Metis: A Small Cap ETH Beta Trade

Introduction

Although Metis is one of the longest standing Ethereum L2s, the protocol has struggled to attract developers and users. Currently with approximately 0.5% market share relative to leading L2s including Arbitrum and Optimism, and secularly declining TVL and fees, the team is executing a large-scale plan to revive the declining ecosystem. This plan includes decentralizing its sequencer, deploying over $180M of funds for ecosystem development, partnering with OKX as the first of many centralized exchanges to help onboard users, as well as deploying two LST solutions on top of its sequencer to enhance capital efficiency. These initiatives are designed to start a flywheel that will accelerate the growth of the ecosystem. 

This report examines the implications of the decentralized sequencer, as well as future catalysts and risks. We believe the ecosystem incentive fund could lead to a 4-5x increase in the number of network transactions, leading to a similar increase in other network KPIs such as fees and TVL. It is likely that the increase in sequencer pool fees, when combined with sequencer mining incentives from the foundation, will create a wealth effect for METIS stakers who could very well recycle profits back into the Metis ecosystem. These developments should position Metis for growth over the next few quarters. On a relative basis, the valuation of the METIS token is in-line with other L2s when one compares metric KPIs. With no more investor unlocks, the only new supply that is yet to hit the market is a linear 2.7%/year unlock through 2031 for ecosystem incentives. In turn, the planned protocol initiatives should be constructive for the token over a 3-6 month time horizon. 

Catalysts

Decentralizing the sequencer is a massive leap for an L2 because the team is necessarily reducing their own value capture: instead of all fees going to their treasury, fees are split in proportions to one's stake. With that said, it is clear that this is the direction that all L2s will eventually go, as for a rollup to asymptotically approach Ethereum’s level of security it must have a fully function fraud-proof system and a decentralized sequencer (or block producer). 

Metis appears to be making this change in what could be a final effort to grow the ecosystem before the team runs out of funds. By utilizing token incentives from their linearly-unlocked transaction mining fund, the team is subsidizing a 20% APY for sequencer node operators, over the next year, in the hopes to attract capital. Although the Metis Foundation will no longer collect 100% of the sequencer revenue, they are making a bet that the overall size of the pie will grow when they allow ecosystem participants to benefit from the growth of the network. By giving others a share in the revenue, they will theoretically be economically aligned with the foundation, and incentivized to participate in the ecosystem to earn rewards as well as growth the value of the METIS token.

Synergies with Metis LSTs will Unlock DeFi Growth