were lumped together under the label “DAO treasury”, so the community didn’t even know that the special wallet existed.

On April 5, the Foundation announced that it would not move any of the remaining 700M ARB into the Administrative Budget Wallet. It also posted two new AIPs designed to impose  restrictions on the Foundation’s spending, including a token lockup.

In response, the DAO submitted a new proposal (AIP 1.05), which would return those 700 million ARB to the DAO Treasury. The authors stressed that control over Arbitrum has been given to the DAO, and the DAO should have the power to reverse decisions made unilaterally by the Foundation.

At the time of publication, 61% were against the proposal. However, the voting period will run until April 15, and we will update this article when we know the  final result.

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